Is buying a home always better? | Housing | Finance & Capital Markets | Khan Academy

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..

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