Economics of Home Buying
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The document discusses the economics of home buying, detailing housing costs, mortgage interest, tax law changes, and loan qualification criteria. It includes financial calculations for purchasing a home, effective tax benefits, and compares different home buying options. Key takeaways emphasize the impact of interest rates, tax deductibility, and potential loan qualification based on income.
Economics of Home Buying
- 1. © 2018 Karthik Ethirajan, all rights reserved Economics of Home Buying Karthik Ethirajan May 2018
- 2. © 2018 Karthik Ethirajan, all rights reserved 2 Agenda 3. Housing Costs 4. Understanding Mortgage Interest 5. New Tax Law Changes 6. Loan Qualification 7. Loan Qualification Calculator 8. True Cost of Ownership 9. Comparing Different Types of Home Buys 10. Key Takeaways EconomicsofHomeBuyingDisclaimer This material does not constitute tax, legal or investment advice. Always, consult with your licensed advisors regarding your personal circumstances.
- 3. © 2018 Karthik Ethirajan, all rights reserved 3 Housing Costs For a home price of $1M with $750K loan amount Buying Costs Monthly Costs Selling Costs Closing Costs Title $700 Escrow $700 Lender Fees $1700 Appraisal $700 $3,800 Basic Renovation $8,000 Relocation $2,000 $13,800 Title/Escrow fees are paid by sellers in Santa Clara county, but paid by buyers in San Mateo & Alameda counties PITI Principal $987 Interest @4.5% $2,812 Property Tax @1.1% $917 Insurance $100 Home Warranty $50 Water, Sewer, Trash $100 Landscape $50 Single Family Home $5,016 Townhome / Condo $5,166 TH/CN adds another $400 in HoA but may cover insurance, water, sewer, trash, landscaping Closing Costs Title $2,500 Escrow $2,000 Recording @0.11% $1,100 Property Inspections $1,000 Buyer Realtor Fees @2.5% $25,000 Seller Realtor Fees @2% $20,000 $51,600 Basic Renovation $8,000 Relocation $2,000 $61,600 $5K monthly cash flow is required to maintain a $1M property About $75K can be spent in turning a home – buying & selling process Note: Some closing costs are representative figures & some others are negotiable
- 4. © 2018 Karthik Ethirajan, all rights reserved 4 Understanding Mortgage Interest 30-year fixed loan at 4.5% for a loan amount of $750K 0 15 30 Years $988 $2,813 Principal Interest P+I Monthly Payment $3,800 Monthly Interest Calculation Interest is always calculated on the outstanding loan balance 1st interest payment = ($750K * 4.5%) / 12 months = $2,813 Over the life of the loan Total interest paid is $618K A quarter point increase in interest rate will cost +$40K Tax benefit @33% is $204k Today’s Low Interest Rate Environment P&I for every $1000 borrowed $4.84 @4.250% $4.99 @4.375% $5.07 @4.500% $5.14 @4.625% $5.21 @4.750% P&I increases by ~$0.08 for every 1/8th point increase in interest rate
- 5. © 2018 Karthik Ethirajan, all rights reserved 5 New Tax Law (TCJA 2017) Changes Affecting Real Estate Changes will revert if Congress does not renew by 2025 (sunset provision) Before After Mortgage Interest Deductible <$1M of loan balance <$750K Property Tax No limits Deductible <$10K of Property Tax & State Tax combined Home Equity Loan (HELOC) Interest Deductible <$100K Not deductible unless used for home improvement Maximum Tax Benefit Tax saving from deducting mortgage interest = $750K loan * 4.5% interest * 33% tax 12 months = $928 per month No Tax Benefits from Property Tax State tax will contribute to most of the $10K max allowed deduction An AGI income of $140K can generate $10K in State income tax Solve using State income tax calculation: 10K = 2376 + (AGI – 4236 – 53980) * 9.3% Interest deductions amount to receiving ~$1K rent check from Government for owning a home Property tax will likely not provide home owners with any additional tax benefits
- 6. © 2018 Karthik Ethirajan, all rights reserved 6 Loan Qualification Back end ratio (liability to income ratio after purchase) is capped at 43% Income W2 income is easier to qualify Bonus may be considered if there is a history Rental income is capped at 75% occupancy rate Assume no liability besides mortgage, no HoA Price * 0.005 = 43% * Monthly Income Price = 86 * Monthly Income = 7 * Annual Income Liability Includes any HoA, car payment, student loan, alimony, child support, etc. Property tax calculated at 1.25% Home insurance is included at $100 monthly Assumes at least 20% down payment Max Loan 20% down, 4.5% interest PITI = Price * 80% * $5 P&I + Price * 1.25% Prop Tax 1000 12 = 0.004P + 0.001P = 0.005P (P is Price) PITI is about 0.5% of property value in today’s interest rate with 20% down payment You can purchase a home up to 7x salary with 20% down payment Monthly Cash Layout
