What’s the cost of buying a home?
Yes, this is a trick question.
The obvious answer is the price you pay for it. If you find a house you like and pay $400,000 cash to buy it, the cost is the price, $400,000. Long-term, buying for cash will probably work out well. The value of the house is likely to appreciate with inflation. The eventual sale will likely be a tax-free event. While you’re living in the house, you’ll enjoy another benefit. It’s what economists call “imputed income.” That’s the invisible, tax-free benefit of shelter you’d otherwise have to pay for with after-tax income.
Sweet.
When simplicity becomes complex
But simplicity becomes complex when you finance the purchase of your home. That’s what most of us do. According to the National Association of Realtors, 87 percent of all home buyers finance their home.
When you sit down to sign that enormous stack of documents, one will tell you how many dollars you will be paying over the life of the mortgage. Borrow $300,000 for 30 years at 3.25 percent — the rate available before Russia invaded the Ukraine — and you’ll be repaying $470,023. Borrow it at 6 percent, as many did long ago, and you’ll be repaying a whopping $647,515.
That’s pretty intimidating. It’s also why many homeowners are in a rush to pay off their mortgage. “Think of all the money I’ll save,” they say.
In fact, the true savings from prepayment will probably be smaller.
A dollar today is worth more than a dollar tomorrow
How can that be? The answer is what financial types call “the time value of money.” A dollar coming our way in 2040 isn’t as valuable to us as a dollar in our bank account this week.
Yup, there’s this thing called inflation.
So how do you calculate the true cost of buying your home?
Sorry, you’ll need a financial calculator to do the specifics for your own house. Meanwhile, let me show you how it would work with some calculations for a typical home cost in Texas. According to a recent report from the Texas Real Estate Research Center at A&M, median home prices in our major urban areas ranged upward from $300,000.
Home prices in Texas
- San Antonio was the least expensive at $303,000.
- Houston followed at $309,100 and Fort Worth at $319,600.
- Dallas came in at $383,100.
- Austin led with a stunning $453,600.
As I write this, a qualified buyer with a good credit score and a 20 percent down payment could snag a mortgage rate as low as 3.75 percent. (This doesn’t count any payments of points that raise the effective interest rate.)
So, what’s the true cost of a $300,000 or $400,000 home?
If you buy a home for $300,000 with a $60,000 down payment, you’ll be borrowing $240,000 and have a monthly payment of $1,111.48, repaying $400,132.80 over 30 years. If inflation matched the interest rate, the present value of all those payments would be exactly the amount you borrowed, $240,000.
Playing “what if?”
But what if the inflation rate is a good deal higher?
If inflation ran at the trailing 7 percent rate, for instance, you’d be paying back $167,063.86 in current value, not $240,000. In effect, the true cost of your house would be $227,063.86 (the $60,000 down payment plus the $167,063.86 present value of the amount you would repay.
Now let’s do the same exercise with a $400,000 house. With a down payment of $80,000 you would need a $320,000 mortgage with a monthly payment of $1,481.97. Over 30 years you’d pay out $533,509.20. But the present value of those payments after 7 percent inflation is $222,751.31, not $320,000. Again, the effect is to reduce the cost of buying your home to the down payment plus the present value of your mortgage, a total of $302,751.31.
In both cases, you’re buying the house at an effective discount of nearly 25 percent.
It all depends on…
How well this actually works out depends on one thing. It’s the difference between the interest rate on the mortgage and the inflation rate you experience. If inflation runs hot, you’ll make out big time.
Yes, it’s a gamble. But it’s the gamble that built middle class net worth for decades after World War II.
This isn’t new finance magic. It has been this way whenever the rate of inflation is greater than the interest rate on mortgages. It’s not a sure thing, but it’s looking like a pretty good bet.
Does this mean home prices in Texas aren’t high?
No. It only means daring home buyers may not be quite as crazy as many seem to think.
Sources and References:
National Association of Realtors: Highlights from the Profiles of Home Buyers and Sellers: https://www.nar.realtor/research-and-statistics/research-reports/highlights-from-the-profile-of-home-buyers-and-sellers
Luis B. Torres, Wesley Miller, and Weiling Yan, Texas Housing Insight, February 2022: https://www.recenter.tamu.edu/articles/technical-report/Texas-Housing-Insight
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
Photo: Scott Burns, St. Petersburg, Fl beach park 2/2022
(c) Scott Burns, 2022