Wednesday, February 20, 2008

The REAL American Dream

NOTE: Don't miss the Debt Rattle for February 20, which you can find below or via the sidebar link

Ilargi: Erica Douglas is a 26-year-old smarty who did some nice and useful math to prove the point that renting a home these days beats buying on all fronts, except perhaps for the emotional one: owning makes you feel good. I think she provides a good and practical example, which many people who find themselves facing similar situations, can use to help them make up their minds.

However, I also think that Erica has a lot left to learn, certainly when it comes to redefining the American Dream. That dream goes of course far beyond owning a home; indeed, the true essence of it lies in accumulating money and wealth. And Erica hasn't lost that dream at all; she's merely figured out a way to accumulate more and faster, in this case by being smart about her housing situation.

In my view, Americans and others will be forced to learn a different lesson, and a different way to define the American Dream, by finding a purpose in life that is not centered around money. Those who fail to achieve that re-defining will face enormous psychological problems, because the money will no longer be there to be gathered. Finding different or smarter ways to cling to the old dreams will be of no use; the old dreams are gone, and I don't think that's necessarily a bad thing. A life focused solely on collecting as much property as you can is, for all intents and purposes, an exceedingly poor existence. Holding on to the idea that money is the meaning of life will cause you a lot of hurt in a world where money is rapidly disappearing.

You need to learn the lesson, or the lesson will teach you.

The REAL American Dream : It’s NOT Owning A House!

I did the math, and I think our society has been sold a pile of crap that we’ve bitten on hook, line, and sinker. I’m not going to mince words or try to make this sound nice, because we’ve been duped, and we have every right to be upset about it. Let’s rewind a bit and figure out where this particular dupe came from.

Several decades ago, the “norm” was to work for one company for most of your adult life, with the assurance that they would provide for you for the rest of your life. My grandfather, in fact, still lives comfortably in a retirement community on pensions from the government and a university where he worked, as well as Social Security. He will be 87 years old next month.

My parents’ generation (my father will be 65 this year) was raised on those ideals, but it didn’t often work out for them that way. My father will grumpily point out that some of his friends who worked for corporations their entire careers have pensions, but he has “nothing”. My parents are both self-employed and are somewhat miffed that they didn’t get to partake in that.

This myth has slowly unwound all the way down to our generation. People in the 21-35 age range, including me, don’t have any illusions about working for any specific company and having that company pay for their retirement. The younger people you talk to don’t believe we will have Social Security to help us, either.

In the span of 2-3 generations, then, we have gone from working for one company as the ideal, to switching jobs every 3-4 years and not really having any idea of how to save for retirement past a 401(k) or similar plan.

What does this have to do with housing?

Housing has had a similar change, but I don’t think we’re aware of it. In fact, housing has shifted so radically in the past 9 years that we’re still trying to unravel the mess. Just 9 years ago, it was possible to buy a house right here in San Jose, CA for about $325,000.

Remember, this was in the middle of the dot-com boom. I lived here in San Jose in 1999. I remember the crazy traffic, the 6-8 week waiting lists just to get a crappy apartment, and the scary projections in the San Jose Mercury News that we would never be able to build enough freeways to sustain the crazy population growth we had here.

It seemed that every week there would be another story of a young dot-com millionaire. I watched several of them get made — I worked for Cobalt Networks, and our stock price rose 618% in its first day of trading on NASDAQ. Everyone who was middle management or higher got their “golden ticket”. I watched multi-millionaires get created before my eyes. (No, I was not one of them!)

Yet houses still only sold for half of what they do now. It is now so much cheaper to rent than to buy — not only here in the Bay Area, but in most high-cost locations in the country. I’m going to do the math and break down why it’s better to rent than to buy. Then I’m going to show you exactly why you won’t listen to the math…and what should sway you to seriously consider not buying a house instead.

The math

I live in a 3BR, 900sq.ft. duplex in the 95118 zip code. I’m going to pick a similar house in the area and estimate what my rent payments would be vs. mortgage payments, property tax, and maintenance on the house. Keep in mind that I won’t use “peak” housing prices here, but the prices as they stand today — about 15% down from the peak. My rent: $1650/month — recently raised by $50/month so the landlord could install central heat and A/C. (Previously, we just had a gas heater on the wall.) My landlord lives in the other half of the duplex.

