Get on the equity escalator and trade up later!
I am hoping someone here will be able to clear this one up for me.
One of the frequently-repeated arguments that real estate salesmen use to try to convince the renter-serfs to buy a home is that once you buy a home, your costs are fixed. While that's not entirely true (taxes, insurance, and maintenance can all increase—and it's not true at all unless you get a fixed-rate mortgage), the costs can certainly be more stable than renting, where your monthly rent is likely to increase with inflation.
However, the very same people that tout the "fixed-cost" of home ownership will turn around and offer another argument for buying: get on the equity escalator so after your home appreciates you can trade up to nicer digs. This is where I get confused. If your goal is to "trade up" for a nicer home in 5-10 years, aren't you negating the entire "fixed costs" argument?
Let me throw a few numbers out here to try to explain what I'm talking about. Let's say Milton S. and his wife are paying $1,200 per month to rent a little two-bedroom house. They decides to stop "throwing away their money" on rent, and rush out to purchase a home (before they get priced out forever), finding a two-bedroom 1,200 sqft house in Shoreline for $325,000. Assuming they get a 30-year fixed at 5.75% and have the $65,000 to make a 20% down payment (a fairly generous assumption), their monthly PITI payment is now just shy of $1,900. They do save over $2,000 that year on their taxes, so let's shave off a slightly generous $200 per month, and round the monthly payment down to $1,700.
Right off the bat our example couple has willingly signed up for a 42% hike in their monthly expenses (not counting maintenance). That's quite a premium to pay just so you can have "fixed costs." With hikes of 3% per year, it would have taken 12 years for their rent to reach that level. But hey, at least their costs are fixed, right?
Well, what happens when 10 years down the road they want to "trade up"? Thanks to the "equity escalator" and annual 4% appreciation, their $325,000 house nets them a sweet payday of $227,500 (after fees & taxes). Unfortunately, the house they would like to trade up to—a four-bedroom, 1,900 sqft house in Ballard that cost $450,000 when they bought their first home—has been appreciating at 4% per year too, and now costs $666,110. Even after putting the entire amount down from the sale of their first home, their monthly PITI payment (minus tax savings) will jump 65% to $2,800. The situation is even more skewed if you assume greater appreciation (like say, 7%), with their $1,700 payment skyrocketing to $3,294.
After 10 years and just one trade up, jumping on the equity escalator has resulted in a 133% increase in monthly costs for our fictional couple (over the original $1,200 rent). If they had instead continued renting, their monthly rent after ten years would have increased "just" 34% to $1,613.
So I guess what I'm saying is that I can't see how the "fixed costs" and the "trading up" arguments can both be true. The real issue here seems to be that the idea of trading up when an over-inflated market is your starting point just doesn't make any sense. If Milton and spouse had bought that $450,000 home to begin with, still only putting down $65,000, the monthly PITI would have only been $2,521 (assuming PMI— it would drop to $2,350 in three years when the equity reached 20%).
Can anyone describe to me a situation in which "trading up" is a winning proposition?
27 comments:
I've heard this argument as well and I'm still not sure how it works. It goes along with the whole "starter home" theory.
I think that one rationale is that when you are just starting out, your income relative to inflation isn't as great as when you've been in your career for 10+ years. Or, say you get married and add a second income.
If you are all on the same escalator, then I don't see how it works. Unless you break it up into specific neighborhoods. But, wouldn't you just end up in a bigger place in a shoddier neighborhood and increase your payments significantly?
One more thing, and you certainly already know this, the tax benefit of deducting the interest paid on your mortgage will reduce year over year as you pay less and less interest per year.
I think that it can be very confusing for the layman when either side of the presentation is made.
All I need to know is the fact that equity on a 30 year fixed grows pretty damn slowly in the first 10 years.
If your house appreciates...so did the one that you want to "trade up" to. If they both appreciated at the same rate, the one that you want to "trade up" to is actually even further out of reach and this is without taking transaction costs into consideration.
So...how do you trade up?
Simple...you make more money.
Real money...not just paper gains on your "housing investment".
3% annual rent increases would basically just be inflation. We need to account for inflation in all those measures (4% nominal increase in house value, 1% real if we're lucky).
the only situation that this argument makes any sense if you are digging a 6 foot hole and planting your foot in it and not planning to move until you die (or close to it)...
this argument does bear fruit if you plan to stay around that home until the mortgage is paid off, then you can move up when you're 65 (but isn't that when you downsize)... so I guess you can move down then .... or lucky you, you're living in the perfect home and don't even have to downsize at retirement ... so you can live there till you die...
you cannot find anybody who bought at the height of the last cycle in the 90's that isn't up....
