Now is the best time to buy. That’s the real estate agent mantra, regardless of what type of economy we’re in. Their incentive and livelihood is based on sales. Consider my alternatives below.
Case for saving instead of owing a mortgage
On a 30 year $300,000 mortgage at 5% interest, the payment schedule is as follows (Source: Wolfram Alpha calculation):
- Year 1: $4,426 principal paid
- Year 2: $4,653 principal paid
- Year 3: $4,891 principal paid
- Year 4: $5,141 principal paid
- Year 5: $5,404 principal paid
If you paid your mortgage over five years, your total principal payments would have been $24,515 leaving you with a loan amount owed of $275,485. If during those five years, you were able to save $20,000 a year, you would have $100,000 in cash. Had you bought a home in year five, then your $300,000 mortgage could have been $200,000.
Home ownership comes with additional costs: maintenance, updates, remodeling, repairs. It’s more than just the mortgage payments. Consider insurance, utilities, etc. These costs could have been saved in the bank instead.
Case against the tax deduction
What about the tax deduction? Isn’t the interest paid tax deductible? Going back to the payment schedules, let’s look at year 1. In year 1, you would have paid $14,899 in interest payments. The standard deduction in 2011 is $5,800. The difference is $9,099. Assuming you’re at the 25% tax bracket, that’s a tax “savings” of $2,274.75.
What does that mean? Lets say your 2011 income is $80,000. You would subtract away $14,899 from your taxable income. The remaining amount is taxed. We subtract away the standard deduction to make better comparison.
As a result, you’ve paid $9,099 to save $2,275. Sounds like a terrible investment.
What does this mean?
This is not necessarily an argument against buying a home. Instead, it’s just meant to shine some light on the not so great math. The interest deduction is simply a subsidy by the government on a really bad plan. You bear all the risk from home ownership, the bank eats all the interest. You’re not a home owner, the bank is until the mortgage is paid. Equity is only built when a home has appreciation potential. Equity is lost when a home is sold due to real estate commissions (6%). Additionally, expenses from operating and maintenance eats away from your equity.
Before you buy a home, consider alternatives, including renting and using the savings to build a stronger cash position. The quicker you can pay the mortgage, the faster you can remove the chain and shackle.