Saturday, November 04, 2006

"Body" -> The Confusing World Of Numbers

Today we are going to talk about houses. Your house will help your finances.

I work with a series of people who handle money, and get paid exceptional salaries. Every once in a while, I stumble across co-workers that are renting. This simply is a very silly strategy, but the reason they do this is because the numbers are confusing. I am convinced that many people that buy houses don't even understand why buying a house is such a good idea. They simply want to own something.

I personally have bought and sold 5 houses. I believe that most people should buy a house twice during their life. I am a special case because all of my moves where paid by my companies that hired me as an employee. Many times they spent mind boggling amounts of money to move me. However, in this post, I am assuming you will not be in my special case. In this post, I am assuming that you are getting out of college, and you know where you want to live.

To see why renting is a bad idea, we need to run the numbers.

To recap, my goal is for you to "be free" from worrying about money and get to the point where working is optional. Now, if you take that freedom to become "a man or woman a leisure," I personally believe that you will commit a sin. The reason to become free is to be able to follow the Lord where ever he leads you.

If you want to establish wealth, potentially one of your biggest expenses will be housing. So what are the strategies for you preserve your wealth when paying for housing.

So a couple of concepts:

In general, renting is bad.
In general, moving is bad.

The ways that home loans are set up, for the first 7 years of owning a home, 90% of your payment goes to simply paying interest. This sounds horrible doesn't it? You're paying a bunch of money, yet it all goes simply for interest! Yet, this will work nicely for you because the federal government has launched a massive program of subsidization to the rich. This program is called "mortgage interest deduction" from your income. This is the biggest bucket of free money that you can get to in most cases.

The tax rates work as the following in the USA as per a snip from Wikipedia.

* 10%: from $0 to $7,550
* 15%: from $7,551 to $30,650
* 25%: from $30,651 to $74,200
* 28%: from $74,201 to $154,800
* 33%: from $154,801 to $336,550
* 35%: $336,551 and above

Let say that you have eye set on living in Cary, North Carolina. You have saved, and you can buy a house up to $120,000 with $20,000 down. So you need to finance $100,000 to move into this house.

Now, a 30 year mortgage at 6.25% interest will force you to pay $616/month for 30 years to buy this house. I'd like to point out that Cary, NC, is a wonderful little town, and around $100-120K would buy you around 1000-1200 square feet in a duplex or condo with 2 to 3 bedrooms and 2 bathrooms.

Unfortunately, the local government will put some property tax on you, so your payments will be closer to $750 per month. However, if you make the average salary in the USA, you will have a take home pay of about $2100-2200 per month, depending on if you have some deductions for medical insurance and other options at work.

Now, here is the beauty of this. Remember that I said that the first 7 years was mainly interest? You get to deduct this from your income tax. You can also take out the property tax. So while you paid $9000 a year to live in your new house, the government will refund approximately $2000 to you (if you are making $40,000 per year.) So in "real" money, you are paying $7000 per year (at least for the first 7 or so years) to live in your house. This is about $580 per month.

To rent something in Cary for about the same square footage, you would have to pay around $150 more per month!

Unfortunately, you shouldn't plan on spending that $150 because you'll need it for things like lawn mowers, saving for a new roof, fixing broken facets. So in the short run you'll be about even.

So why move into the house that you own? There are two main reasons:

1. The house will appreciate in value every year 3%. In 10 years, the house will be worth $135,000. You will still be paying around $583 per month for your mortgage. Now lets say you need to the previously mentioned $150 per month for roofing and other house things.

2. The apartment will increase rent every year 3% (people do receive rent increases), and you'll be paying $978 dollars in rent per month.

So in ten years, you'll be saving over $200 per month! This will like giving yourself a $2400 raise in salary per year. This is a lot of money on a $40,000 salary, and it will be because you made a smart move today.

Let's review the facts one more time:

1. You are living in a house
2. You're out of pocket expense for this house is initially no more than renting, other than an initial down payment.
3. In 10 years, you will be pocketing an additional $200 per month.

Thus getting into a house will be a "no brainer."

Are there downsides?

The answer is yes, with the biggest downside being "the lemon." In an apartment, buying a lemon means that you move out. So before you buy that first house, you need to really think about what you are buying. There are many ways of buying a lemon.

a. The house has structural problems
b. The house has loud neighbors
c. The house has mold problems
d. The house has a bad roof
e. The piping is bad
f. There is no insulation and your heat bills are enormous

As few books as are on individual finance, there is even less on how to buy a house. All I can say, spend time educating yourself. There are two things that lead to financial ruin:

1. Picking the wrong spouse
2. Picking the wrong house

And often I see people doing both.

Now remember I said that moving is bad?

The main reason is the real estate fees and the increases in property tax.

Let's say in 10 years you want to sell the house. Unfortunately, for all practical reasons, you need to use a real estate agent. They will normally charge you between 6-7% fees to sell your house. The real estate agent takes $8000 in fees when they sell your house for $135000. So you don't make $35,000, you make $27,000. Thus they take 25% of your profits. It's enough to make you want to become a real estate agent.

Also, almost always, when you move, you will find out that the property tax goes up more than you expect. By in large, the government assessor tends to not raise taxes as fast as they could. If they did this, they would get angry citizens storming their office. Instead, they raise the property tax a little slower than is real. However, when you buy a house, they don't give you a break. They hit you with the full amount.

You can go the opposite on this. If you can find a house with a great outside and property, but a trashed inside, you should be able to get it for a bargain. In turn, if you fix up in the inside, then the tax assessor will simply not be clued in and not assess you aggressively as if you bought a perfect house from the get go. The fixer upper can be a bargain. My only words as why NOT to do this is split focus.