We’re going to use MLS #770964 as the comparison house. It’s a single family home in my zip code. It appears from the listing to have central heat and A/C. It is also 960 square feet…slightly larger than my current rental. It appears from the pictures to be in fairly good condition. It’s currently priced at $522,200, making it one of the lowest-priced houses in my zip code, and has been on the market for 40 days. To make a completely fair comparison, we’ll stipulate that the house buyer has agreed to accept $510,000 on our “offer”. We need to come up with a 10% down payment to buy this house.
  • Down payment: $51,000
  • Closing costs: (We’ll be generous and assume the seller has offered to pick up the tab.)
  • Mortgage payment: $2,570/month (10% down; 6% interest)
  • PMI: $100/month (since we put less than 20% down)
  • Property taxes: $5100/year
  • Maintenance: $5100/year (estimated at 1% of the value of the house, per year)
  • Total cost to own the house: $3520/month.

However, there’s another number that most people forget to add in. That is the opportunity cost of having your down payment sitting in an illiquid asset that will most likely decline over the next few years, as opposed to having it in an interest-bearing account. But, again, I’ll be generous, and give you 2% appreciation per year on the house — as opposed to a modest 6% return in the stock market. (Returns of 10% or more are still achievable with a bit of footwork, but that’s another blog entry.) The difference between 2% appreciation and 6% appreciation is $2000/year, or $166.67/month. Adding that in to the house payment, we arrive at $3686.67/month.

UPDATE: I forgot to add in the mortgage tax deduction. Basing this house purchase on a $150,000/year income, which is in the 28% tax bracket, you would save $800-$900/month as a deduction. Let’s take $900/month to be safe, and deduct that. Keep in mind that the mortgage tax deduction will get a bit lower every year. I’m taking the best-case scenario — by the time you’re 20 years in to owning the house, you will only pay about 1/3 as much in interest as you do the first year, so your costs of owning the house over time do go up.

REAL cost to own the house: $2786.67.

The difference between owning and renting, then, comes out to a shocking $1136.67/month.

Most people see those numbers, though, and it doesn’t sink in. To find out why, you have to look no further than Why You Don’t Save Money, Even Though You Know It’s The Right Thing To Do . Much like me buying the new car instead of a less-expensive used one, buying a house makes you feel good. It makes you proud.

So, instead of beating you over the head with numbers, I am going to give you an emotional reason to not buy a house.

What you SHOULD take to heart: Not buying a house means complete freedom!

Imagine if, instead of buying a house, you lived in a rental. Instead of taking that $51,000 and putting it in a down payment, you invested it. For this calculation, I’m going to assume you can earn 10% — with a bit of know-how and the right mutual funds, you can achieve that. Furthermore, since I assume you can afford the full house payment, I will also assume that you set up an automatic deduction of $2000/month into that same mix of mutual funds.

I will assume you start doing this when you are 26 years old, which is the average age of “Generation Y” homebuyers. (Coincidentally, it’s also how old I am.) You might balk at putting that much away, but I assure you — if you think you can afford the house, this is an essential first step. Also, if you find out you can’t do it, it’s much easier to fail now than have a foreclosure on your hands later.

Let’s take our $51,000 down payment and $2000 a month addition and hand it to the compound interest calculator. Using 10% as the interest rate, we find that 20 years is the magic number to get us to over $1,000,000 in principal. 10% interest means we can pull just under $100,000 a year out at that point without lowering our principal.

That means, just when those around us are paying off their mortgages and celebrating, you can celebrate complete financial freedom. That means never having to complain about the boss again, never having to work a job you don’t love again, and basically…retiring. Believe me, as someone who “temporarily retired” after selling my business several months ago, it’s incredibly liberating to know that you can do absolutely whatever the heck you want, and still have the money rolling in every month no matter what. It is an amazing feeling.

Redefining the “American Dream”

You see, up until I did the numbers, I thought I wanted to own a house, too. If prices came down enough, it made sense. And surely, if prices come down significantly, to where a house plus property taxes, insurance, and maintenance is cheaper or the same cost as renting, then I may consider it. There are places in this country where that is the case now. In that case, I say “buy” if you plan to stay in that area for a while. For most areas of the country, though, I can’t recommend buying for quite a while. Do the math. In most urban areas, you’ll find numbers similar to the ones I quoted above.

