The interest rate is the cost of the capital to purchase something that you would otherwise have to rent. Thus, in order to understand what you are “making” you have to understand what you would be paying in rent.
To help sort this out – assume two worlds. In one you rent and in the other you buy.
Lets ignore property taxes, income tax breaks, insurance (and anything else I forget or don’t want to calculate). You can add those in later.
In both worlds lets assume inflation is 5%, home
appreciation is 5% and interest rates are 5%.
WORLD 1:
On day 1, You buy a $100,000 house with a 10-year fixed rate mortgtage of 100% of the home value. Your monthly payment is 1060.66 per month for 10 years
After 10 years, you own a house worth $162,000.
WORLD 2:
On day 1, you rent a house with a 10-year lease at 1060.66 per month.
After 10 years, you own nothing.
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When you buy a house, you are using your monthly income to buy a durable capital good rather than burn it on an expense.
Another important thing to understand is that the useable life of the capital good is longer than the loan period.
This means you are paying a little more earlier in life to avoid paying rent later in life. In WORLD 1, after 10 years, your payment is zero. But in WORLD 2, you are still forking out rent, and your new lease payment will be higher due to inflation.
Even if the value of the house stays at $100,000, you have used debt to finance the purchase of a capital good that retains significant tangible value at the end of the loan.
Now, in reality, your rent probably wouldn’t be the exact same as your house payment and there would be maintenance expenses involved in keeping the house up. Lets say in WORLD 2, your rent is only $500. This means you can put away $560 per month into an investment that earns 5% per month. Cool, huh?
Well, after 10 years, you would still only have about $78,000 in the bank – well short of the $162,000 house in WORLD 2.
Try this analysis with reasonable “real-world” rents, interest rates, house values and a 30-year mortgage.
This is why the interest rates, home prices, AND the rental market need to be considered when purchasing a home or an investment property.