Yes, I think I could shed some light.
A fish tank, dog, three kids, two grown adults (theoretically), massive cedar trees constantly raining debris on your roof & yard all crammed into a 1300 sq. ft. 3/1 home, a large Cargo Van and two cars parked in the driveway and garage spoke loud and clear that it was time to add sq. footage/remodel (thousands and thousands) or move. Move won.
The Problem:
I couldn't afford the type of house in my own neighborhood that would suffice for our needs. My brain said "move north young man, move north." More bang for your buck I thought. We were on the hunt for over a year. Got into a multiple offer situation and that's when I knew the market was a little icky. Fortunately for me, I had comps and I had the last sales price of said home which took place about 3mos. earlier. I took the money off the table, thus, costing my competitors about $40K in nothing more than emotional hot air, in my humble opinion.
Which meant I was a big fat cheater:
Being in the biz has it's perks. Most notably access to a lot of information that assists with our decision making. Understand though that in 04' selling prices were not publicly available and unless you enter into a buyer brokerage agreement where they will give you that info. (theoretically), your agent ain't working in your best financial interests. No Zillow, no selling prices on any real estate website. We've come a long way in 3 yrs.
So we took our proceeds of about 8-9 yrs in Edmonds and plopped it down on our current McMansion (not). So, there you have it stylish bubble friends. Please don't ask me how much I've spent fixing up the old place and our current place. I will only think positive thoughts.
When my septic system fails on our current place, I'll send all the pictures of that fiasco to the readership so you can make fun of S-Crow eating crow. I'm crossing my fingers that it will last until my DNA tells me I will have a fatal heart attack. Until then...fingers crossed.
So how do you trade up?
Take equity money with you and put yourself into a position where your income far exceeds your monthly nut. Check in with me in the Fall. Pun intended.
Oh, and stay in your home a while. Oops, almost forgot, don't refinance over and over again. Dang it, forgot another one. Stop buying brand new cars with payments of $600 mo (not including insurance,fuel and maintenance).
:)
Just hypothesizing here, but maybe the theory is that the escalator is really just a mechanism of allowing you to continually get more and more leverage, so that you will profit even more from PERPETUALLY appreciating real-estate.
If you didn't buy the first home, you would never have enough for the down-payment on the next trade-up. But now, you will gain MUCH more equity since the total value of the home is more (e.g. 7% appreciation of a $600,000 home is a lot more than a 7% appreciation of a $200,000 spread).
So what if your income doesn't increase enough to afford the mortgage on the trade-up. You can always do cash out refis to suplement your income. This is no big deal, of course, since the annual appreciation will be for more than the extra money you need to cover the payments/taxes, etc.
Eventually, the end-game is to sell the monstrosity you eventually wind up in at the end of this process (after trading up 5 or 6 times over your career), and have a cool 2 or 3 million in cash that you can then use to retire in a cheap condo in Phoenix.
In short, if the appreciation is high enough, and you keep doing cash-out refis, then you'd might as well use ALL the leverage you can possibly get, and keep moving up that escalator indefinitely.
Isn't 7% overly optimistic and a continuation of "real estate never goes down" fallacy?
I have listened to my father's stories about how he bought a house for 25k and it took everything he had to pay the mortgage off on a monthly basis. Now, that house is worth over a million dollars and it's not even in a great neighborhood.
So tell me, who is to say that inflation has gone away? The rent back them was pennies on the dollar... and he wouldn't have had to stress about the payments on a month to month basis... and he could have gone to disneyworld, or better yet, invested in Microsoft stock ten years later.
Now, he could have invested in some stock in some company that crashed... but he chose to invest in the American Dream...
I think across the board real estate is a proven commodity that continues to do well.
How long? Who knows... but how long before we hit another Black Friday?
mikhail,
you are joking right??
This whole ideal is predicated on the idea that:
1) You want to own your own home at some point.
2) Eventually you want to trade up to your dream house.
In general, the owning renting debate is discussed purely in financial terms on this blog. In those terms, renting can often be the same or better. However, it leaves out the qualitative aspect of the equation. In general, most people are happier owning. But if you don't care, then you may be better off renting.
But if you want to keep trading up to the dream house, you need to get on the equity train as early as possible.
