Why do people buy houses they don’t plan to pay off? Most people don’t spend their entire lives paying off one house, so what is the financial benefit of getting a “starter home”? I’m new to the economics of real estate and I’ll take any wisdom offered.
In: Economics
Let’s say you have two choices – rent an apartment, or buy a $400,000 starter home. You’re going to stay there for five years, then you’re gonna buy the $550,000 house you actually want. All the numbers below are made up and grossly oversimplified, but I think they’ll give you the idea.
**Rental scenario:**
You pay rent for five years, then you have (whatever you’ve saved up) to put toward your “keeper” house.
**Starter scenario:**
You get a $400,000 mortgage on your starter house, and make payments on that for five years. During that time your payments chew the mortgage down so you only owe $350,000. After the five years, you sell the house for $400,000. You spend $350k of that to pay off the mortgage. Now you have $50,000 that you can spend on hats…or add it to your savings for the “keeper” house.
**Ways this is oversimplified:**
* It assumes rent and the mortgage cost the same. They’re not completely different leagues, but the mortgage is almost certainly higher.
* Some (many? most?) mortgages penalize you for closing out early.
* Depending where you are, you might be able to sell your house for the same amount you paid (or more! Dare to dream!)…or you might not. Hope you took care of it. Hope the market is positive. Hope your realtor doesn’t take too big a bite for themselves.
* You have to pay for maintenance on the starter house while you’re in it. That can be no big deal, or your starter can be a total vampire if it’s old, or if you’re unlucky.
* You have to pay property tax on the starter house while you’re in it, unless you know some tricks I don’t.
* Imagine that the house you want is finally up for sale, so you put your starter up for sale…and you don’t get any offers. Time passes. You’re worried somebody is going to snap up your dream house, but you need the old house to sell so that you’ll have your $50,000 to put down on the new one. More time passes. No offers come in. You feel slightly ill.
The idea is that owning a property builds wealth because it goes up in value.
Over time you’ll be able to increase your net worth via equity in the home. So if you wanted to you could borrow against the equity in the home to pay off debt or make investments.
Additionally the cost to borrow against your home is cheaper than other lending alternatives because the expectation is that homes hold their value well and even appreciate in value. So there’s less risk for the lender.
I buy a house for $500,000 with a $400,000 loan and $100,000 down payment. On day 0 I have $100,000 in equity, because I own the amount I already paid. I make mortgage payments to pay off that house over 30 years. Over 10 years, $100,000 of my payments have gone into principal, which means that my loan is now $300,000.
But during that time, my house has gone from being worth $500,000 to $700,000, and I still only have $300,000 on the loan.
If I sell the house, I can get $400,000 cash.
Of course there are things like property taxes, loan interest, homeowners insurance, and maintenance costs, but that’s out of scope for ELI5.
When you sell the house, the money you get is used to pay off the rest of the loan. So if you buy a house for $400,000, pay off $100,000 and sell it again for $400,000, then you get $100,000(minus some closing costs) and you can use that towards another house. More importantly, houses tend to appreciate in value, so you might actually be selling the house for $500,000, in which case you get $200,000.
Compared to renting, where the money you pay just goes into someone else’s pocket, it’s usually a pretty good deal.
If you rent, you just pay out, and get housing. If you buy you get equity, the house, which holds value and also houses you. If the house value goes up well past the debt you have, you might be able to sell the house, pay off the loan, and come away with a gain.
Your rent money is just gone. Your mortgage payments are at least partially “recoverable” when you sell the house.
The value of the home is very likely to go up over time, so when you sell it you make money.
Not fully paying it off is completely irrelevant here and quite simply doesn’t matter.
If you buy a home for 100k and then you are able to sell it for 200k in the future you made 100k. Having outstanding loan doesn’t change anything, in what way do you think it would?
There’s a bunch of other potential benefits of owning a home but they all kind of come back to “homes go up in value, its good to own things that go up in value”
Because you own the equity you’ve already paid into it.
If you buy a $500,000 house and take out a 30 year mortgage, but after 5 years you need to move. Even if you sel the house for $500,000, you get back the principle you already paid. So say $20,000 (or whatever) so the interest payments you can consider as “rent” also, if the house is now worth $800,000 then you only have to pay the bank back whatever is owed on the mortgage and pocket the profit.
Well to be clear, it is not a decision that is at all “automatically good”. If someone believes that
a) they will likely stay in that house for 5+ years (rough guideline)
b) have a relatively stable income during that period (to cover mortgage and still have living expenses and some savings) plus savings to cover downpayment.
c) that home prices will appreciate in that period by at least 10%-15% (in most markets, home prices generally appreciate over long enough periods) Some people have become over optimistic of short term property price appreciation.
d) can have the personal discipline or satisfaction to manage a property, pay taxes, repair and maintenance (this takes more time than one imagines)
then buying a starter home might make sense – financially. Even if the person decides to move (upgrade or relocate) after 5+ years, the home appreciation would likely have made up for the loan costs, property taxes paid etc.
However if the conditions above don’t hold, then there is risk of financial loss although if someone is very home proud, the added satisfaction of owning their own home might make up for it. The point of the starter home is also “forced savings” which makes it much easier typically to purchase the next home since the equity is easily reinvested.
Depending on the interest rate environment, it may be preferable to invest your money in the financial market, instead of paying off the mortgage. I.e. the interest you pay may be much lower than the return you can achieve on your assets.
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