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With or Without Interest – Do You Know What You Paid

In housing, the rent vs. own debate has been going on for years. I don’t come down too strongly on either side. I’m currently renting because 1) the area is very expensive, 2) we’re focusing on debt repayment, 3) we’re not planning to stay here long, and 4) we really don’t need more than our 1-bedroom apartment, even if I’d like a sewing room.

One of the things that’s pitched about housing is that it’s an investment. Before the bubble burst, people were buying houses for $150k and selling them for $400k a few years later.

As home prices settle down, many are realizing that in most economic climates you’re not going to get a return like that, and it’s ok. Even so, one still hears it being talked of as an investment. Over the long run, it’s true that housing prices have climbed.

This weekend, I was thinking about the unacknowledged role that interest plays in the equation. Suppose that I buy a house for $150k, pay it off over 15 years and then sell it at $225k. That’s a nice appreciation in an average area during an average (bubble-free) person and it looks like a good ROI. Now let’s use a mortgage calculator to figure out interest.

According to Bankrate’s calculator, with a 15-year mortgage at 6% interest, I would pay an additional $77841.34 in interest. Adding that on to the original $150,000 brings the total to a little over $227,000, $2000 more than I sold it for.

If the house served me well, then it’s great that I’m getting most of my money back (not including taxes, repairs, etc) and that it served as a home—something we all need, whether it’s rented or owned. Yet it’s not nearly as good-looking an investment now that I’ve thrown in the interest.

With almost all other investment, interest doesn’t factor into the equation. If you buy a stock at $5/share and sell at $15/share, you know just what you made (though some people don’t factor in fees when talking about it). When talking about a house in terms of investing, you have to use the amount you actually paid, rather than the selling price.

For this example, I just came up with a set of reasonable numbers to make the math easier and opted to have the house paid off, for simplicity’s sake. But the point isn’t to say “don’t buy a home that costs $150,000 at 6% interest” or “don’t buy a home.” What I encourage you to keep in mind is this:

A home (not a rental property, a home you live in) is primarily a home. There are good reasons to own it, just as there are good reasons not to. If you choose to think of it as an investment as well, keep in mind what you paid for it, not just the selling price.

The same is true for anything which you pay off with interest. Cars, electronics, anything that you pay more than cash for. Keep in mind that, if there’s interest, the price on the sticker isn’t the real price.

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Miranda October 5, 2009 at 8:46 am

I agree completely. I am glad we bought, but I have no illusions that we will come out ahead once interest is accounted, even if we do get a tax deduction. I just figure that it’s nice to recoup some of the money paid in, and enjoy the fact that when we do sell, we’ll have a nice chunk of cash for another down payment.
.-= Miranda´s last blog ..Saturday Staples: Personal Finance Posts =-.

MrsMicah's Mom October 5, 2009 at 9:25 am

An excellent point. I think people do forget to consider the interest in calculating the cost of a house.

We bought a house to have a pleasant place to live and raise children, if we were blessed with any, which we were. We didn’t consider it an investment.

T'Pol October 5, 2009 at 11:55 am

Actually the negative difference is much more than 2,000 USD because 225,000 after 15 years is much less than 225,000 USD today.

mrsmicah October 5, 2009 at 12:06 pm

@Miranda & Mom homes make excellent homes indeed. 🙂

@T’Pol Excellent point, I hadn’t taken that into account. I see Vulcan is turning ’em out logical. 😉 (though I never got into Enterprise.)

Rachelle October 5, 2009 at 3:28 pm

I never thought about interest in buying and it is making me reconsider every sell price I’ve ever heard iterated to me.

I think what tips me over to the buying side is the non-monetary reason of “owning my own place.” It is ingrained in our society that owning a home is a dream, that when fulfilled, brings you one step closer to success.
.-= Rachelle´s last blog ..Why I love October =-.

plonkee October 5, 2009 at 3:45 pm

In the UK, house prices have historically increased at around 2% above inflation. I think that means that you can expect to at least break even on a house over the lifetime of a mortgage – of course, I’m never quite sure if I’d done the interest rates right.

In a more real life comment, it’s still commonplace for people over here to refer to renting as ‘throwing money away’. Does my head in. If you have a place to live, it’s not throwing money away. If you have money to throw, send it in my direction.
.-= plonkee´s last blog ..are you spending less for no particular reason? =-.

Kacie October 5, 2009 at 4:11 pm

Good job doing the math! I think a 6% interest rate might be a bit high right now (I’ve seen some 15-year mortgages going for under 5%), but STILL, you’re probably barely breaking even.

Property taxes add up to a lot of money you’ll never see again. And homeowners insurance. And repairs and general upkeep.
.-= Kacie´s last blog ..October outlook =-.

Simplelivin' October 6, 2009 at 9:32 am

Great post! I actually linked it in my post for today. Most people (myself included) forget about the interest part. Not to mention inflation over time, and the interest that could have been EARNED if they invested it.
.-= Simplelivin’´s last blog ..Oct. 5th Spending =-.

Wil October 8, 2009 at 8:38 am

Sorry, but I consider this upside down thinking. If you buy a house and live in it for 15 years sell it take away ANYTHING, you are ahead of renting, since you take NOTHING away from 15 years of rent. If you rented the same house for 15 years, the rent would probably be more than the payment since the landlord would account for property taxes, routine maintenance, and other fees. Additionally, the example didn’t mention the income tax implications of mortgage interest paid.

