Photo by Rev Dan Catt

The problem for me when it comes to home buying though is that I hate carrying a large mortgage. I was always brought up to pay my debts in their entirety and to not have any financial obligations hanging over my head. For example, I always pay my credit cards on time. I rarely if ever borrow money from friends. Hell, I won’t even borrow money to buy a car unless the finance rate is at or below the interest rate I can get at a bank.

All of these ideals are further reinforced by all of the frugality and personal finance blogs that I read on a regular basis. But principles aside, it looks like I’m going to have to bite the bullet with the house since I simply don’t have enough money to buy a home entirely in cash.

Our Situation

Speaking of cash, my wife and I are in fairly good shape. Because of our frugal ways and our online business, we have managed to save at least what I consider to be a decent amount of cash. And having this nest egg of money has allowed us to sleep very soundly at night. If I were to ever lose my job, we could survive pretty much indefinitely on our online business income at our current burn rate. If I were to lose my job and our business went under, we could still survive for a decent amount of time as well off of our savings.

But when you factor in the cost of the new house into the equation, our financial situation definitely worsens. That’s not to say that we are going beyond our comfort zone with this new house, but the size of the down payment will put a huge dent into our nest egg and introduce a fairly hefty mortgage payment as well.

The Question

If everything continues to go smoothly with both my job and our business, we can easily afford this house. If I lose my job for an extended period, our business can still pick up the slack for a very long period of time. But if I were to lose my job and our business went under, we might be in a bit of a bind. We could still survive for a reasonable amount of time but it would definitely be stressful.

By the way if you haven’t noticed, I’m more concerned about losing my day job rather than our business going under. That’s not to say that I’m insecure about my job, but I’m not 100% in control over my day job like I am with our online business. The likelihood of our online business suddenly making zero revenue is pretty close to nil. If anything bad were to happen to the business, it would happen gradually over time and we would be able to see it coming and adjust accordingly. With my job however, the executives and the board of directors might suddenly decide that the project I’m working on is no longer worthwhile and lay me off at a moments notice. This is a very important distinction and one of the main reasons having our own business is more stable than my day job.

In any case, I’m left with a very difficult decision. Do I borrow more money and maintain a larger nest egg or do I borrow less and have a much smaller monthly mortgage payment?

The Case For Borrowing More

We are currently in a unique situation living in this depressed economy. Interest rates for mortgage loans are at rock bottom. And while it’s still a bit difficult to get approved for a loan, once you do it’s a major bargain to borrow money right now. In fact the interest rates are so low that it is highly unlikely that rates will be this low again for a very long time. In addition at the rate the US government is printing money, it seems that higher inflation is inevitable making it extremely favorable to take out a larger loan.

The other thought I had in regards to taking out a larger loan and putting less money down is that my salary and our online business earnings will continue to rise to offset the increased mortgage payment. Borrowing more money also means having more cash readily available in case of disaster or more realistically in case we need to make any additional modifications on the house.

The Case For Borrowing Less

Borrowing less money is more inline with the principles that I was brought up with. By having a more manageable mortgage, either the business or my day job alone would suffice to cover all of our costs at our current burn rate. We would have to live frugally but I would have peace of mind that we could continue to pay the mortgage even in pretty bad times. The only problem is that our nest egg would be depleted leaving us with less money in case of emergencies.

Clearly there is a fine line here where we need to find a happy medium. Given the following hypothetical scenarios, which would you choose?

• Take out a larger mortgage while maintaining a large enough nest egg for a years worth of burn rate in case something bad happens.
• Take out a smaller mortgage with a significantly smaller nest egg but with a mortgage payment that is easily manageable by either the day job or business alone
• Take out the largest mortgage possible to offset future inflationary pressure

I’m eager to hear your thoughts.

Argument 1:Interests Rates Are Low And They’ll Never Be This Low Again

One of my readers strongly urged me to take advantage of the ridiculously low interest rates while they still last. His argument was that interest rates may never be this low again so you should take advantage of your increased purchasing power.

Honestly, I want interest rates to rise. Hell, I want interests rates to rise so high that my borrowing power goes to crap. Why? Because if interest rates go up then housing prices will go down and I can get a better deal on a house. The prices for housing in my area are still a bit inflated and they are still high partially because low interest rates are propping prices up.

Interest rates are at historic lows and people are losing their jobs. Most of my friends aren’t getting raises this year and many of them are lucky just to be employed. Once interest rates go up, housing prices will drop because incomes are not increasing and peoples’ borrowing power will decrease. Since interest rates are practically as low as they can go right now, rates can only go up which means housing can only go down in the near future.

I would much rather have a cheaper house with high interest rates than a more expensive house with lower interest rates.

Argument 2:Real Estate Never Drops In Value In The Long Run

I strongly dislike general arguments like this one that have no specific time frame involved. Sure, if you hold real estate long enough, eventually you’ll probably come out ahead. It’s the same as the tried and true ‘buy and hold’ strategy for stocks right?

But you know what? If you think that housing is going to drop in the near future, shouldn’t you wait until it makes sense to buy and hold? If you thought that a stock was going to drop in value for all of this year, wouldn’t you want to wait and buy the stock next year?

Times are tough right now and I personally want to keep as much money in cash in case of emergencies. It is not my goal to burden myself with a large mortgage which I could potentially get stuck with if housing goes down.