Rebutting the naysayers

Somehow, homeownership has become entangled with the words “American dream” and even “freedom.” I want you to have the courage to think differently. My goal is actually to be completely financially free by age 30, so I have my work cut out for me. Owning a house, unless it’s cheaper than renting with taxes, maintenance, and opportunity costs factored in, is not a feasible option.

If people ask me why I don’t own a home, I can simply say “My goal is to be completely financially free by age 30. Owning a home at current prices is not congruent with that goal.” I feel good with renting, because I know that by renting, I can sock away money for my future. That future can include spending years abroad, traveling the world, or taking time off to learn foreign languages or learning how to fly a plane. In other words, I can spend my life doing the things I love, instead of being tied to doing something specific for any length of time.

If you asked me how I define the “American dream”, I’d say: My American dream is to have the freedom to do what I want, when I want to do it, with no worries about my finances . That statement resonates more strongly with my heart than owning a home ever will. I encourage you to step up and define your “American dream”, too. Dare to go head-to-head to those who say that signing up for debt has anything to do with an “American dream.” Become a powerful voice for change in this country’s way of thinking. You, too, can be free just by changing the way you think about freedom.


Anonymous said...

Rich Romans were probably the last to see the provinces falling. I don’t see the "professional class" of Americans I know learning much of anything. To paraphrase Kunstler—they’ve been driven insane by their lifestyle. What sanity is in this sentence?

"My American dream is to have the freedom to do what I want, when I want to do it, with no worries about my finances."

Complete absence of reality about what it is to be a mature adult. If such a person learns anything, they try to sell it.

Thomas Kuhn in The Structure of Scientific Revolutions suggests that paradigms don't change because people confronted with a new paradigm change their minds, but that these people die and are replaced by those with a more complete paradigm. From this perspective, surviving the future is not the issue; living responsibly is.

Anonymous said...

Eesh, having "the freedom to do what I want, when I want to do it, with no worries about my finances"
that is sure a nice dream for fantasy land, but that isn't a basis for a personal plan, much less a whole economy! Indeed, I predict that if you DID become wealthy enough to pull that off temporarily, you'd find the "what I wants" getting more expensive, until you began worrying about finances again.

Notice that what she really wants is not wealth or money, but immunity from worry. And as she says that is a common goal but a generationally angled one. Once folks actually thought that society would provide them with security, social security as it were, and it often did. But the hope of society supporting you if you have troubles just doesn't make young folk feel secure anymore. Similarly, once people trusted an employer or a career path to make them secure, and maybe these things worked once, but again these routes don't seem very trustworthy to the young.
So Erica says no, trust money to make you secure! And she assumes you can get 10% a year forever, risk free "with a bit of know-how and the right mutual funds." (If you can just get that first million while your young enough to enjoy it!) I know homesteaders, who believe that with a bit of land, and sufficient skills in gardening and animal raising they can live poorly but securely indefinately. Again, the appeal of self-sufficiency is not primarily the freedom or independence but the economic security (with perhaps a side helping of moral superiority).

Our society has bought wealth at the cost of risk, and hidden the risk for a long time. But what everyone actually yearns for is not the wealth, but the freedom from risk.

Buy hey suppose you really did convince me that not buying a house saved me money in the long run (er in some urban upscale markets, for folks who make over 3 times what I do) that would still leave the question of whether owning a house prevented risks commensurate with its cost. And evalating that would involve thinking about the risks of homelessness, of moving around, of being disconnected from community because of moving around, and so on.

Anonymous said...

Comments so far are somewhat right to attack the philosophy behind the article, but they ignore the point that most people buy homes for emotional satisfaction. If this were false, home buying would not be such an easily-demonstrable financial loss. Thus, it's difficult to criticize the idea of not buying a home for the purpose of emotional satisfaction.

I take Brian's point that the considerations are very different for homesteaders outside urban areas, but I think it was fairly evident this article was intended for urban areas: the author made qualifications about the inflated value of homes being an important factor.

Finally, it's not really a criticism to point out that the author has the means to either invest heavily or put a decent down payment on a home. Frankly, those who cannot should be renting for an altogether more serious reason: they cannot truly afford a home.

super390 said...

