Welcome back. I'm now going to take a slight

tangent and cover a topic that, I think, this is probably

the single most important video that really

anyone can watch. I go to all of these parties

where I go see family. And my wife and I right now,

we live in Northern California. And we're renting. And I like to point

out, by choice. And I have family members,

why don't you buy? You're at that stage in

life, that's a major milestone, all of this.

There's a lot of pressure

to buy. And when I tell friends,

I tell them I'm not going to buy. Because I think I'm pretty

convinced, almost 100% convinced, that housing prices

are going to revert back. And I'm going to do a bunch

of presentations to justify why they will. But then my friends, they'll

just throw out the statement that I hear from them, that

you hear from real estate agents, because obviously

they want you to buy.

Well, isn't buying always

better than renting? And I think that kind of common

wisdom comes out of the notion of, when you have a

mortgage or when you borrow money to live in a house, every

month that money that you give to the bank is kind

of going into savings. That's the perception. While when you rent,

that money's just disappearing into a vacuum. In this video I'm going to work

through that assumption, and see if that actually

is the case. So let's say I have a choice. Let's say there are

two houses. This is house number one. And this is house number two. And let's say that they're

identical houses. These are three bedroom, two

bath, townhouses some place in Silicon Valley, which

is where I live. And I want to live in

one of these houses. I'm indifferent as to which

house I live in, because they are identical. So living in them is the

identical experience.

I can rent this house

for $3,000 a month. Or I could buy this house

for $1 million. And let's say that in my bank

account right now, let's say I have $250,000 cash. So let's see what happens

in either scenario. Let's see how much money

is being burned. So in this scenario

what happens? I'm renting. So in a given year, let's just

see how much money comes out of my pocket. So in a given year

I pay $3,000. $3,000 times 12 months,

so I lose $36,000. So I'll put a negative

there, because that's what I spend in rent. $36,000 per year in rent. And then of course I

have that $250,000. I'm going to put that into the

bank, because I have nothing else to do with it. I didn't buy a house with it. And let's say that I can,

in the bank, let's say I put it in a CD. And I get 4% on that. So let's see, 250, that's

what? $10,000, I think. That's 0.04. Right, I get $10,000 in interest

a year on that.

So I get $10,000. So plus $10,000 a year

in interest. So out of my pocket, for the

privilege of living in this house, in Silicon Valley, with

beautiful weather, out of my pocket every year

goes $26,000. So that's scenario one. So what happens if I give in

to the peer pressure of family, and realtors, and the

mortgage industry, and I buy this house for $1 million? Well I only have $250,000, which

is more, frankly, than most people who buy $1 million

houses have. But I have $250,000 cash. So I need to borrow $750,000. So I take out a mortgage

for $750,000. And I'm going to do a slight

simplification. And maybe in a future

presentation, I'll do kind of a more complicated one. In a lot of mortgages, when you

pay your monthly payment, most of your monthly payment,

at least initially, is the interest on the amount that

you're borrowing. And you pay a little bit

extra on that, to bring this value down. That's called paying

off the principal. You can also take an

interest-only loan, but the component of the interest

is the same.

Essentially, when you take a

traditional mortgage, kind of a 30-year fixed, every month

you're paying a little bit more than the interest, just

to take down the balance. But for the simplicity of this

argument, I'm just going to say that we're doing an

interest-only mortgage. And then maybe with any

extra savings, I can pay down the principal. And that's the same notion. And right now, if I do 25%

down, and I'm buying a $1 million house, I'll have to

take a $750,000 mortgage. I don't know what a

good rate is, 6%? So let's say at 6% interest. So

to live in this house, how much am I paying just

in interest? Well I'm paying $750,000

times 6% a year. So $750,000 times 0.06 is equal

to $45,000 in interest. That's coming out

of my pocket. And of course, on a monthly

basis, that means in interest per month, I'm paying,

just to get an idea. I'm paying about $3,700, $3,800

in interest a month. My mortgage actually might be

something like $4,000 a month.

So I pay the interest. And then

I pay a little bit to chip away at the whole

value of the loan. It takes 30 years to chip

away at the whole thing. And over time, the interest

component becomes less, and the principal becomes more. But for simplicity, this is the

interest that I'm paying. $45,000 a year. And then of course at a party,

when I start to explain this, it's like, ah-ha. But interest on a mortgage

is tax deductible. And what tax deductible means,

is that this amount of money that I spend on interest

on my mortgage, I can deduct from my taxes. I can tell the IRS that

I make $45,000 less than I actually did. So if I'm getting taxed at,

let's say 30%, what is the actual cash savings? Well I'll save 30% of this. I'll have to pay $15,000

less in taxes. How does that work? Well, think about it. Let's say I earned $100,000

in a year. And I normally have

to pay 30%. So I normally pay $30,000

in taxes. Right? This is, if I didn't

have this great tax shelter with this house.

Now I have this interest

deduction. So now I tell the IRS

that I'm actually making $55,000 a year. And let's say my tax

rate is still 30%. it actually will probably go

down since I'm — but let's, just for simplicity, assume my

tax rate is still $30,000. So now I'm going to pay $16,500

in taxes to the IRS. So how much did I

save in taxes? So I saved $13,500 from taxes,

from being able to deduct this $45,000 from my income. So let's say tax savings,

plus $13,500. Now what else goes into

this equation? Do I get any interest

on my $250,000? Well, no. I had to use that as part of the

down payment on my house. So I'm not getting

interest there. But what I do have to

do is, I have to pay taxes on my property.

In California, out here we have

to pay 1.25% in taxes, of the value of the house. So what's 1.25%? So, taxes, this is

property tax. And that's actually tax

deductible too, so it actually becomes more like 0.75% or 1%. So let's just say 1% just

for simplicity. Property taxes. So 1% times $1 million. That equals what? 1% of $1 million is

another $10,000 a year in property taxes. And notice, I'm not talking

about what percent of my mortgage goes to

pay principal. I'm just talking about money

that's being burned by owning this house. So what is the net effect? I have a $13,500 tax savings. I have to pay $10,000 —

actually I have to pay a little bit more than that, but

we're getting a little bit of income tax savings on

the deduction on the property taxes. And then I actually have to pay

the $45,000 of interest that just goes out the door. So I'm paying $41,500. Notice, none of this $41,500

is building equity. None of it is getting saved. This is money that is

just being burned. So this is a completely

comparable value to this $26,000.

So in this example — this

example is not that far off from real values. Out here in the Bay area, I can

rent a $1 million house for about $3,000. But in this situation I am

burning, every year $41,500, where I could just rent the same

house for $26,000 out of my pocket, when I adjust

for everything. And then people a couple of

years ago said, oh, but houses appreciate. And that's what would

make it up. But now you know, very recently

— we know that that's not the case. And in the next video, I'll

delve into this, and a little bit more. I'll see you soon..