I'm now going to take a slighttangent and cover a topic that, I think, this is probablythe single most important video that reallyanyone can watch.
I go to all of these partieswhere I go see family.
And my wife and I right now,we live in Northern California.
And we're renting.
And I like to pointout, by choice.
And I have family members,why don't you buy? You're at that stage inlife, that's a major milestone, all of this.
There's a lot of pressureto buy.
And when I tell friends,I tell them I'm not going to buy.
Because I think I'm prettyconvinced, almost 100% convinced, that housing pricesare going to revert back.
And I'm going to do a bunchof presentations to justify why they will.
But then my friends, they'lljust throw out the statement that I hear from them, thatyou hear from real estate agents, because obviouslythey want you to buy.
Well, isn't buying alwaysbetter than renting? And I think that kind of commonwisdom comes out of the notion of, when you have amortgage or when you borrow money to live in a house, everymonth that money that you give to the bank is kindof going into savings.
That's the perception.
While when you rent,that money's just disappearing into a vacuum.
In this video I'm going to workthrough that assumption, and see if that actuallyis the case.
So let's say I have a choice.
Let's say there aretwo houses.
This is house number one.
And this is house number two.
And let's say that they'reidentical houses.
These are three bedroom, twobath, townhouses some place in Silicon Valley, whichis where I live.
And I want to live inone of these houses.
I'm indifferent as to whichhouse I live in, because they are identical.
So living in them is theidentical experience.
I can rent this housefor $3,000 a month.
Or I could buy this housefor $1 million.
And let's say that in my bankaccount right now, let's say I have $250,000 cash.
So let's see what happensin either scenario.
Let's see how much moneyis being burned.
So in this scenariowhat happens? I'm renting.
So in a given year, let's justsee how much money comes out of my pocket.
So in a given yearI pay $3,000.
$3,000 times 12 months,so I lose $36,000.
So I'll put a negativethere, because that's what I spend in rent.
$36,000 per year in rent.
And then of course Ihave that $250,000.
I'm going to put that into thebank, because I have nothing else to do with it.
I didn't buy a house with it.
And let's say that I can,in the bank, let's say I put it in a CD.
And I get 4% on that.
So let's see, 250, that'swhat? $10,000, I think.
Right, I get $10,000 in interesta year on that.
So I get $10,000.
So plus $10,000 a yearin interest.
So out of my pocket, for theprivilege of living in this house, in Silicon Valley, withbeautiful weather, out of my pocket every yeargoes $26,000.
So that's scenario one.
So what happens if I give into the peer pressure of family, and realtors, and themortgage industry, and I buy this house for $1 million? Well I only have $250,000, whichis more, frankly, than most people who buy $1 millionhouses have.
But I have $250,000 cash.
So I need to borrow $750,000.
So I take out a mortgagefor $750,000.
And I'm going to do a slightsimplification.
And maybe in a futurepresentation, I'll do kind of a more complicated one.
In a lot of mortgages, when youpay your monthly payment, most of your monthly payment,at least initially, is the interest on the amount thatyou're borrowing.
And you pay a little bitextra on that, to bring this value down.
That's called payingoff the principal.
You can also take aninterest-only loan, but the component of the interestis the same.
Essentially, when you take atraditional mortgage, kind of a 30-year fixed, every monthyou're paying a little bit more than the interest, justto take down the balance.
But for the simplicity of thisargument, I'm just going to say that we're doing aninterest-only mortgage.
And then maybe with anyextra savings, I can pay down the principal.
And that's the same notion.
And right now, if I do 25%down, and I'm buying a $1 million house, I'll have totake a $750,000 mortgage.
I don't know what agood rate is, 6%? So let's say at 6% interest.
Soto live in this house, how much am I paying justin interest? Well I'm paying $750,000times 6% a year.
So $750,000 times 0.
06 is equalto $45,000 in interest.
That's coming outof my pocket.
And of course, on a monthlybasis, that means in interest per month, I'm paying,just to get an idea.
I'm paying about $3,700, $3,800in interest a month.
My mortgage actually might besomething like $4,000 a month.
So I pay the interest.
And thenI pay a little bit to chip away at the wholevalue of the loan.
It takes 30 years to chipaway at the whole thing.
And over time, the interestcomponent becomes less, and the principal becomes more.
But for simplicity, this is theinterest that I'm paying.
$45,000 a year.
And then of course at a party,when I start to explain this, it's like, ah-ha.
But interest on a mortgageis tax deductible.
And what tax deductible means,is that this amount of money that I spend on intereston my mortgage, I can deduct from my taxes.
I can tell the IRS thatI make $45,000 less than I actually did.
So if I'm getting taxed at,let's say 30%, what is the actual cash savings? Well I'll save 30% of this.
I'll have to pay $15,000less in taxes.
How does that work? Well, think about it.
Let's say I earned $100,000in a year.
And I normally haveto pay 30%.
So I normally pay $30,000in taxes.
Right? This is, if I didn'thave this great tax shelter with this house.
Now I have this interestdeduction.
So now I tell the IRSthat I'm actually making $55,000 a year.
And let's say my taxrate is still 30%.
it actually will probably godown since I'm — but let's, just for simplicity, assume mytax rate is still $30,000.
So now I'm going to pay $16,500in taxes to the IRS.
So how much did Isave in taxes? So I saved $13,500 from taxes,from being able to deduct this $45,000 from my income.
So let's say tax savings,plus $13,500.
Now what else goes intothis equation? Do I get any intereston my $250,000? Well, no.
I had to use that as part of thedown payment on my house.
So I'm not gettinginterest there.
But what I do have todo is, I have to pay taxes on my property.
In California, out here we haveto pay 1.
25% in taxes, of the value of the house.
So what's 1.
25%? So, taxes, this isproperty tax.
And that's actually taxdeductible too, so it actually becomes more like 0.
75% or 1%.
So let's just say 1% justfor simplicity.
So 1% times $1 million.
That equals what? 1% of $1 million isanother $10,000 a year in property taxes.
And notice, I'm not talkingabout what percent of my mortgage goes topay principal.
I'm just talking about moneythat's being burned by owning this house.
So what is the net effect? I have a $13,500 tax savings.
I have to pay $10,000 –actually I have to pay a little bit more than that, butwe're getting a little bit of income tax savings onthe deduction on the property taxes.
And then I actually have to paythe $45,000 of interest that just goes out the door.
So I'm paying $41,500.
Notice, none of this $41,500is building equity.
None of it is getting saved.
This is money that isjust being burned.
So this is a completelycomparable value to this $26,000.
So in this example — thisexample is not that far off from real values.
Out here in the Bay area, I canrent a $1 million house for about $3,000.
But in this situation I amburning, every year $41,500, where I could just rent the samehouse for $26,000 out of my pocket, when I adjustfor everything.
And then people a couple ofyears ago said, oh, but houses appreciate.
And that's what wouldmake it up.
But now you know, very recently– we know that that's not the case.
And in the next video, I'lldelve into this, and a little bit more.
I'll see you soon.