The Dumbest of All Pre-Recession ‘Golden Rules’
This article comes from Nathan of www.NathanWMorris.com
“Buy the biggest house you can afford.”
This golden rule was really dumb even when it was popular. The idea was and is to buy the biggest house you can afford, mortgage it to the hilt so that you get a big tax deduction and of course you’ll be able to take advantage of the sweet appreciation of the home all on the bank’s dime.
At the time, housing prices seemed to just be sky rocketing with no end in sight. Of course, this is human psychology at play, when things are good we tend to think things will remain that way, and when the sky starts to fall… well, we think the world is ending.
The thing is, while homes were going up in price, it’s never a good plan to borrow money for investing purposes because while you might, keyword, might benefit from the upside of the investment, you’ll very likely be crushed by the downside of the investment.
Besides, a primary residence is not an investment. It does not produce income for you and it does not really appreciate either. A 3 bedroom 2 bathroom house in whatever neighborhood is still a 3 bedroom 2 bathroom house 20 years from now. In other words, whatever you sell that house for at a later date will only buy another similar home in a similar neighborhood at that date and time. It doesn’t increase in intrinsic value and if anything, it costs you money in the meantime to maintain, redecorate, and so on.
Therefore, this is one reason to stay far away from geeks and fast talkers with mathematical projections. While the charts and numbers look good, over a 30 year window, a lot can happen in your life, the world economy, and even your neighborhood.
Math is good, but understand that in personal finance, we’re mostly talking about behavior and psychology.
Then there was the tax deduction nonsense. While it’s true that if you write off a lot of mortgage interest on your taxes you’ll get a fatter refund, it’s not actually saving you a penny. Matter fact, especially if you’ve chosen to maximize your tax deduction by buying a bigger house, you’ve actually signed up for a deal where you’re giving someone $1 to save you $0.33 or so.
How does a tax deduction work? Well, all year, you or your employer pays estimated taxes from your gross pay. In other words, they give you $100 and they go ahead and send $30 off to the government for you. At the end of the year, if you’ve overpaid the government (sent them too much money) they owe you a refund. That’s easy enough to understand.
However, this whole tax deduction mess gets a bit “crazy” for even some CPAs so stay with me. Let’s say that I paid in $30 a month in taxes because we live in a dream world where the tax rate is insultingly small (or sometime in the early 20th century).
At the end of the year, I’ve paid the government $360 right? Okay, now let’s say that I was paid (gross) $1200 for the year, I got to keep $1200-360 = $840 net.
Now, if I paid my taxes perfectly, then I get to keep my $840, I owe nothing and I get nothing back.
Here’s where the mortgage tax deduction messes people up. They know they get the deduction on let’s say $50 in mortgage interest they paid that year. The government now says (after some complicated maths) that I only owe them $345. Well I paid them $360 so I get $15 back.
Now it SEEMS like I just “made” $15. But I didn’t. I got $15 of the $50 back. So I spent $50 to get the $15 back.
Folks would see the bigger refund and assume that this meant they were saving money this way on taxes. However, in fact, the only thing that really happened, is the interest rate on their loan effectively dropped a half point to a point. This makes the mortgage a cheaper loan to carry, but still a loan, and certainly not a good way to save money.
So where does that leave us today?
Thankfully, 2008 happened and so now fewer people believe this nonsense that was spread around by financial planners, bankers, talking heads, and even otherwise well-meaning authors and policy makers.
Essentially, people have now seen that homes can go down in value and that can really suck. You can get trapped in a home owing more than it’s actually worth which can of course make moving difficult. Since the job market is a bit sketchy in most parts of the country, being stuck in a home is also not so great either.
I have long recommended to people to only buy when they’re ready to settle down in an area for a very long time. According to the U.S census bureau, we move on average about once every 5 years in this country. That’s a very short amount of time and the expense of buying and selling a home is high, not to mention that equity does not build up much in 5 years on a 30 year mortgage and frankly, when you own the home, you also own the problems that go with it.
So in today’s market, while I still recommend that folks eventually buy a home, I hold very firm to my stance that you should rent inexpensively, save aggressively, and put 20% or more down, 15 or less year mortgage term and no more than 2-2.5 x your annual income as the mortgage principal.
Of course, that’s assuming you want to be extraordinarily free compared to a typical American and would fancy the idea of not having a mortgage for real one day.
In the meantime, if you’re renting… don’t stress. Think about it, someone else is responsible for the dishwasher if it breaks. If you don’t like where you live or a job comes along that’s to die for, you can move with minimal expense and hassle. Matter fact, if you’re young and you’re traveling about (as I certainly recommend that you do), you might as well rent.
The days of “sky rocketing home prices” and your home being a so-called great investment or tax shelter are hopefully behind us now after reading through this.
The reality is, real estate is a great investment, but your home is your home, that’s it. While it’s technically a financial asset, don’t ever think of it as such only as home sweet home.
