Thursday, October 3, 2013

210. How much does owning a home really cost?

Home ownership has always been part of the American dream. Complete with a dog, two kids and a white picket fence—it is our slice of American pie.  Millions of American workers get up and work long, hard days to make their house payment—week after week, year after year.  For most of us, it is a 30 year commitment.

Even in the current housing market and after the loss of billions of dollars in home equity during the housing collapse, many people still place value in owning a home. Americans also generally regard home ownership as an investment.

However, despite our perceptions, owning a home can have its financial shortcomings.

Anyone who has purchased a home has to gasp for air when they consider how much they will pay in interest over the course of the loan. Depending, of course, on the loan terms, the interest can be as much or even exceed the value of the home itself. This is particularly common on 30 year mortgages, since interest equals principal multiplied by rate and compounded over time.  Thus the interest on a $150,000 loan at 5% for 30 years is $139,883; for 20 years, it is only $87,584.

5.30% is the interest rate in which you will pay double the price of the house for the cost of your loan. If you take a loan for 150,000 over 30 years, you will pay 150,000 in interest.

The problem with home loans is that the interest is paid up front, as much as 80 percent the first five years and 70 percent the next five. So while the interest rate in a fixed loan may remain constant, it is calculated first and subtracted from the payment amount. Whatever is left is applied to principle. Thus a higher percentage of the payment is applied early in the loan.

On a $150,000, 5%, 30 year loan—at 10 years, the homeowner would still owe $122,308 despite making total payments on the loan of almost $96,000. Thus, although the homeowners have paid one-third of the loan term, they still owe 80 percent of the home value.

In a sense, when you also consider closing costs, renovations and repair, maintenance, taxes,  private mortgage  insurance (the cost paid by the homeowner to secure the lender’s loan) and the current state of depreciation, homeowners are really only renting their home for the first ten years. There are many factors to consider, such as down payment and tax advantages, but all things considered the first ten years of the loan are difficult for the homeowner (and actually, even at 20 years, the homeowner has only paid 50 percent of the loan value).

The problem is that many people live in their home for 10 years or less—due to changing family size, relocations, etc. From 2001-2008, the average was 6 years. With little salvageable equity over the first ten years, the new loan starts all over again with the purchase of another home—with all that interest again paid up front.

Thus, if a home is sold after ten years, the bank collected $96,000 in mortgage payments and the payoff value of the home, which is about $122,000. They loaned $150,000 and in ten years recovered $218,000—the same amount an 8 percent loan on $150,000 would return in 10 years.

If the homeowners stay in the home for 30 years, less and less of each payment is dedicated to interest. The formula dedicated to the value of money over time works out. Over the last ten years, only about $20,000 is interest. So while interest rate is constant, depending on the circumstances—and subject to debate—one might be able to do better through investment.

Prior to the housing crisis, homeowners and lenders relied on appreciation to balance the interest heavy loans. If the house had appreciated to $175,000 over the first ten years, the homeowner would at least walk out of the loan with $50,000. Today, homeowners are lucky to get the $122,000 still due on the loan. Thus, the homeowner is back to where he or she started.

When housing values and home equity were rising quickly, many people were tempted to cash out their home early in the loan and purchase a larger one. For lenders, this was great, because as noted, the earlier in the loan it is paid off, the more interest the lender collected (as a percentage of the entire loan). It also affected the availability of second mortgages. Due to declining equity, banks can no longer double up on the same house.

Owning a home is still part of the American dream, but as those underwater in their mortgage can attest, it is not the investment it was in the early 2000s. Homeownership favors those who can take out shorter loans or make additional principal payments—a couple ways to reduce the interest advantages afforded to mortgage lenders.