possible/probable

A couple of younger guys call me “Boss.” One of them emailed me the other day with a couple of basic questions along the lines of: “I’m thinking about buying a house. Should I? What are these tax breaks people keep talking about?”

I responded with a long, rambling email, which I present here. The information is pretty basic, so if you are already a homeowner you should skip this posting.

Here’s how it works: You find a house that you would like to live in. You buy it. Someone gives you a loan.

Assuming you get a fixed-rate 30-year mortgage, the payment is the same every month for the entire 30 years. Every payment you make goes toward two things: principal (paying off the loan) and interest (5% or so of the amount that you not payed off). At the start of a 30-year loan, almost your entire payment goes to interest. Near the end, almost all of your payment goes toward principal.

In general, a house is a bad investment. Buying a chicken is a good investment, because it produces eggs — it is a productive asset. Gold, for example, is not a productive asset. When you buy gold you are speculating. When someone says that “Real estate is a good investment,” what they mean is “I like to gamble on real estate.”

That said, the federal government wants you to own a house. So they do two things: tax breaks and they help keep the interest rates on fixed-rate mortgages low.

Tax breaks: You get to write off the interest on your mortgage. How does this work? At the end of the year, your mortgage holder will send you a statement that says “Of your payments, $30,000 went to interest and $5,000 went to principal.” When you do your taxes, you subtract the $30,000 from your income.

Let’s say that you are in the 28% tax bracket and you make $100,000/year. By taking your income down to $70,000, the interest has saved you $8400 on your taxes. As you can imagine, this deduction goes down as the years pass and less of your payments goes toward interest.

A fixed-rate mortgage is a great hedge against inflation. Here’s how it would work: You buy a house for $300,000. You make payments of $1700. Then inflation hits. Now, a loaf of bread costs $1700. Your house is worth billions, but you are still paying only $1700. (Your friends who are renting? Their rent goes to a million per month.)

Generally, the bigger your downpayment is, the lower your interest rate is. (The more skin you have in the game, the less nervous the bank is.) There is also points. Points are a fee you pay up front. More points, lower rate, but you need to bring more money to closing. Also, a 15-year mortgage has a lower interest rate than a 30-year mortgage. (We have a 15-year mortgage on our house.)

How much should you spend? Well, the money you put into principal is the stuff that is actually paying for the house; that is investment. The other money, that goes toward interest, is essentially your rent — what you pay to the bank to live in a house that you don’t really own yet. So, multiply the cost of the house by the 5%, subtract out the tax break you are going to get, add back in the property taxes, and that is your annual rent. If you would rent the house for that much, it is a bargain. If you wouldn’t, it is too expensive.

I should mention leverage. If the value of your home fluctuates, you can make or lose a lot more than you have in it. For example, let’s say you buy a $500,000 house. You put $50,000 down (10% down is possible). And the next year the values of the houses in your neighborhood go up 20%. Suddenly, you own a $600,000 house — you essentially made $100,000. Of course, leverage cuts both ways. The value of the neighborhood goes down 20%, you lose $100,000.

You seldom live in a house for 30 years, so when someone buys your house you pay off the remaining principal. If, at that time, your house is worth less than the remaining principal, you are said to be “underwater”. Being underwater sucks because to sell or refinance the house you would have to come up with a check for the difference.

Should you buy a house? Interest rates are low. House prices are significantly lower than they were two years ago. There is a first-time home buyer tax credit of $8000. If you want to own a house, this seems like a pretty good time to do it.