The Economics Of Buying Your First Home

I have always told my friends that not everyone needs to learn advanced Math, but almost everyone should take two classes when they are in high school: Psychology and Finance.

All our education, taking so many years, and getting so competitive, are mainly to prepare some workers to be used by large or small businesses. The goal seems to be making enough money and make a good living. Money is certainly useful, but it is more like a weapon, it is powerful, it is needed, and it could help you, but it could hurt you too (if you don’t know how to use it properly).

That is why we need to learn Psychology, to understand what makes us happier.

What about Finance? People spent so much time on learning and worked so hard everyday, but most of them only spent very little time on learning how to invest the money they earned. Gambling on stock market without the know-how, or being too conservative can and did cost them a lot.

One basic lesson for Finance for everyone is that regular people (layman) usually makes money on real estate investing, but loses (or gains much less) money on stocks. It doesn’t have to be the case, but it has been the case for decades. One main reason for this is that stocks have businesses behind them and these businesses are very complicated for regular folks to understand well. The stock market also has a lot more short term fluctuations than the real estate market, which is used/produced/taken advantage of by the sharks or wolves of wall street.

On the other hand, real estate is much simpler (relatively), with much less short term fluctuation (long term cycle is still there though), and more importantly it is a “non-scalable” strategy. “Non-scalable” means people who have a lot of money can’t use the same strategy, since finding a real estate deal requires a lot of time searching it, it may also require extended knowledge about a local area, and each transaction is separate, all of these require personal care.

Of course, stocks have its advantage too, such as more diversification, global reach, and not require a large sum of money. But to invest in stocks, you need a lot of time to study it, follow it, or you need to find a trustable expert to do it for you.

So real estate investing is better for regular folks, but the “crown jewel” here is buying your first home. And I will explain why that is the case.

Suppose there is a betting game, which requires you to bet $50k, and you have 90% chance to double your money, but 10% chance to lose all that bet, and you only need to pay $10k out of your own pocket (you can borrow $40k from “the house”, and you don’t have to pay it back if you lose!), and best of all, there is no income tax for your profit, would you do it?   (When you think about it, if you don’t have to pay back the money you borrowed if you lose, the upside is 500% with 90% probability, and downside is 100% with 10% probability. )

It certainly sounds too good to be true. But that is what you get when you buy your first home. To get your vote, and encourage home ownership, government has sweeten the deal a lot, to the point that it really sounds too good to be true (to investment experts). I will list out the benefits here:

  1. 20% downpayment without any liability to pay it back, and no forced liquidation as long as you can pay the mortgage every month.

Leveraged investing is not something new. You can borrow money to invest in pretty much everything, but if you are “under water”, say if your stock goes down 20% when you leverage 5 times, your portfolio will be liquidated and you will be on hook to pay anything left to pay if the liquidation doesn’t pay back all the loans.

You don’t get the same treatment with your first home. In 2008, so many people defaulted, and still get to walk away without having to pay anything back – they even got to live in the house for one year without any payment before the foreclosure finally happened.

Essentially, the bank or government (most mortgage loans are bought by the government even though it might be originated by the banks) is on the hook when lending money to you.

2. The loan interest rate is ultra-low, so low that you can’t get the money in any other way.

When we borrow a mortgage, we often find that the interest rate is so low, often just 1% above what the bank pays us for the CD deposit. How can the interest rate go so low?

When we put it together, “high leverage and long term loan with no terms attached” + “no liability for the loan other than losing some of your credit” + “ultra low interest rate” are truly unbelievable treats, but this is all built on top of two credit systems:

The first is your own credit. The salary you have is a stable income source (your “credit”), and it should be used to make some borrowing against it and not wasted. And the loan is collateralized, meaning your house will be taken away if you can’t pay mortgage.

The second is the government’s credit. When government buys the mortgage from the banks and later sells it to investors, it has an implicit loan guarantee on it. Investors are willing to accept this “agency” debt (“agency” like Fannie Mae which represents the US government) for very low interest rate because it is virtually risk free. If anything happens (another 2008 for example), you can bet on government to pay it back. What if government can’t pay it back? That almost will never happen, we have yet to see one government to default on a loan made in its  own currency (Yes, Greece wouldn’t have had default if it had borrowed loans in its own currency), since the worst that would happen is just printing more money.

So this is a “benefit” given by the government, but government is not a person, it is an entity owned by all of us. Essentially, this “free lunch” is provided by all the rest of us who don’t buy a house. It is not our choices to not provide that “free lunch” to other first time home buyers, but not taking it for those who need and can afford a home under such a favorable term would seem unwise.

3. Real estate generally goes up over long term.

Like any other financial assets, real estate will also have a boom and bust cycle, although it is generally a very long cycle and has relatively stable trends in the short/mid term. However, over even longer term, such as 10 – 20 years, real estate generally goes up, unless the country had a big bubble in the past, or local economy is in deep trouble.

It goes up because of inflation and city growth. Chances are the place people find more jobs is exactly the place that real estate will go up faster.

4. No income tax (or capital gain tax) on profit up to $500k per couple.

Again, almost no other investing can avoid tax except buying your first home. And that could make a big difference. This is another benefit our government gives to home buyers on behalf of all the other tax payers.

With all the good things, does this mean this “free lunch” is risk-free? It is certainly not, just like other investments, it would have some risks, but I would say much less risks. You just need to be careful on some of these points:

  1. Generally, you should NOT time the market when buying your first home, unless the bubble is too big and too unbelievable. (Usually I define a bubble as being at least 3 times of its fair value, but it also depends on the growth rate of the country and local economy.)
  2. One major benefit of buying first home is to save on the rent expense. So if the mortgage payment has to be many times more than the rent for the same house, you might need to be more careful. (If the mortgage is twice of the rent, it is not ideal, but still not too bad. If you wonder why that is the case, it is because part of mortgage is to pay  down the loan over time, and the mortgage doesn’t go up over many years, but your rent would go up over time.)
  3. You might need some cash in hand, so you wouldn’t go default when you lose your jobs for 1-2 years.
  4. Housing price is tied to local economy, so if you expect foreseeable big trouble in local economy, you might need to be more careful.
  5. The benefits listed above only apply to the first home purchase. For investment homes, generally it is still a favorable investment, but the things will get a lot more complicated than the first home.

Many first home buyers in an up-trend face this dilemma: it looks too expensive to buy, especially when you compare it with the last few years. As a result, they often try to time the market and hope to catch it when it drops back, only to find that it continues to go up for many following years, and not enjoying the benefit of their first home in the process. This is because they failed to understand the economics behind the first home purchase. It is a very good deal for most people, of course it could get better when the price drops, but you may not want to bet on that to happen.

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