Case in point, the previous owners of my place bought it in 97 for 160K. They put in about 60-100K remodeling it, and then sold it 7 years later for 430K. So they earned almost $200K in equity, which they rolled into a bigger nicer house that was about $550K. Deduct the 200K in equity (never mind how much they paid down the mortgage) and they got a 550K house for 350K. If they had been renting all that time I doubt they would have saved $200K.
This is based on the idea that a "dream house" is a monster house. That certainly isn't the case for me. I'd rather have a 2-3 bedroom house in the woods than a McMansion in the city. I don't need to "trade up" to get the house I want. I just need to not be tied to a job in the city. =P
Matthew said: "you are joking right??"
I am just outlining the only way that I think the "escalator" can work. I certainly am not a proponent of that theory since it relies on some pretty optomistic assumptions. If homes don't keep appreciating at a fair clip, or cash-out refis become harder to get, then this whole concept would fall apart.
Case in point, the previous owners of my place bought it in 97 for 160K. They put in about 60-100K remodeling it, and then sold it 7 years later for 430K. So they earned almost $200K in equity, which they rolled into a bigger nicer house that was about $550K. Deduct the 200K in equity (never mind how much they paid down the mortgage) and they got a 550K house for 350K. If they had been renting all that time I doubt they would have saved $200K.
I'll spare the boring details.
The owners originally had a 160k Mortgage.
Then they spent an additional 60-100k
now...being that you chose the optimistic route that left them with 200k...
not quite sure how that worked out after commissions...unless they had a down payment and an original mortgage of less than 160k
but anyhow.
Now their mortgage is 350k
They moved into a house that was only 120k more than the one that they sold yet they now have a mortgage that is more than double their original.
did I lose you on that one?
pretty simple...really.
Can anyone describe to me a situation in which "trading up" is a winning proposition?
Tim,
Many people leave higher priced areas after taking a ride on the 'equity train'.
They trade up the starter for their dreamhome in a cheaper area - sometimes able buy a house with just the equity they have earned. These are commonly known as equity locusts. Areas that seattlites might move to include Cle Elum, idaho, montana and in my case North Carolina.
I could, right now do this scenerio and live "free", but we are not ready to go back yet.
Now their mortgage is 350k
Right...but they have a nicer, bigger house for less then if they had gone straight from renting to buying. They built equity over a 7 year period.
Again, this is all predicated on the fact that you want to own and want to trade up. The main motivation is quality of life, not just financial.
Also, during the equity building period many people's personal finances improve. Better jobs, raises, etc. So they can afford more...which was the case with the previous owners of my place.
Combine higher income with 7 years of equity, and you can get a way nicer house for far less then if you had rented all those years. But if all you ever want to do is rent, it doesn't matter as much over the short term. But over a long period, 20-30 years, you'll most likely spend less as an owner then a renter.
just like your 401K if you're in it for the long term you should stop looking at the day to day fluctuations of the market...
kinda like checking your home's value every week knowing it makes no difference coz you won't sell for years...
and in a few year who knows what will happen...
but yes if you plan to live there long enough, real estate has always been better.... not just financially but because of the stability (not having to move) and the fact you can do stuff to you home...
but this is assuming you are able to afford your mortgage comfortably and not on a toxic loan...
I may be wrong here as I'm just starting my first cup of coffee on the day, but if you subtract their original down payment + the remodel costs from their $200k I think you'll have a much more realistic view of how much they would have had to save over that 7 year period of ownership to equal the equity they came out with.
"I think that one rationale is that when you are just starting out, your income relative to inflation isn't as great as when you've been in your career for 10+ years. Or, say you get married and add a second income.
If you are all on the same escalator, then I don't see how it works."
That sums it up. I see owning as useful in two ways:
1. A leveraged call on inflation. Like you said, owners are all on the same escalator. The house you trade up to didn't stop accelerating just to let you catch up. As you said, it has more to do with your natural income growth and increased savings, which brings us to:
2. A forced savings plan. Granted, you're paying ~$2 to the bank for every $1 you actually save, but that's apparently better than most people can do on their own. Of course, this was before they leaned how to "liberate" all that equity.
That's about it. The people who really make out, of course, are the ones who buy the bottoms and sell the tops.
Well lets compare the fortunes of the previous owner my house with someone who didn't buy during the same years (97-2005). Why not use Synthetic?
Previous owners: Earned 200K in Equity and now have a great place valued well over 600K (but are only paying a mortgage of around 350K)
Synthetic: Invested in stocks, went bankrupt in 2001. Had to leave S.Cal and now rents a little place on Capitol Hill.
