Buying a home is often the most important investment we make in our lifetime. Besides providing shelter, our homes are often a major source of personal wealth. But how does this work. Why should you own your home?
Of course, everybody needs some place to live. So, we are all going to have a housing cost whether we rent or own. When we rent, we are paying someone else for the use of real estate. They get the short term cash and the long term appreciated value of the property. Renters have the freedom to move at the expiration of the lease, but get no real economic value from their lease other than having a roof over their head.
When we buy a home we leap into a completely new category. Homes are usually purchased through a loan called a mortgage. And even if you have enough money to pay cash for your home, you might find that purchasing with a mortgage is still better than paying cash. This is because of two reasons.
The first one is that the federal government lets you deduct your entire mortgage interest from your earned income. This tax advantage effectively has Uncle Sam paying part of your house payment. For example, John and Sally are a married couple making an adjusted income of $120,000 per year. This puts them into the 28% tax bracket. So, they pay $33,600 in federal income tax. Now, John and Sally purchase a $220,000 home. They put down a $20,000 investment and take a $200,000 30 year mortgage.
Their principle and interest on the $200,000.00 is $1,200 per month. During the first ten years of the mortgage term, most of the payment goes toward interest. For this demonstration, let’s say that $1,100 is monthly interest. This totals $13,200 in annual interest. Because of the mortgage interest deduction, John and Sally reduce their taxable income by that $13,200 making their taxable income $107,800 instead of $120,000. The tax bracket for $107,000 is 25%, so their tax bill is $26,950.00, not $33,600. This is a tax savings of $6,650, or $555 per month. The tax break effectively reduced their monthly payment from $1,200 to $645. Imagine living in a $220,000 home for $645 per month. Compared to a $645 per month apartment, I’d bet that the home has more space, better quality, and a better environment.
The real estate rule of “leverage” is the second reason to purchase through a mortgage. Simply put, leverage allows you to pay a percentage of the value while getting the appreciating value of the whole value. In our example above, John and Sally purchased their $220,000 home with a 10% down payment ($20,000). Now, if the home appreciates at 3% rate, after one year it is worth $206,600. Notice that the entire $220,000 appreciated 3%, not just the $20,000 down payment. Had they left the $20,000 in the bank, even at 5% they would have received $1,000 in interest, and that interest would be taxable. The gains on the home are tax free if you live in the home for at least 24 months in any five year period. If John and Sally sell the home in 7 years, the expected value would be $270,500. The gain on the $20,000 down payment is $50,500, not including the tax savings from reason 1 (above). And, the gain is tax free. Even if John and Sally used a Real Estate Agent to sell the home and paid 6% commission ($16,230), they would still net $34,270 tax free gain. They would have turned their $20,000 into $54,270 in 7 years, lived in a $220,000 home, and saved money on their income taxes. What investment can be better than that?
So, do your self a favor. Buy a home. You will never be sorry that you did.