Home › Forums › Financial Markets/Economics › Some advice on home loan interest rate vs. typical home appreciation rate
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October 9, 2006 at 4:59 PM #7707October 9, 2006 at 7:13 PM #37521DoofratParticipant
I think you answered your own question, and no, your calculations are not wrong.
First, we have seen a very rapid and outlandish increase in home prices in the last several years. All the prior booms and busts pale in comparison to the one we are in now. Do not let that fool you into believing that the housing market always rises at 6-8%. That’s like timing the acceleration of a car and saying “it’s gone from 0-60 in 7 seconds, it’ll be doing over 500 miles an hour in 53 more seconds!”
Second, the ‘tax break’ that everybody cites, but not everybody truly understands is about equal to what you will pay in property tax. The break is a deduction equal to the interest (not principal) from what you list as your income, not a tax credit. If you are in say the 30% tax bracket and you payed $30,000 in interest on that $600,000 loan, you will get a discount of $9,000 from what you pay in taxes. This is equal to the property tax you will have to forever pay on that $600,000 house. Eventually, if you keep the house, you will pay less and less interest, so even this benefit will decrease over time.
Third, you keep talking about appreciation. Houses can be counted on for only two things: Shelter for you, or rental income from somebody else. They are not an investment by themselves (waiting for appreciation to happen) . They are a great asset to own as your primary residence since they can usually be counted on to keep up with inflation or a growing economy, or you may even be able to argue that buying them and renting them out is good business (not now though). But to buy them to count on appreciation is a bad bad idea. Houses just sit there, they don’t produce anything.
Think about it houses have to keep pace somewhat with inflation and the size of the economy because they have to be affordable to the people who are working in that economy (you and me). Currently we are in a phase where house prices have outpaced the economy and aren’t really affordable to the people in the economy (without using exotic financing) Do you really think housing prices will contiune to rise faster than the economy? They can’t do that forever. If you want something that paces the economy, why use such a risky and troublesome ‘investment’?.
My advice is to look up tulip mania (if you haven’t already done so) and try to draw some comparisons to the housing market.
October 9, 2006 at 7:58 PM #37524lindismithParticipantGreat post Doofrat!
I just finished Tulipomania and was staggered at the parallels between bubbles. It was fascinating!
October 9, 2006 at 7:59 PM #37525powaysellerParticipantdoofrat, your post brings to mind a conversation I had today with a realtor who says that there is no way that San Diego rental properties will ever be cash flow positive. He says this has probably never happened, and it never will. Home prices will not fall enough to be equal to 10x annual rent. I’m going to get some data on rents over the past decades, but in the meantime, do you have any comments?
October 9, 2006 at 9:11 PM #37535sdduuuudeParticipantThe 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 yearsAfter 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.
——————————————-
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.
October 10, 2006 at 9:25 AM #37576(former)FormerSanDieganParticipantpoway –
At the low point in SD house prices (’96), there were properties that could nearly cash flow with ~10-20% down.
The following is based on my personal experience at that time.
Example: Clairemont, 160K for a 3bed/1 bath.
20% down, 30-year fixed rate at 8.25% => 962 P&I
Taxes ~ 170/month
Insurance ~ 50/month
Total PITI : 1156Rent : ~ 1100
With repairs and other expenses (vacancies) you needed to count on the depreciation deduction to come out positive.
October 10, 2006 at 11:32 AM #37584DoofratParticipantOn that $100,000 house, the rent would not be $1066, with the present price to rent ratio of say on the low end in San Diego would be 25, so with that, the rent would be only $4000 a year right now, or $333 a month. The renter could use the excess of $733 a month and invest this. Plus, the renter could also use the money that he didn’t put down for a down payment and invest that in something else as well.
For the original poster:
There are alot of investments out there, and using housing (especially now) as an investment and waiting for appreciation is something that may look good when only a few factors are looked at. I know these real estate “guru’s” tout using leverage to purchase a bunch of properties and waiting for appreciation, and if I knew this market would continue to rise like it has for the last few years, I would be the first one buying up properties like crazy using as much leverage as possible. This market will not do that, it can’t, in fact it is just about impossible for it to continue like this. Consider all the possibilities before you invest in Real Estate.October 10, 2006 at 12:42 PM #37590sdduuuudeParticipantdoofrat – that is correct. It was just an example to show how important rent is when calculating the quality of the investment. You can’t just use the interest rate of the loan and the rate of growth of the house. By the way, I included no down payment in WORLD 1 – 100% financing was assumed to simplify the example. But if you do assume a down payment, of course you would have to look at the growth of that money.
i.e. your actual mileage may vary – do the numbers.
Also, as you say, if the asset you need is depreciating and you have an opportunity to buy later at a lower price, then do so.
October 10, 2006 at 10:56 PM #37663RottedOakParticipantI question the 7-8% figure even as historical appreciation, much less near future appreciation. I don’t have California-specific numbers, but I just did a calculation for a post on another site using Rober Shiller’s national housing price numbers. The total appreciation for 1950-2005 equates to about 5% per year, but most of that is inflation. Adjusted for inflation, the 1950-2005 appreciation is about 1.1% per year. If you take out the unusual increases of the last few years and use 1950-2001, it is closer to 4.6% unadjusted/0.4% adjusted.
Generally speaking, both housing appreciation and interest rates tend to track with inflation. Over the long term, investment in residential real estate is a great an inflation hedge, and if you want a diversified portfolio of investments then I think that’s a good thing to have. If inflation really takes off and you have loan already locked in with a low fixed rate, you win and the bank loses.
All that said, you are right that timing is important, because buying in at the top before a significant decline would create short-term equity losses so large that even the inflation-hedging aspect would be ruined. So I would suggest that now is not the best time to buy in California. Check back in a couple of years.
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