The Economics of House Buying
By David Henderson
A friend of mine is thinking of buying a house in California. He’s a good academic but he’s in a different area from mine and he’s not as good with numbers. The house he’s thinking of buying is priced at $1 million. After doing some calculations, I told him that I’m pretty sure he can afford it. He gave me permission to share the analysis and I think it might be of more-general interest.
So here are his details. He’s currently paying $2,500 in rent for a small apartment and $800 a month in rent for a storage facility, for a total of $3,300. The $800 is relevant because the house is large enough that he could shift everything from storage to the house.
He has over $200,000 in a money market fund that he could use for a down payment. He’s about 67 and hasn’t started taking Social Security yet, even though I advised him that, given his life expectancy (he has an ailment that will likely shorten it), he should. He’s making about $175K a year, on a 12-month basis in his academic job and will likely retire in a year or two.
Price of house: $1 million.
Property tax on house (given Prop. 13 1% limit): About $10K annually.
Down payment: $200K.
Mortgage interest rate: 4.02 percent. (I’m being conservative here–it could be lower.)
Annual mortgage payment: $45,184.
Annual interest (first year): $32,160.
Annual principal: $13,024.
Under the 2017 tax law, the interest on “only” $750K of the mortgage is deductible. So the deductible portion is $30,150. (calculated from 750/800 * $32,160.)
Also, under the tax law, his state and local tax deduction is limited to $1oK. He hits that number with his state income tax alone, so the property tax is effectively non-deductible. (This will change when he retires.)
So let’s look at his net cost when considering the tax law.
Principal payment per year (first year): $45,184 – $32,160 = $13,024.
Marginal tax rate relevant for most of the deduction: 24% federal + 9.3% state = 33.3%
Interest net of tax deduction: $30,150 (1 – 0.667) + $32,160 – $30,150 = $20,110 + $2,010 = $22,120.
So his net annual cost = $13,024 (principle) + $22,120 + $10,000 (property tax) = $45,144.
To this we need to add home insurance. I somewhat arbitrarily chose $2K annually.
So his net annual cost is $47,144.
Go back to what he’s paying in rent: $3,300 monthly or $39,600 annually.
So his overall cost is about $7,500 more than now annually, which is just over $600 a month. So yes, he can afford it. Now.
Let’s say he retires in 2 years. He will have two defined benefit plans: Social Security, which will give him about $33K a year, and a federal government retirement plan that will give him about $49K a year. He has about $1.1 million in a 403(b). Given his life expectancy, I told him he could easily draw down 7% a year, which gives him $77K. So that’s an annual income of $33K + $49K + $77K, or $159K. That’s not far below his current $175K income. Moreover, the tax treatment is lighter. “Only” 85 percent of his Soc Sec will be taxable income for the feds, and, amazingly, the California government, for all its greedy graspy behavior, does not tax Soc Sec. Also, none of that income is subject to the payroll tax.