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

Summary

In this video, the speaker challenges the common belief that buying a house is always better than renting. Using Northern California as an example, he compares the costs of renting a $1 million house for $3,000 a month versus buying it with a $250,000 down payment and a $750,000 mortgage at 6% interest. He calculates that renting costs $26,000 annually after bank interest, while buying, with tax deductions, still burns $41,500 annually without building equity. The video questions the assumption that mortgage payments are savings and suggests renting might be financially smarter.

Takeaways

• 🏠 The speaker emphasizes the importance of considering whether to rent or buy a house, especially in high-pressure environments like Northern California.
• 💭 There's a common belief that buying a house is always better than renting because mortgage payments are perceived as a form of savings.
• 💰 The speaker challenges this notion by comparing the costs of renting versus buying a $1 million house in Silicon Valley, with a $250,000 down payment.
• 📈 The annual cost of renting is calculated to be $36,000, with an additional $10,000 in interest earned from a CD, resulting in a net cost of $26,000 after interest.
• 🚫 If buying, with a $750,000 mortgage at 6% interest, the annual interest payment alone is $45,000, which is a significant outflow not contributing to equity.
• ✅ The tax deduction on mortgage interest can reduce the effective cost, with the speaker estimating a 30% tax rate saving approximately $13,500 per year.
• 🏦 However, the speaker points out that the $250,000 down payment does not earn interest when used for buying a house, unlike in a CD.
• 🏡 Property taxes on a $1 million house amount to $10,000 per year, which is an additional cost of homeownership.
• 📉 The speaker concludes that, after accounting for all factors, buying results in an annual 'burn' of $41,500, compared to renting for $26,000, challenging the idea that buying is always better.
• 🔍 The script hints at a follow-up discussion on the topic of housing price appreciation and its impact on the decision to rent or buy.

Q & A

Why does the speaker choose to rent instead of buying a house?

The speaker chooses to rent because they are almost 100% convinced that housing prices are going to revert back, and they believe it's not a good time to buy.

What is the common misconception about renting versus buying a house mentioned in the script?

The common misconception is that buying a house is always better than renting because the money paid towards a mortgage is seen as going into savings, whereas rent payments are perceived as disappearing with no return.

How much does the speaker spend on rent annually for the house they are considering?

The speaker spends $36,000 per year on rent for the house they are considering.

What is the interest the speaker earns on their $250,000 if they choose to rent?

If the speaker chooses to rent, they earn $10,000 in interest annually from their $250,000 at a 4% interest rate.

What is the total amount the speaker would pay out of pocket annually if they rent the house?

After accounting for rent and interest earned, the speaker would pay $26,000 out of pocket annually if they rent.

How much money does the speaker need to borrow to buy the $1 million house?

The speaker needs to borrow $750,000 to buy the $1 million house, as they have $250,000 in cash for a down payment.

What is the annual interest payment on the mortgage if the speaker decides to buy the house?

The annual interest payment on the mortgage would be $45,000 if the speaker decides to buy the house.

How does the interest on a mortgage affect the speaker's tax liability?

The interest on a mortgage is tax deductible, which means the speaker can reduce their taxable income by the amount of interest paid, resulting in tax savings.

What is the approximate tax savings the speaker would get from the mortgage interest deduction?

The speaker would save approximately $13,500 in taxes from the mortgage interest deduction, assuming a 30% tax rate.

What are the additional costs associated with owning the house that the speaker mentions?

The additional costs associated with owning the house include property taxes, which amount to $10,000 per year on a $1 million house at a 1% tax rate.

How does the script suggest that the cost of owning versus renting compares in the speaker's scenario?

The script suggests that the cost of owning the house, after accounting for interest payments, tax savings, and property taxes, is higher compared to renting the same house.

Outlines

00:00

🏠 The Debate: Renting vs. Buying a Home

The speaker begins by expressing the importance of the topic at hand, which revolves around the decision to rent or buy a home. They describe social pressure to buy a house, especially when living in Northern California, and share their personal conviction that housing prices will decrease, hence their choice to rent. The speaker challenges the common belief that buying is always better than renting, as it is perceived that mortgage payments are a form of savings, unlike rent payments which are seen as a loss. To explore this notion, the speaker sets up a scenario comparing the costs of renting versus buying identical houses, considering their own financial situation with $250,000 in cash and the option to invest in a Certificate of Deposit (CD) at a 4% interest rate. The annual cost of renting is calculated, and the potential interest earned from the cash is compared to the costs of buying a house valued at $1 million with a $750,000 mortgage at 6% interest.

05:06

💼 Financial Breakdown of Home Ownership

In the second paragraph, the speaker delves into the financial implications of owning a home, focusing on the costs beyond the mortgage. They calculate the annual interest payment on the mortgage and discuss the tax-deductible nature of this interest, providing a hypothetical scenario to illustrate the tax savings. The speaker also considers the property taxes on a $1 million home, noting that these are also tax-deductible, albeit to a lesser extent. They conclude by comparing the 'burn rate' of owning versus renting, highlighting that despite tax benefits, the net cost of homeownership remains significantly higher than renting. The paragraph ends with a nod to the historical belief in housing appreciation as a justification for buying, a point the speaker intends to address further in a subsequent video.