Argument 3:The Equity Of Your Payments Increases Over Time

This is very valid argument. In my last article, I didn’t account for the increase in equity year over year for a mortgage payment. After the first year, the equity portion of the payment does in fact increase slowly over time. Arguably, after 5 years or so, I would be just about break even in the scenario I presented in my last article.

But let’s say I think housing prices are going to drop. What happens to my equity then? Buying a house is a lot like trading stock options without a time frame mainly because real estate is a highly leveraged investment. Let’s say I put 125k down on a 625k house. My equity is 20% right?

But if my house were to go down 10% in value or 62.5k, I would be effectively losing 50% of my investment. When it comes to buying a house, everything is amplified. Why should I risk leveraging my wealth when I think housing still has a ways to drop?

Argument 4:Buying A House Is A Good Hedge Against Inflation. Rents May Rise

This is a completely valid argument. No matter how much prices or rents may rise in the future, your monthly housing payments will remain fixed for the term of your loan (assuming you have a fixed interest mortgage). And the way the fed has been printing money lately, it is inevitable that we will hit a large amount of inflation sometime in the future.

But I don’t think that this will happen anytime soon. Arguably, we’ll see flat prices or even a little bit of deflation because everyone’s houses are dropping in value. In fact, most people are struggling just to make payments on their loans. The general public simply does not have the money right now to buy anything. Because everyone’s income is staying flat to lower, it is unlikely that rents or rates will rise in the near term.

Argument 5:The Intangibles Of Owning Are Worth It

I can’t really argue with this one. Believe me, my wife and I really want to own a home. But on the flip side, we also don’t want to put ourselves in a situation in which I’m forced to work for my mortgage.

This article is not intended to say that housing is not a good buy for everyone. Hell, I’ll bet that housing in Detroit or Florida is probably a great value right now. Perhaps it makes sense to buy something there!

But where I live right now, housing prices are still disjointed from rental costs. As long as I believe that housing is still going to fall and that renting is cheaper than buying, I’m going to stay on the sidelines no matter how badly I want to buy something.

Further Reading

• Housing Has Dropped And Rates Are Low – Should I Buy A House?

Calculating The Monthly Mortgage Payment

Photo By Fotographix

The easiest way for me to perform a buy vs rent analysis is to run the calculations on the home that I’m currently renting. Right now, my rent is $2200. According to other comparables in my area, the house I’m renting is worth roughly $625K.

If I were to put 20% down, take a 500K loan at 5% (30 year fixed), my monthly payments would be roughly $2684 dollars. As you can see already from a cash flow perspective, buying a house would increase my monthly payments by roughly $484 right off the bat.

Taking Into Account Tax Benefits and Equity

But just taking the mortgage payment at face value isn’t really a complete and fair calculation since there are tax benefits involved with owning a home. In addition, since a small portion of my payment goes directly towards the equity in the house, I need to factor that amount in the final calculations as well.

My handy mortgage calculator tells me that the amount of equity I would be gaining per payment (for the first year) is roughly $600 and the remaining $2084 is what I would be paying as mortgage interest.

If I assume that I’m in the 33% tax bracket, that’s roughly a savings of about $695 dollars a month. If I factor these two numbers into my calculations, my true monthly costs of buying a house come to about $2684 – $695 – $600 = $1389. Keep in mind that $600 of this money is in equity that I can’t easily extract unless I get a home equity loan. All of a sudden though, it appears quite favorable to buy.

Property Taxes and Other Expenses

What else am I missing here? Here’s something that most people forget to include in the cost of owning a home, the dreaded property tax. In California, property tax is roughly 1.25% a year. For a $625k house, this amounts to $7812 a year or about $651 monthly.

This amount is technically tax deductible but because of AMT, I’m never able to deduct my property tax. Therefore, property tax becomes a pure cost to owning the home for my particular situation.

Another expense that most people forget to include is fire insurance. It really depends on your coverage but the quote that I received from my insurance provider was roughly $100 a month for a comparable home. If you also factor in another $100 (being really conservative) a month for upkeep (gardening,repairs, renovations), that puts us at about $2684 – $695 – $600 +$651 + $100 + $100 = $2240.

Opportunity Costs

Still seems about even in terms of buying vs renting right? The other item missing from our calculations is the time value of money. By sinking $125k of my hard earned cash into the home, I could’ve been using this money to earn even more money. Even if we assume a very conservative 3% yearly rate of return, this amounts to $3750 a year or about $312 a month.

With everything taken into account, it all of a sudden costs

$2684 – $695 – $600 +$651 + $100 + $100 + $312= $2552

to buy the same home that I’m renting. If I look at things from a pure cashflow standpoint, I’m effectively spending $3152 (removing the equity portion of the calculation) to buy vs $2200 a month to rent the exact same house.

The Intangibles

Most people will argue that the pride of owning your own home outweighs the additional costs involved. They’ll also tell you that real estate never goes down in the long run.

It’s tough to take into account the intangibles when buying your own home, but during these hard economic times, one thing is absolutely clear. You need to be conserving cash. You need to be controlling your cash flow to prepare yourself for potentially harder times ahead.

The real estate market is still in the doldrums. Instead of shelling out extra cash for the pride of ownership or as an investment, you need to run the numbers and all of the scenarios involved.

In my case, I believe that real estate prices are going to remain flat for at least the next few years. Why risk my cashflow when there’s very little financially to gain in the near term?

Further Reading

• Reader Response: Should I Buy A House Right Now?