I’ve been talking to a lot of people lately about home values. Many homeowners have seen their homes fall in value and they talk about how much money they’ve lost, how they can’t leave the house to seize other opportunities, how they won’t be able to sell for decades. In all the discussions, it seems there’s one thing that people focus on – purchase price. It happens when markets are good, it happens when markets are bad, and in both cases I think focusing on the purchase price is incorrect.
When markets are good, people say they bought a house for $100,000 and sold it for $400,000, implying they earned $300,000 of profit. The reality is that they didn’t – they paid interest and taxes and insurance, they paid agent commissions, they paid for repairs, etc. We forget that because it’s not the headline number. I think the same is true when markets are bad.
When the housing market is down, people focus on the purchase price without adjusting for tangible factors that improve their situation. As I thought about it some more, the more I realized that there’s a range of values, below the purchase price, where you may still come out “ahead” of renters if you were forced to sell.
Here’s the basic idea – if your mortgage payment is close to the cost of a rental in your area, then owning a home puts you slightly ahead each month. A portion of your mortgage payment is returning to your pocket as equity. The portion disappearing forever, like interest and insurance, can be compared to your rent payment. The savings, the difference between the interest/insurance/taxes (disappearing) portion of your mortgage payment and your rental payment, is how much your home can fall in value and have you break even.
Let’s take a real life example with our living situation:
- Our mortgage is $1,400 a month with $1,000 in interest. Adjust our payment for the mortgage interest deduction and the cost of our housing is only $1,150 a month (assuming 25% tax bracket ). The extra $400 doesn’t go towards principal, some goes to taxes and homeowners insurance. Last I checked, we’re accumulating about $250 in equity each month.
- If we were renting, a two bedroom apartment averages, according to Rentometer , about $1,250 per month. There is no tax deduction for rent but we would claim the standard deduction, $11,400 for married filing jointly. Spread it across 12 months and rent falls to $1012.50.
With our mortgage payment, we are spending $900 that we can never recover. By renting, we would spend $1012.50 that we can never recover, a difference of $112.50. Each year, by owning, we come out ahead by $1350. As the years pass and rent increases, this difference will also increase since the mortgage payment will not change.
If our home’s value fell by less than $1350 each year of ownership, we as owners would be ahead of ourselves as renters. (plus we control our own destiny, a landlord can’t kick us out or raise our rents)
Warning… we’ve simplified the problem significantly because we haven’t discussed a lot of issues that complicate matters. We ignored capital losses (you can deduct $3,000 of capital losses each year, which is additional savings) and real estate agent commissions, which becomes tricky if you’ve lost a lot of equity in the home. My point was to introduce the idea that you can still come out ahead, or at least not as far behind as you think, if you are forced to sell your home for less than the purchase price.
This was just an idea that I had floating around in my head and I knew that if I wanted help in working it out, I could turn to the Bargaineering community to set me straight. I think the logic is sound, the math is only valuable as an example, so I’m curious what your thoughts are on the idea.
What do you think?
(Photo: pnwra )