Keywords

💡Renting

Renting refers to the act of occupying a property, such as a house or apartment, under a lease agreement in exchange for periodic payments to the property owner. In the video, the concept is explored as a financially savvy alternative to homeownership, especially when considering the costs involved in buying a house. The speaker compares the annual cost of renting a house for $36,000 to the financial implications of purchasing a house, emphasizing the potential savings and flexibility that renting offers.

💡Homeownership

Homeownership is the state of owning a home, which often comes with responsibilities such as mortgage payments, maintenance, and property taxes. The video discusses the societal pressure to own a home and challenges the common belief that buying is always better than renting. The speaker uses the example of a $1 million house to illustrate the financial burden of homeownership, including mortgage interest and property taxes, which are 'burning' money without building equity.

💡Mortgage

A mortgage is a loan used to finance the purchase of real estate, with the property serving as collateral for the loan. The video script delves into the details of mortgage payments, highlighting that a significant portion of these payments goes towards interest, especially in the early years of the loan. The speaker calculates the annual interest on a $750,000 mortgage at 6%, which amounts to $45,000, to demonstrate the cost of homeownership beyond the initial purchase price.

💡Interest

Interest in the context of the video refers to the cost of borrowing money, specifically the money paid to a lender as a percentage of the principal for a loan or mortgage. The speaker explains that while the interest paid on a mortgage is a significant expense, it is also tax-deductible, which can reduce the effective cost. The video uses the example of a 6% interest rate on a $750,000 mortgage to show how much interest is paid annually and its impact on the overall cost of homeownership.

💡Tax Deduction

A tax deduction is an expense that can be subtracted from one's taxable income, thereby reducing the amount of tax owed. The video discusses how the interest paid on a mortgage is tax-deductible, which can provide financial benefits to homeowners. The speaker provides a hypothetical scenario where a person saves $13,500 in taxes by deducting $45,000 of mortgage interest from their taxable income, illustrating the potential financial advantages of homeownership.

💡Property Tax

Property tax is a levy imposed by local governments on real estate, and it is used to fund public services such as schools and infrastructure. In the video, the speaker mentions that property taxes are an annual cost of homeownership, calculated as a percentage of the property's assessed value. The example given is a 1% property tax on a $1 million house, resulting in $10,000 per year. The video also touches on the fact that property taxes, like mortgage interest, can be tax-deductible, which can provide some financial relief.

💡Equity

Equity in real estate refers to the difference between the market value of a property and the outstanding mortgage on it. The video script challenges the notion that homeownership automatically builds equity, pointing out that the interest paid on a mortgage does not contribute to equity. The speaker emphasizes that the $41,500 spent on mortgage interest and property taxes each year does not add to the homeowner's equity but is instead 'burned' as an expense.

💡Silicon Valley

Silicon Valley is a region in California known for its high-tech innovation and as a hub for the tech industry. The video uses Silicon Valley as a setting to discuss housing costs, illustrating the high price of real estate in the area. The speaker mentions renting a house in Silicon Valley for $3,000 a month as an example to compare the costs of renting versus buying.

💡Interest-Only Mortgage

An interest-only mortgage is a type of loan where the borrower pays only the interest on the loan for a certain period, with the principal balance remaining unchanged. The video script simplifies the discussion of mortgage payments by considering an interest-only scenario, which helps to focus on the cost of interest without the added complexity of principal repayment. This allows the speaker to clearly demonstrate the impact of interest payments on the cost of homeownership.

💡Peer Pressure

Peer pressure refers to the influence that other people have on an individual's behavior, often leading to conforming to certain societal norms or expectations. In the video, the speaker mentions the pressure from family and real estate agents to buy a house, which is a common societal expectation. The script uses this concept to frame the discussion around the personal decision of whether to rent or buy a home, highlighting the need for individuals to critically evaluate such pressures.

💡Housing Prices Reversion

Housing prices reversion refers to the idea that real estate prices will eventually return to a more stable or average level after a period of significant increase or decrease. The video script introduces this concept as the speaker's belief that housing prices will decrease, which influences their decision not to buy a house. The speaker plans to present justifications for this belief in future content, suggesting that the current high prices may not be sustainable.

Highlights

The video discusses the common belief that buying a house is always better than renting.

The speaker challenges the notion that mortgage payments are a form of savings.

A comparison is made between renting a house for $3,000 a month and buying a $1 million house.

The annual cost of renting, including interest earned on a $250,000 cash deposit, is calculated.

The annual interest cost of owning a house with a $750,000 mortgage at 6% interest is detailed.

The tax-deductible nature of mortgage interest is explored and its impact on actual cash savings is explained.

The video presents a simplified example to compare the net annual cost of renting versus owning.

The concept of property tax and its deductibility is introduced as part of the cost of homeownership.

A comparison is made between the 'burn rate' of money when renting versus owning a house.

The speaker anticipates addressing the issue of housing appreciation in a future video.

The video concludes with a call to question the conventional wisdom that homeownership is always superior to renting.

The importance of considering the total cost of ownership, including interest and property taxes, is emphasized.

The potential for housing prices to revert is mentioned as a reason for the speaker's personal decision to rent.

The video suggests that the perception of mortgage payments as savings is a common but potentially misleading belief.

The financial implications of a 25% down payment on a $1 million house are examined.

The impact of property taxes on the cost of homeownership is discussed, including the potential for tax deductions.

The video highlights the need to consider both the direct and indirect costs of homeownership.

Transcripts

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.