Buying a house? Don’t fall for the myths

Myth 1: Interest and taxes are deductible. You are getting paid by the government to own a house

Lets walk through an example. You make $100K a year. Pay $6K in real estate taxes and $10K in mortgage interest. There are two types of deductions available when you file your tax returns, a standard deduction and itemized deduction. For 2011 the standard deduction is $11,900. Assuming you did not buy a house your taxable income = $100K – $11.9K = $88.1K. At a marginal tax rate of 35% you will owe $30.8K in taxes. So effectively you paid $30.8K out of your pocket. Now assume you took the itemized deduction and deducted the entire taxes+interest. So taxable income = $100K-$16K=$84K. At 35% tax rate, tax = $29.4K. So great right, you paid less tax, so less out of pocket?

Nope.

You forgot about the $16K you already paid in taxes+interest. So the total cash out of pocket = $29.4K+16K = $45K which is a good 19% more out of pocket if you have a house! The mortgage deduction is exactly that a “Deduction” not a “credit”. A deduction does not wipe our your tax obligation. The tax benefit only comes into play on the amount that is greater than the standard deduction. You are not getting a free ride, you still end up paying more out of pocket!

Myth #2 – You are owning an appreciating asset

House prices will always go up! The Case Schiller index shows how bad this recession has been for house prices. There a lot of ground to cover for prices to get back to just what they were before!

House Prices have to rebound a LOT to get to previous levels
Author: Juan Toledo

For followers of this myth, I always pose the question, why is it that for all other goods that we buy for personal use, we expect the value to always decrease, but when it comes to a house, we expect appreciation? What makes the house so special?

Myth #3- You are building equity.

The common line is – You are investing in yourself by putting money into your own house, If you rent you are throwing money away. To address this myth, lets first tackle what does “Equity” really mean. Simply put, it means you own the asset, in the case of the house you start off as a fractional owner (since you have a mortgage) and in the end you own the whole asset when you pay down the entire mortgage.

Huge myth again, you are ignoring the opportunity cost that is involved when you to have front the 20% down for your mortgage. If you had invested that  in alternative investments you are still building equity, just in another asset. Once you own your house outright, you still need to sell it to another person to actually convert your equity into cash. We all know that housing is an illiquid market (compared to say stocks) and every time you sell you are going to lose 6-7% in commissions. The only way you are going to make money is your house appreciates more than that. Think this is going to happen in the near future? See myth #2.

Renting has huge advantages. Typically the net $ out of pocket is less than owning a house.  There are also other qualitative advantages. In today’s tight job market. you can move at the drop of a hat to a new location in pursuit of a good opportunity. Renting makes you highly mobile.

Myth #4 – You are forced into saving.

There is some truth to this, having a mortgage will make you make sock away money into an asset (your house) by force. But isn’t this more about self control than anything else? If you can be disciplined enough to pay a mortgage, you can be disciplined enough to save.

In my opinion, for the house you want to live in, buy it because you need the space, like having a yard and/or just like the concept of a house. It’s not an investment, its a lifestyle choice. Real estate is only an investment if you are getting cash flows from it (rent) i.e its not your primary residence!

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6 thoughts on “Buying a house? Don’t fall for the myths

  1. As much as I didn’t want to comment, I had to, for the sake of a severe flaw in the first “myth.”

    The “standard deduction” of $11.9K is what any layman could receive.

    If you own a house, it would make sense to itemize your deductions to minimize your total taxable income. Hence, in this scenario the “itemizing your deduction” is only a perk for HOMEOWNERS (NOT RENTERS) to take advantage of.

    Using this logic, the difference between the standard deduction & the itemized deduction is the TRUE benefit of home ownership = $4.1K

    What do you get with this $4.1K “additional” that you’re paying out of pocket? A place over your head!

    This is where your argument fails. Here are the actual numbers that prove my point:

    Scenario #1 (for any laman): $100K – $11.9K (standard tax relief) = $88.1K. At a marginal tax rate of 35%, you will owe $30.8K in taxes + rental costs (which you’re also paying “out of pocket”).

    1) By being a renter, the additional rental costs you pay would be going toward nothing.

    Scenario #2 (for homeowners): $100 – $16K (standard tax relief + $4.1K in additional tax relief for itemizing/being a homeowner) = $84K. At 35% tax rate, tax, you will owe $29.4K in taxes + $0 in living/rental costs.

    By being a homeowner and paying $16K “out of pocket”, you generated two key benefits:

    1) An the additional $4.1K over the standard deduction that could reduce your taxable income and provide you with $1.4K in less taxes total.

    2) You get an amazing place to live in that you actually “own” (even if you don’t completely own the house yet, you can recoup a good chunk of money that you’ve put into the home i.e. paid off the lender with). $6K in real estate taxes means this house that you live in and partially “own” must be pretty huge/valuable = an estimate would be close to $300K!! Imagine how much rent you would have to pay to get a place that huge/valuable.

    • Basim, First thanks for reading! at least somebody reads this blog :). You have a point, on adding rent back. The focus of the post was not to just focus on the financial aspects (tax deductions/equity owning) as the primary reasons for buying a house. I can generate an equal gain (300$K) with a lower risk investment on the downpayment and saving the spread between renting and owning. The value of the 300K asset is still very illiquid (see myth 2). I live in texas where houses are dirt cheap, if you go to high value areas such as the bay area and NYC the large downpayment (lost opportunity cost) and the high monthly mortgage payment + insurance + Maint will typically be much higher than equivalent rent (spread higher).

      The point i am trying to make (which I believe you are making as well) is that in the end buying a house is a lifestyle decision, a lot of folks view it as in investment decision first and lifestyle second and these myths drive them in that direction.

  2. Hi. I just dropped by after clicking on a link you posted on a related post at another blog.

    In your tax calculations you seem to have conflated marginal tax rate with average or effective tax rate. Nobody who earns $100k in wage income pays thirty grand in federal taxes. They pay much less because the first $8925 is taxed at 10%, the next $27,325 is taxed at 15%, the next $51,600 is taxed at 25%, and their last $250 is taxed at 28%. So this hypothetical person is in the 28% marginal tax bracket, but they don’t pay 28% of their entire earnings in tax, just 28% on the next dollar they earn (marginal dollar). This person would actually have an effective tax rate of just below 18%, and pay $17,961 in federal taxes. Most states have similar progressive tax brackets.

    • Hey Andy! Thanks for the comment. Yes you are correct, I’ve assumed the marginal tax rate for simplicity. The main thrust was to show that you end up paying more taxes out of pocket. If we apply the effective tax rate method, you would still end up more taxes since the rate would apply to both scenarios. What do you think?

  3. followed the link from mmb. interesting.

  4. I do agree with you on your overall point that people should buy a home to live in it, as opposed to treating it an investment, unless it is a rental property or you’re paying full cash with no mortgage. I own a house too and I bought it to live in it.

    People who really want to invest their money, REIT is an overlooked aspect of real estate investing. I’ve talked about this on my blog. The recession of 2008-2009 provided a great opportunity to buy REITs, but apparently people were running away from them.

    http://www.buyandholdblog.com/a-primer-on-real-estate-investment-trusts-reits/

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