I've seen too many people thinking about their house at work. When this happens, the work suffers. The promotions don't come. The salary doesn't increase. So this is choice you need to make. Make sure to count the REAL cost of a bargain.

So the strategy is to minimize the amount of times you need to move.

If you want a good guideline, do the following:

1a. Get out of college and save every penny you can. If you are single, move into your parents house if they will let you. If you need to, rent a room. The whole goal is to work hard and save every penny you can for that down payment.


1b. If you happen to be married to a hard worker, congratulations, you hit the jackpot. You probably need an apartment, but it is much easier to save with two salaries.

2. Now plan on the following schedule, on AC (after college):

AC year 1 to AC year 3 = Save as much as possible for a down payment. If you are single, try for $500 per month. You need to invest it wisely! If you can do this at 10% interest in 3 years, you'll have $22,000. If you are married and you can save $1000 per month, you'll have $44,000.

AC year 4 -AC year 13 = Buy that first house. If you live in the right area of the country, you should be able to afford 1000-1200 square feet as a single guy. If you are married to a hard worker, you can probably afford 2000 square feet. About AC8 or so, if you are fortunate, plan to have the first kid.

AC year 14 - death = Buy that final house. Now is the time to be a bit more picky. You may have some kids by now, and you are probably busting out of that first house .

Can you afford a bigger house at your AC year 14?

Well you have a couple of things going for you:

1. You have the initial $20,000 you saved up for the first house
2. You have the increase in equity (remember you will sell your house for more than you bought it for)
3. You paid down the original $100,000 loan, on the first house, from $100,000 to $84,000.
4. Perhaps you have a better paying job
5. Perhaps you were able to save some more.

Now, remember that this is 10 years in the future, so if you buy a $200,000 house then, it would be like buying a $150,000 house now. So, the second house will be bigger, but not twice as big. Also, you will have your mortgage payment go up. You'll be paying closer to $1000 per month with taxes, but then again your salary should be going up over the next 10 years. The average salary should be around $55,000 in the USA. This will allow you to swallow hard and buy that bigger house.

If this is the final house that you buy, this is it. No more increases in housing costs!

With this final house, you know that you are never going to pay more for your monthly housing costs. As a matter of fact, by the time you are 65, you will have paid your house off. Life will be beautiful!

For the AC14 house, you really need to start thinking hard:

How big of a house do you need?

I am going to speak out of school, since I don't know you and I don't know your life style, but, as I read the Bible, we are to be satisfied with what we have. Buying dream homes is not the point of our life. Our dream home is in heaven and not on earth. However, you DO need a house. For example, with my family, I have four kids, a homeschooling wife, and they spend virtually every moment at home. In this instance, I do believe that I need a "farm house" of sorts. It is pretty big, and for our life style it is a really good idea.

Secondly, remember that a house is nothing more than a place to lay your head. Having a big house will not pay you a single dime. So while buying a house is a great deal, to be financially free you need to have an income source. Since we want you to get to a point where you don't need to work, you need to be saving money for your investment portfolio. So, with this second final house, you should be thinking hard and long.

In the perfect world, you want to be able to spot what you need early, buy it, and pay it off as slow as possible. Which brings us to point #2.

2. Pay it off as slow as possible.

To many people this may sound crazy, but this is extremely logical if you can do the following:

a. Limit your "free wheeling spend" budget.
b. You have good options about where you will invest your money.
c. You have the discipline to stick to a program.

3. Case example.
Now let's say you are thinking about 2 mortgages:

15 year (House bought in just 15 years!)
30 year (House payments a long time)

If you can swing the extra payments, doesn't the 15 year look a lot better?

By going to a mortgage website that determine your after tax impact, you can find out that "after taxes" you have the following:

15 Year:

Monthly Payment = $845
Total Payment = $152,000

30 Year

Monthly Payment = $616
Total Payment = $222,000

Man, if you can just swing a bit more every month (the extra $229 for a 15 year payment), then you can save $70,000. Sounds good doesn't it?

But look at it another way. Let's say that you sign up for the 30 year mortgage, and rather than spending that extra $229 per month, you put it into an investment that yielded 11% per year (the average of the S&P 500). You can use this calculator to see this.

In 15 years, you will have accumulated $104,000 dollars by just investing that extra $229 in a high yielding investment.

So at the end of 15 years (on your 30 year mortgage), you look at your statement at you'll see that you have around $72,000 left to pay. Because you want, for any reason you desire, to pay off your mortgage, you take your $104,000 dollars and pay off your mortgage. This will leave you with $32,000 more than if you decided to simply go with a 15 year mortgage.

Now this was a big long example, but there are shortcut ways of thinking about this.

I will tell you how to "do this quickly" and we'll bundle in a bit more tax impacts.

Take your interest rate on your house 6.25% for the 30 year mortgage. Now times it by (100%-your tax rate). In this example, it would be 6.25*.75%.

This is the marginal cost of your mortgage rate = 4.65%. This is your "real cost" of interest on your mortgage. In other words, after the government refunds some of your interest expense, you are paying 4.65% interest.

Now, you want to find out how much your investments will bring in. Now times the investment return rate times your (100%-tax rate). In this example, it would be 11%*.75%. (I have oversimplified this, since there are some investments like a 401K plan, where you don't get taxed, and you should really look at all the different things you can do, but the example I'm giving is about the worst case.)

So this is your marginal investment return rate = 8.25%

The difference is the "better off" rate = 3.6%. (Your marginal mortgage rate - your marginal return rate.)

So now we can plug this into our calculator to find our the rate for 30 years of outside investing your money.

If you go to the previous website, you'll find out that you are $55K better off in 30 years by using the outside investments.

For our example, this is worth 6 months worth of salary! (In 30 years, the average salary will be around $100,000 per year at historical rates.)

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