How to calculate the real cost of buying a house |
What is the cost of buying a house?
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. In the long run, buying cash will probably work well. The value of the house is likely to appreciate with inflation. The eventual sale will likely be a tax-free event.
While living in the house, you will enjoy another benefit. This is what economists call “imputed income”. It’s the invisible, tax-free benefit of housing that you would otherwise have had to pay for with after-tax income.
But simplicity becomes complex when financing the purchase of a home, and that’s what most of us do. According to the National Association of Realtors, 87% of all home buyers finance their accommodation.
When you sit down to sign that huge stack of paperwork, you’ll be told how many dollars you’ll be paying over the life of the mortgage. Borrow $300,000 over 30 years at 3.25% – the rate available before Russia invaded Ukraine – and you’ll pay back $470,023. Borrow it at 6%, as many did long ago, and you’ll pay off a whopping $647,515.
It’s quite 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 real savings from prepaying are likely to be less.
How is it possible ? The answer is what financiers call “the time value of money.” A dollar that comes to us in 2040 is not worth as much to us as a dollar in our bank account this week.
And yes, there is this thing called inflation.
So how do you calculate the real cost of buying your home?
You will need a financial calculator to do the details for your own home. In the meantime, let me show you how it would work with some calculations for a typical home cost in Texas. According to a recent report from Texas A&M University’s Texas Real Estate Research Center, median home prices in our major urban areas ranged upwards of $300,000.
—San Antonio was the cheapest 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% down payment could get a mortgage rate as low as 3.75 %. (This does not count point payments which increase the effective interest rate.)
So what is the true cost of a $300,000 or $400,000 home?
If you buy a house for $300,000 with a down payment of $60,000, you will borrow $240,000 and have a monthly payment of $1,111.48, paying off $400,132.80 over 30 years. If inflation equaled the interest rate, the present value of all those payments would be exactly the amount you borrowed, or $240,000.
But what if the inflation rate is much higher?
If inflation continued at a rate of 7%, for example, you would repay $167,063.86 in present value terms, not $240,000. In effect, the actual cost of your home would be $227,063.86 (the $60,000 down payment plus the present value of $167,063.86 of the amount you would pay down).
Now let’s do the same exercise with a $400,000 house. With a down payment of $80,000, you would need a mortgage of $320,000 with a monthly payment of $1,481.97. Over 30 years, you would pay $533,509.20. But the present value of those payments after 7% 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 current value of your mortgage, a total of $302,751.31.
In both cases, you buy the house with an effective discount of almost 25%.
How it actually works depends on one thing. It is the difference between the interest rate on the mortgage and the rate of inflation that you are experiencing. If inflation works hot, you’ll do just fine.
Yes, it’s a bet. But it’s the bet that built middle-class net worth for decades after World War II.
This is not new financial magic. This has been the case whenever the inflation rate is higher than the mortgage interest rate. It’s not a sure thing, but it looks like a pretty good bet.
Does this mean that house prices are not high?
No. It just means that bold homebuyers might not be as crazy as many seem to think.
(Scott Burns is the personal finance columnist for The Dallas Morning News.)
© 2022 The Dallas Morning News. Distributed by Tribune Content Agency, LLC.