Renting does make sense to me if you are living in an area for a short period of time, don’t have an adequate down payment or have credit issues, but to me, that’s about it..

mrsmicah October 8, 2009 at 8:53 am

I think you’ve made a poor assumption, Wil, concerning whether or not renting is cheaper than a mortgage. For one thing, you assume that I’m talking about houses. There are many cases where it’s cheaper or about the same to buy the house, but there are also plenty of times that the price is actually lower than mortgage et. all. Renting a paid-off house, for example. Renting half a house or an apartment (sometimes one doesn’t need a whole house, heck I only need a 1-bedroom right now).

If we continue renting small apartments instead of buying a house, odds are good (depending on the area and the prices) that we’ll end up with a lot of extra money instead of equity.

I didn’t write this to say that renting is always better, as you seem to be assuming. I’m just asking people to consider everything they’re spending, especially on purchases where interest can nearly double the price of something.

All or nothing assumptions like yours are exactly what I’m trying to steer people away from. We’re conditioned to make those assumptions instead of doing the math on our particular situations.

Wil October 8, 2009 at 9:36 am

I did assume that you were talking about housing and comparable living accommodations in the same area. Obviously, if you “only need a 1-bedroom right now” you can probably rent that for less than a payment on a 4-bedroom ranch on a ¼ acre lot.

You may be able to rent for less that the payment + taxes + upkeep that I describe in some areas. Local economics, housing availability and other factors create some strange disparities, but my point was that situation is really not typical. There are some cases where the landlord does take an economic hit to keep an especially good renter. I have had one renter for more than 20 years. He has paid for the house TWICE in that timeframe, plus all the taxes and upkeep. Obviously, I want to keep him.

Certainly everyone should do the math and take advantage of unique situations in their area. I just felt like you were describing an atypical situation. For me, debt for a home is the ONLY acceptable (routine) debt. I don’t think that anyone should look at their house just as an investment, nor should they buy a lot more house than they need.

All I have to say!

mrsmicah October 8, 2009 at 10:08 am

Well, I wasn’t intending to compare renting and mortgage in the post at all. I only brought it up when I mentioned that I’m currently in an apartment. I’m not opposed to buying homes when people stay in an area, only asking them not to think of them as investments or to do the math when thinking of them in those terms.

So, I’m not really sure what your first comment was about after all because it seems that we agree for the most part. Math is important, renting is good when you can’t afford to buy, don’t need to buy, short-term, and ownership is probably better if you’re going to be somewhere in the long-term. But it’s important not to think of it as something you plan to profit from, just as a place to live and way to save money to apply to future living arrangements.

I wasn’t comparing it to renting but to investments (which is one way a lot of people talk about it)–in which barely breaking even or having ANY profit isn’t really the goal.

I’m glad that’s all you have to say because I’m really confused about what you were trying to disagree with in my post. 😉

Scott October 9, 2009 at 2:43 pm

Found your blog via FrugalDad today.

You’re forgetting another important aspect of this calculation. Most people remember to factor interest in (counts against you) but few remember to factor inflation in (helps you).

I wrote about this extensively recently following a post on Get Rich Slowly :

Here is an excerpt from the comment I left there:

But, we always forget to take inflation and Net Present Value of money into account when making these calculations. (Same applies to prepaying your mortgage)

Remember, a dollar today is worth more than a dollar tomorrow. Assuming inflation is 2% and you have a 5% rate on your mortgage, you’re carrying cost of the debt is really only 3% as you are using tomorrows dollars to pay off your obligation so it is cheaper for you.

Quick example:
$1800 / month payment
2% Inflation

Value in today’s $ of payment 1: $1800
Value in today’s $ of payment in year 30: $993

By spreading the payments out into the future you are actually saving yourself some money.

R.A.T December 30, 2009 at 5:03 pm

1) Mortgage interest deduction – which makes your effective interest rate something like Gross Rate * (1 – marginal tax rate). This effectively means that the more you make the more of a discount you get when you purchase a house (because your tax rate is higher).

2) In the US since 1950 the average annual inflation adjusted rate of return has been 1-2% (you can get house price indexes and CPI from the BLS if you want to do the math yourself). The number varries depending on when you stop the series: 2000, 2006, 2008

3) Inflation has run 3 to 4% over the same period.

4) Average mortgage interest over a similar period is about 7%

You can add 1 thru 4 together to see, as you pointed out, that in many cases the net effect is – break even or a little positive.

However, there are a few highly positive financial externalities from owning –
a) Lower insurance rates.
b) You can make infrastructure investments in an owned property that are impossible in a rental – i.e. heating and cooling system upgrades, energy/water efficient appliances.
c) Your cost of housing does not go up as the CPI goes up – so the longer you stay put the better deal you get.

These are real, tangible financial benefits of owning.

There are some slightly less tangible, but financial benefits as well:
i) modified risk profile – you now have an asset directly tied to the CPI.
ii) modified risk profile – your cost of housing is now 80% fixed
iii) modified risk profile – real estate is only loosely correlated to other assets
iv) forced savings – we like to assume we are rational when we make our financial plans, but for the stark majority of people, a forced savings plan is better

People like to assume that buying a house is a simple investment – and shudder at the complexity of CDOs, Options, Futures, Swaps, Etc. But, the stark fact is that the economics that underly valuation of derivatives is MUCH simpler than the economics that underly house values.

House values are insanely complicated derivatives. To get fundamental house prices you have to look at the intersection of wages, interest rates, tax policy, population density, mortgage structures/leveragability – and then you have to forecast all of those things forward and figure out the correct way to discount them.

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