Wednesday, June 01, 2005

Home Economics

The Wall Street Journal has had recent reports on how people are taking out interest-only loans or home equity loans to invest in real estate. This prompts me, the Capitalist Running Dog, to point out some misunderstandings people may have about the economics of real estate.

Your real estate agent may say, “The mortgage interest is tax deductible.” While you might not pay taxes, you are still paying the interest. The money is not free.

Your banker may say, “We will lend you this ridiculously large sum.” That does not mean you should. The bank cares little your ability to make payments in the event that you lose your job, have a divorce or suffer some other financial shock. The bank makes money processing and reselling your mortgage. Denying you an additional $100,000 in mortgage debt because it would increase your chance of defaulting costs the bank money today to avoid a potential repossession cost in the future. Money today wins most of the time. The bank’s lending limit is not a reliable guide for telling you how much you should borrow. It is a reliable guide to how much borrowing would make the bank the most profit.

Your relatives may say, “Renting is just throwing money away. A house builds equity.” This makes the most sense when you compare renting to the most basic house that reproduces what an apartment offers. As you move from a small house to a larger house the logic breaks down because you own in either case. What does happen with each $50,000 upgrade in size and location is that you paymore taxes, insurance and upkeep. Also, if you are borrowing that additional money, then you are actually reducing the amount of equity you create because you pay more in interest.

Your friends may say, “Borrow as much as you can because real estate prices will not collapse like stock prices sometimes do.” It is true that real estate values are very unlikely to fall dramatically; however, they can certainly stop rising. Does your interest-only mortgage or investment property make you a profit then? You may think you can sell out before the market stalls, but realize that you are taking a gamble. Taking risks can be reasonable investing, but, if you do not believe that you can get burned, then you are set up for a big surprise.

Is that enough cold water for such a sunny day?

Your Running Dog

2 Comments:

Blogger PatCA said...

"What does happen with each $50,000 upgrade in size and location is that you paymore taxes, insurance and upkeep."

Interesting. I'm finding that out as I look for a nice townhouse to replace my less nice home. Also, the assessments to keep the community nice represent ultimately another house payment, but one that does not build equity.

10:36 AM  
Blogger tempus42 said...

You are truly wise, CRD. Whatever the opposite of an economist is, I'm it, but I'm still always baffled at how most people just don't understand the basics of consumer debt. It's pretty straightforward, really, but I guess it keeps the debt consolidation and bankruptcy lawyers busy.

I once worked with a guy -- older and presumably more experienced than I. I was explaining to him how I had recently re-financed my home and I had reduced the term to 20 years, keeping my monthly payment about the same. He said, "But now you won't get that nice tax break because you're paying so much less interest". I said, "True, my refund in April will be less, but I'm coming out way ahead since the refund is only a third (give or take) of what I'm paying." Duh, right? And yet he just stared at me like it made no sense. Why would you *not* want a nice big juicy refund?

3:24 PM  

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