Rent is nice slavery. It has been the form of oppression of most humans for the last 5000 years, in the form of tenant farming and the resulting polarization of wealth. If the fatcats can make more money by selling houses, they'll rig the laws to favor that. If they must make money by terrorizing tenants instead, you know what's coming.

And I bought my house in the Houston Heights in 1999 for a $400 mortgage payment when it cost over $1000 a month to rent a house in this area. Apparently rents can be inflated too.

Anonymous said...

There's no way in h3ll I would buy a $510,000 house. Why did I buy a house instead of continuing to rent an apartment? Well, the lack of desire to assault my upstairs neighbors due to their lead feet, I don't hear the dog in the apartment to the side of me, and I don't have to put up with crappy appliances that the apartment has because they're cheaper than the quality ones I would purchase.

I can paint my interior whatever way I want to, I don't have apartment people coming in whenever they please, I don't have regulations against pets if I wanted them, If I want a satellite dish on my house for TV or Internet I can, I'm not forced to buy cable from my apartment company, I have a yard to work on projects in if I like, I have a garage to park my car in, I can put political signs in my yard, I can shoo people off my yard who are trespassing, I don't have to walk half a block to get to my mailbox, I can remodel my house whenever I choose, I can have 4 cars in my driveway if I so choose, I can construct a haunted house in my front yard for Halloween, I can put those obnoxious inflatable Santa's in my front yard if I so choose, etc, etc, etc...

But wait! I could go for something more practical.
I could grow a garden in my front/side/back yard.
I can install solar panels on my roof. (PV or water heat.)
I can install a wind turbine on my land.
I can choose to have a natural landscape instead of a "lawn."

Ah, but who cares, if she wants to live in a condo or apartment, who am I to complain? It means she's not in my neighborhood!

Anonymous said...

How could someone write an article like this and not involve home equity in the discussion? Home equity is totally vital here. The author charitably estimates a 2% price appreciation per year. The argument for owning all along has been that it is an investment from which you will ultimately profit, whereas rent is a totally sunk cost. In other words at 2% appreciation, you will eventually get every penny you put into that house back when you sell it, but you will never ever see your rent money again.

So the real question is, which one is greater:

(total ownership cost) * (rate of house price appreciation)


((total ownership cost) - (total renting cost)) * (rate of appreciation in whatever alternate investment vehicle you choose)

Only if #2 will be greater is renting ultimately financially favorable.

The bottom line is that sometimes renting is a better investment and sometimes owning is. You have to do the math on the basis of each individual situation.

Anonymous said...

My kids are the reason I own a house, i.e. I want a yard they can pretty much ruin, walls I can paint or knock down as needed, the freedom to have pets and the basic stability that home ownership implies. Of course kids pretty much ruin any chance of my doing what I want when I want with no financial worries. Boy am I stupid!

LJR said...

She's insufferably smug and egregiously wrong in her calculations. 6 percent of 50,000 is 3000. 2 percent of 500,000 is 10,000. One comes out ahead by $7K if the property appreciates 2% a year. Let's face it, that's a pretty stupid mistake to make.

She didn't even figure in the tax benefit until a commentor pointed it out to her. What a dufus.

Anonymous said...

brian m,

Quite agree with your "Eesh" though I might express it diferently as "Arrrgh", and about:

... the risks of homelessness, of moving around, of being disconnected from community because of moving around, and so on.

I think in one particular year in the 60's I maxed out, living at over a dozen different places, and through those years never felt more connected with a community, before or since. Living with no fixed adress lacks a lot but the one thing it doesn't lack is community.
The other thing that moving about offers is increased opportunity for uncertain times.

Maybe the best thing to emulate in the coming times for so many people, without the do-re-me even for rent, is possibly the Gypsy?

Anonymous said...

guy forgot to add insurance to his math.

Stoneleigh said...

The argument for renting is much stronger at times like these when we're facing a historic collapse in property prices IMO, especially when that property was bought on margin (ie mortgaged). Your home equity - painstakingly built up over many years - could be gone very quickly, leaving you with only debt. Walking away from that might not always be as painless as it is now if history is any guide. Selling while you can and renting allows you to preserve your home equity in a liquid form at a time when liquidity matters a great deal.

