FINANCING LIFE
Fall 2015
Session #4 –The Financial Aspects of Home Ownership
The United States has the highest level of home ownership of any nation in the world—just over 2/3 of all
households own their own homes. Many of those who rent consist of young persons who have not yet formed
“households” or of younger households who will eventually buy a home. For the vast majority of Americans
homeownership will be one of the most significant financial decisions they will make. For most it is the largest
single financial commitment (except having a child) they will ever make at one time. It involves specific issues
of debt financing, tax advantages, asset appreciation, insurance as well as more general issues such as risk,
commitment, and a sense of “being a grown up.”
Highly Variable Housing Costs
The first thing to recognize is that housing prices vary widely from place to place. There is no single standard
of how much buying a house will cost. $100,000 will buy a very nice home in some sections of the country
but won’t even pay for the garage in others. Unfortunately, and not surprisingly, the more “attractive” the
region or city, the more expensive the housing—San Francisco is much more expensive than small town
North Dakota. When choosing a location or accepting a job offer, variations in the cost of housing should be
a real consideration on the financial side of the deliberations. No matter where you buy, the purchase will
almost surely involve a mortgage.
Mortgage Financing
Few people indeed can pay cash for a house. A “rule of thumb” is that you can afford a house equal to 2½ to
3 times your annual income. Very few people can wait around to save up that much. Virtually all housing
purchases in the U.S., and especially “first” houses involve mortgage financing. A mortgage is a secured
loan whereby a bank or other mortgage lender loans you money to cover some share of the purchase price of
the home. The bank will not loan you the full cost of the house, however. They will demand a down
payment often of 10% or more. (There are some special arrangements in many states for “first time home
buyers” that reduce this requirement.) You agree to pay back the principle plus interest over some time
period—usually 15, 25 or 30 years. (You don’t have to stay in the same house for that long. If you sell the
house, the proceeds will first go to pay back the lender and then any excess will go to you.) Because the term
of the loan is often long, total interest charges can easily exceed the actual cost of the house. The table below
shows total interest costs on various loans for 15- or 30-year terms at 3 different interest rates. These are in
addition to repaying the principle.
Principle
$100,000
$200,000
$300,000
6.0%
$ 51,894
$103,788
$155,682
Total Interest Cost on Various Mortgages
15 Year Loan
30 Year Loan
Interest Rate
Interest Rate
8.0%
10.0%
6.0%
8.0%
10.0%
$ 72,017
$ 93,428
$115,838
$164,155 $215,925
$144,034 $186,856
$231,676
$328,310 $431,850
$216,051 $280,284
$347,514
$492,465 $647,775
Variable rate mortgages
Mortgage loans can have the interest rate fixed for the term of the loan, or the rate can be adjusted
periodically to reflect interest rates at some future time. Variable rate mortgages are usually somewhat
cheaper “up front” but carry the risk of becoming more expensive later. (They also have the prospect of
becoming still cheaper if interest rates should fall in the future.) Which is best for you depends on your
tolerance for risk, your expected earning profile over the life of the loan, and the number of years you
expect to be in that house. Much of the current “subprime mortgage crisis” right now is the result of
variable interest rate mortgages “resetting” to much higher interest rates—beyond what the borrowers can
afford.
Refinancing: Because finance costs are so significant, if there is a large drop in interest rates it may make
sense to refinance a mortgage, i.e., take out a new loan and use the proceeds to pay off the old, more
expensive loan. When mortgage rates are at relatively low levels (the current national average is about
5%) homeowners with loans much above the current rate can save significant amounts by refinancing.
Sponsored by the Center for Women & Financial Independence
FINANCING LIFE
Fall 2015
Other Costs of Home Ownership
Property taxes: As the owner of a home you will also be responsible for paying local, and in some cases state,
property taxes. These are annual or semi-annual payments based on assessed value of the property—e.g.
21/2 % of the total value is due in taxes each year. Because failure to pay the taxes gives the government
the right to take title to the property to collect the taxes, your mortgage holder may require that you add
your tax payments to your mortgage payment and the mortgage holder will then pay the property tax.
Home Owners Insurance: Simply because your home is such a large investment you will need to carry
complete insurance on it to cover losses from fire, theft, storm damage as well as liability for parties who
might be injured on your property. In addition to the obvious wisdom of having insurance, you mortgage
holder will make maintaining it a condition of the loan.
Maintenance and Repair: Every house needs continual care. The furnace needs cleaning, the plumbing gets
clogged, the paint is peeling, the driveway is cracked…and on and on… Renters can call the landlord.
Homeowners are responsible for it all. Your budget needs to leave room for those recurring expenses.
Tax Benefits
Now the good news. Because many of your homeownership expenses are deductible under the federal
income tax law, Uncle Sam will help “pay” for them. The interest expense on your mortgage and your
property tax payments are both fully deductible. That means the money spend on them does not “pass
through the tax filter” so it is the same as having the government pay a share of those costs. The amount of
the “subsidy” depends on your marginal income tax rate. It could be as low as 10%. It could be as high as
35%.
Secondly, even though appreciation of any asset creates a “capital gains” tax liability, there is a special
exemption for capital gains in your primary residence. ($250,000 for an individual, $500,000 for a couple).
If you had stocks that appreciated that much you would have a large tax liability. With the investment in your
home you escape that.
Appreciation
The dollar value of your home will almost certainly grow over time [except in the last year or so when home
prices have been falling. Hopefully that is an aberration.] Over long periods it should increase in dollar value
at least as rapidly as the general price level increases so that the real value of your house will not be eroded
by inflation. For the past several decades the increase in home values has exceeded the rate of inflation so
that there are genuine capital gains from owning a home. At an annual appreciation rate of 3% a $200,000
home will be “worth” over $300,000 in 15 years and “worth” nearly $500,000 in 30 years. Home ownership
is the major form of wealth accumulation for most American households.
Building Equity
As your home appreciates in value and as the amount owed on the mortgage declines, you are increasing the
equity you have in your home. (Equity = Market Value - Debt on the Home). That equity can then be used to
borrow for education, to buy a new car, etc. and because it is a real estate based loan the interest charges
may be deductible on your federal income tax.
Sponsored by the Center for Women & Financial Independence