I live in an area where there seem to be more expensive houses than cheap houses. How can this be? Let’s see: Today, a $300,000 house is at the low end of the housing market in many areas, but for purposes of this letter, let’s say that it is an average price in many areas. If the average person were not able to afford an expensive house, how can so many people live in them? Bear in mind that all the payments you make on the house you live in are negative cash flow that you can support. Let’s look at some numbers:
A 90% loan at a 6% interest rate on a $300,000 house would require $30,000 down and monthly PITI payments of $1,618. In many areas, taxes and insurance would bring payments up to $2000 per month, or $24,000 per year. This amounts to about 45% of the average family income for Americans. Statistically speaking, bumble bees shouldn’t be able to fly; and the average family shouldn’t be able to live in a $300,000 house, but millions of them do. All that’s left to do is to find out how,
If you think about it for a couple of seconds, the answer is obvious: They either bought their home back when prices were lower, or they traded up from an existing home. More numbers: Suppose a family bought a $100,000 home ten years ago with FHA financing when interest rates were at 8%.
Their down payment and closing costs would have been around $4000 and PITI payments would have been $719 at a time when their family income would have been around $40,000. When you include taxes and insurance, their housing costs represent about 30% of their income. Buying it would have stretched their budget just as buying a home stretches it today.
At the end of the last ten years where appreciation averaged 10% per year, their house is worth $259,000. Let’s say that they sell their house and wind up with $150,000 tax free from the sale after paying off their old loan balance. They use this plus a 6% mortgage for $150,000 to buy a $300,000 house. Their new PITI payments are about $899, but their family income has risen by about $1000 per month in this period and interest rates have fallen. They are now able to live in home that costs $200,000 more than the home they left and continue to use before and only spend about the same percentage of their income as before.
So what! What’s this got to do with buying and renting houses. I’ll connect this all up next time.