In addition, home ownership in a depression has the unfortunate effect of tying you to a location where there may be no means of earning a living. Real estate can go illiquid very quickly and can stay that way for a long time, leaving you unable to sell if you need to go where the work is. Renting allows you to be flexible in the face of considerable uncertainty.

Anonymous said...

I think the deep issue here is the whole cost/value of moving around.

I fully believe that in the 60s you could move around a lot and still be well connected in a community, but the the US has lost a LOT of social capital since then. We changed states every year for 4 years recently chasing temporary academic jobs, and it did cut badly into our community connectedness. But we did it because the jobs moved around. The real main advantage of renting is that it lets you chase jobs, at the price of some rootlessness. If you are wealthy enough to think of real estate as an investment choice rather than a lifestyle choice, so be it. But for most of us, most of our income comes from a job or career, and as Stoneleigh points out that is a big constraint on where we live.

But it is very, very easy to raise the rent where the jobs are. It is hard to estimate the cost/savings of renting, because just because you know the cost of renting THIS MONTH, doesn't tell you much about the cost of renting in 20 years, whereas you can calculate your future housing costs with much more certainty if you buy and hold. Renting vs buying is about speculating on the long term futures of the rental market.
Sure housing and probably rent are going to crash over the next several years. But suppose Stoneleigh is right and there will be hyperinflation from fiat currency creation, after a hard deflation. The rental market in 15 -20 years could well be a killer. If you can hold your home through the deflation phase without defaulting, it could be much cheap than renting in the future. Long term, landlords spank renters, and it is only during and shortly after eras with lots of construction, that renting looks good. Of course, we're just past such an era now. But that is speculation on futures, not investment, and it is fairly detached from equity issues.

My brother's house in a small town is not worth much equity-wise. Few people move in or out of the town so the real estate market sucks, and there aren't a lot of surplus jobs. But he has one of those few good jobs, and the rental market is a killer (because there is both little to rent what little demand there is is pretty much trapped). So the real value of his house is not what he can sell it for, but the rent he doesn't have to pay because he owns it. But that only makes sense if you plan to stay somewhere for a while, rather than moving again soon. If you hope to resell, then the market price matters again. Americans have led a very mobile lifestyle for a while so the economic strategies of buy and re-sell, have been more pronounced than the economics of buy and hold. So I agree with Stoneleigh, rent now buy later if you still want the mobility. But if you are ready to buy and hold, the fact that the market value will drop like a stone over the next few years, isn't necessarily a stopper, especially if you anticipate inflation following a deflation phase.

goritsas said...

Brian M. said...

But if you are ready to buy and hold, the fact that the market value will drop like a stone over the next few years, isn't necessarily a stopper, especially if you anticipate inflation following a deflation phase.

I completely disagree. It is the biggest stopper you could possibly ask for. First off, why, if you knew prices were going to drop like a stone, would you stand pat and watch every dollar in equity you’d built up during your mortgage payment years disappear like fog in the late morning sun?

Second, why wouldn’t you sell now, stand pat, and when the time was ripe use your now king cash to buy back your property, or its equivalent, for a 50% to 90% discount? Your brother will unlikely see in his lifetime a chance to cash out his equity again.

As for the hyperinflation scenario, use a bit of the cash from the sale of the property to buy gold and silver. If hyperinflation does materialise then these metals may very well hedge your loss in purchasing power during said inflation.

Anonymous said...

Brian said Renting vs buying is about speculating on the long term futures of the rental market.

Now that's the absolute foundational truth of what we're talking about here. Everything revolves around what you expect in the future, where you live (as a Canadian, a lot of factors for me are markedly different from what's being mentioned here), and what you value more. It really is an individual decision, and to some extent a gamble either way. For me, the better choice right now is to save on the considerable costs of owning an overvalued home in the downtown core (because that is where I live and will continue to live for now) and instead rent a nice apartment (which I can renovate as I wish, keep pets in, and so on - I hunted out a good landlord the way anyone would hunt down a good location for their home) and invest the savings.

I plan to have a lot of money for a down payment on a house when (a) I want a yard and (b) housing prices come down. Prices are currently a no-go for me.

Stoneleigh said...