- 7. © 2018 Karthik Ethirajan, all rights reserved 7 Loan Qualification Calculator Max loan amount with 20% down Note: Blue cells are model inputs Income Annual Salary 150,000$ Monthly Salary 12,500$ Rental Income -$ Adjusted Rent -$ Total Income 12,500$ Adjusted Income 5,375$ Liability Monthly Payments 500$ Property Sale Price 850,000$ Insurance 100$ HoA 400$ P&I 3,490$ Property Tax 885$ Loan Amount 688,281$ 81% Down Payment 161,719$ 19% Note: Blue cells are model inputs Income Annual Salary 200,000$ Monthly Salary 16,667$ Rental Income -$ Adjusted Rent -$ Total Income 16,667$ Adjusted Income 7,167$ Liability Monthly Payments 500$ Property Sale Price 1,300,000$ Insurance 100$ HoA P&I 5,213$ Property Tax 1,354$ Loan Amount 1,028,107$ 79% Down Payment 271,893$ 21% Note: Blue cells are model inputs Income Annual Salary 250,000$ Monthly Salary 20,833$ Rental Income 2,500$ Adjusted Rent 1,875$ Total Income 22,708$ Adjusted Income 9,765$ Liability Monthly Payments 500$ Property Sale Price 1,800,000$ Insurance 100$ HoA P&I 7,290$ Property Tax 1,875$ Loan Amount 1,437,788$ 80% Down Payment 362,212$ 20% Townhome Single Family Duplex $150K salary qualifies one to buy $850K townhome with HoA $200K salary qualifies one to buy $1.3M SF home $250K salary qualifies one to buy a duplex with rent potential Note: Monthly Payments include all other non-home related liabilities
- 8. © 2018 Karthik Ethirajan, all rights reserved 8 True Cost of Ownership (TCO) Include opportunity cost of equity (down payment): if investing equity elsewhere returned the same rate as interest rate, then the loan amount is irrelevant Primary Residence Investment Property Effective Interest Rate = 4.5% * (1 – 33% tax rate) = 3% Monthly Cash Layout, PITI = Price * 3% + Price * 1.2% Prop Tax 12 12 = 0.0025P + 0.001P = 0.0035P Rent Equivalency Home Price = (1 / 0.0035) * Rent ~ 300 * Rent Every $1 in monthly payment will buy about $300 of additional home Effective interest rate Tax consideration is likely diminished as rental income is netted against monthly expenses Monthly Cash Layout, PITI = Price * 4.5% + Price * 1.2% Prop Tax 12 12 = 0.004P + 0.001P = 0.005P Rent Equivalency Home Price = (1 / 0.005) * Rent ~ 200 * Rent Every $1 in rental income will offset about $200 of additional home
- 9. © 2018 Karthik Ethirajan, all rights reserved 9 Comparing Different Types of Home Buys Compute effective price using TCO conversion rates Townhome Single Family Duplex $1M Effective Price $1,000 $400 $0.12M TCO Monthly x 300 $2,500 = $1.12M = $3,900 Interest Property Tax HoA $1.5M $1,500 $250 $0.07M $3,750 = $1.57M = $5,500 Interest Property Tax Insurance, Landscape, Water, Sewer, Trash $2M $2,000 $250 $0.07M $5,000 = $1.57M = $5,600 Interest Property Tax Purchase Price Purchase Price Purchase Price – $2,500 * 66% – $0.5M After-tax Rental Income
- 10. © 2018 Karthik Ethirajan, all rights reserved 10 Key Takeaways HoA is deemed evil but it can include some benefits such as insurance, landscaping, water, sewer, trash, club house, gym, pool, etc. Cost of borrowing $1000 is about $5 (P&I) A quarter point increase in interest rate costs $40K in additional interest over the life of a $750K loan New tax law makes Property Tax more or less not tax deductible in CA Max tax benefit of owning a home equates to getting a $1,000 monthly check from Government PITI is about 0.5% of property value with 20% down payment You can loan qualify to purchase a home up to 7x salary with 20% down payment Every $1 in monthly payment will buy about $300 of additional home for primary residence. For e.g., paying $3,000 in rent is equivalent to owning a $900K home. An effective price calculated from TCO can be used to compare Townhomes with HoA to Single Family homes with extra utility expenses to Duplex with rental income Many of the insights assume Bay Area market and low interest rate environment