Hmmmm....I'll take the owning route.
Meshugy,
Here's another way of looking at it:
Previous owners: ~$350k in debt, with a monthly PITI of over $2,000 on a nice house.
Synthetik: $0 in debt, with a monthly rent of <$2,000 on a nice condo, AND hundreds of thousands in liquid investments, accessible without having to move or take out a loan.
Not as clear cut as you make it sound.
To win at trading up you have to move from a place that has over-apreciated to a place that has under-appreciated. In a free market this is difficult to do and in theory would require a work and time investment equal to the gain you will receive.
hundreds of thousands in liquid investments,
Yeah right....ha ha
To win at trading up you have to move from a place that has over-appreciated to a place that has under-appreciated.
Actually not so hard...get a starter home in an up and coming area which will appreciate faster then more established areas. Works every time...
"hundreds of thousands in liquid investments,
Yeah right....ha ha "
Feed the troll and this is what you get, Tim.
You do like I just did and....
1) Buy in '03 with nothing down. Crib was 300K even 3/2. Let's face it, I didn't have 60K laying around in my back pocket.
2) Current hyped value is around 430K.
3) Purchase a home double the size, triple the yard, and almost 2/3 of the original selling price in Seattle for 200K. New mortgage payment is around 1300 whereas the old pymt was 2200. How's that for savings?
I did this just this past week and I already have an offer on my apt...er....house in Kenmo for what I listed it at ---> 440K. Oh, forgot to mention that the new house is nowhere around here. (suburban Dallas). Oh yeah, I also forgot to mention that I got a 30K a year raise my moving there, and I stayed in the same field (IT). Kissing Washington bye bye.
Richard,
You are right, that is one way to make it work. Congratulations if you are happy in Dallas.
This had been happening around here for years with folks from California selling their crap-boxes and buying larger Seattle crap-boxes with some cash to spare.
It appears that this Californiafication has produced a new strain called Washingtonification that now affects other markets around the country, such as Dallas, Boise, et al.
My two cents, having bought my first house in January using the Washington State Housing Finance Commission's first-time homebuyer assistance program (a 1040 square foot 3bd 1.75ba in South Seattle for an even $300k): I didn't do it for the fabulous ride on the equity escalator, or whatever crap. I did it mostly for the stability.
In the past 3 years, I've had to move 3 times from apartment to apartment. A perfect renter, it has never been my fault--the roommate I had at the first place decided to move home to Marysville, and the rent was too much (at that time) for me to afford alone, so I had to scramble and find a new apartment. The second place was just a cash generator for the building owners, who never did a lick of maintenance on it, so after a year of dealing with that, I moved.
The landlady at the third place was nice enough, allowing me to get a long-hoped-for dog, but at the end of a year she abruptly gave me a month to move out so her divorced brother-in-law could move in. Now I had a hundred-pound German Shepherd, I'd been moving almost once a year since 2003 (and we all know what a fun experience that is)--I was flat sick of it. I wanted to stop living at the whim of a landlord for a change.
So I took the plunge and bought a house, knowing the risks, having followed this blog and other similar cautionary information sources for quite awhile--I did it anyway. I'm not looking for a cash cow, I just want a place to call MINE. I want to be able to offer a spare bedroom to a friend in need for a week or two without breaking a lease that says I can't allow anyone to stay more than 10 days in a month without permission. I want to have a shedding German Shepherd and not be charged extra for it. I want to paint the walls and maybe do a tiny remodel in the kitchen--or not, if I don't want to.
I'll be honest, I have a little credit card debt still, and I'm stretching a bit to afford the place right now (my partner being between jobs). Cutting back on extras like cable TV and eating out. But I thought about that possibility when I bought the place, and I'm in a stable job myself--and living on the bus line that goes straight to work. (And right on the coming light rail line, too.) My car's paid off. The interest rate on my 30-year mortgage is fixed. The only way I lose my job (other than me suddenly starting to embezzle funds or something egregious) is if there is some mighty severe economic depression--in which case, only the rich are safe anyway, and I'll have plenty of company on the street, right?
I don't know. It's nice to know that only my own ineptitude, or an economic crash of catastrophic proportions, will get me to move again for many years. No more crazy landladys. No more neglect of the premises. I'm not looking for a cash cow, but for a home, and I plan to stay in this house until I am ready to leave this area, period. And at that point, like acbaldwin72 pointed out, I'm hoping to move back home to southern Oregon to be nearer the rest of my family.
That's all. Flame away.
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