I agree that renting versus owning is a very personal decision dependent on individual circumstances. There's a lot to be said for being rooted in a community, but perhaps not enough to risk losing everything as home equity evaporates and jobs disappear. It's not fair, but the wealthy will be able to afford that rootedness even if they stand to lose quite a bit on their property investment, whereas the less wealthy may not be able to. For them renting may be the only way to avoid the road to ruin. A really strong community may be able to offer enough mutual support for people to make it through one way or another though. It really depends on the circumstances.

Brian M makes a good point about not wanting to be a renter during any hyperinflation phase that may follow deflation. This I very much agree with. As Brian points out, some may be able to own now, ride out the deflationary storm without losing their home (if they have no debt and can still afford the property taxes), and then do very nicely as owners of hard assets during hyperinflation. For others the better route is to sell, 'keep your powder dry' (ie preserve your liquidity) and pick up a bargain property later at a huge discount.

One advantage of doing so is that there should be a vast amount of choice for anyone who still has money, so you may be able to get hold of a viable homestead that you wouldn't be able to afford right now, and that could be a considerable advantage. Which areas will be viable isn't necessarily obvious right now, so waiting could allow you to make a more informed choice.

You have to look after your liquidity carefully for that to work though. Don't trust an insolvent banking system.

Anonymous said...

Your equity doesn't disappear if the house loses 90% of its value over then next 5 years, and then regains its value in the following 25 years, and THEN you sell. Likewise you don't lose your equity if you have very little equity in the house to begin with. Equity is a feature of re-sale strategy not of rent-avoidance.

So why not sell now, hold cash, and buy back your property or its equivalent for 50% to 90% discount?
Well, first, who says my property will be for sale again that quickly? And second, there are 4 houses that are its equivalent (all built in 1902), or not even that, because the other one I have been in is not nearly as well-kept up. Houses are not interchangable commodities like gold-bars or bags of corn. This is partly emotional attachment of course, but not entirely. Houses outside of cookie-cutter land, are simply not equivalents of each other, they have unique locations, and other unique features. Third, our market is really slow, houses routinely stay on it for several years without selling. So it is probably already too late to "sell now" but this also means that our prices aren't nearly as out of whack as many places.

But there is a deeper problem. Suppose I was able to sell quickly. It would be very hard to pay rent AND a mortgage (and student debt, and our other monthly expenses) at the same time, so we'd have to use whatever we got back out of the house to pay down (or off) the mortgage, and wouldn't net cash unless we happened to sell the house for more than we bought it for, which seems unlikely in this decade. Then when house prices are cheap we'd buy on your plan. But what TERMS would mortgages have in those trying times? When mortgages have just defaulted left and right, and no one has faith in real estate anymore? My current mortgage is doable, even long term, as long as I can stay decently employed, and if I fail all they can take is the home, so they have an incentive to work with me. But the terms of mortgages, if you can get them at all, in a few years will be horrible! They will be recourse loans at least, and may even have debtor prison clauses or some such. That's what a credit contraction IS, it will be hard to get credit on sane terms, even if you do happen to be creditworthy and making a reasonable purchase, instead of lying about your income and buying something worth 10% what you pay for it.

In 3-5 years houses will be vastly cheaper, but nonetheless vastly less affordable to people like me, as will rent. If you have the monthly cash flow to sell, take the cash, and still pay your current mortgage and rent, then your sell-rebuy strategy makes sense (as long as you can time everything right, and have predicted correctly). But I've seen several otherwise sane, solvent people ruined by the bad overlap of trying to pay 2 houses at once, or a mortgage and rent at the same time. And if you will need a new mortgage to pull this off then be wary. Debt now, on easy terms, is vastly better than debt later on terrible terms, although as alway no debt is even better if you can afford it long term.

Sell-rebuy, is just the flip of buy-resell, and both are quite different strategies than buy-hold.

My brother will not see decent chance to cash out his equity for at least 20 years, I agree, but HE WENT INTO THE DEAL KNOWING THAT! That is what BUY AND HOLD is! You want the dividends the investment pays (rent defrayment and a place to grow food, when food supplies are in trouble), not the equity value for re-sale. Equity is for rich folk and speculators. And buy-resell and sell-rebuy are speculating on a market famous for turning suddenly illiquid.