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: $800K.
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 =Â $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.
READER COMMENTS
Phil H
Mar 22 2020 at 4:50am
This is something that really worries me. A professor – a high-earning member of the country’s intelligensia – needs help figuring out whether he can do something absolutely fundamental like buying the shelter he needs.
It’s possible that this is the government’s fault! All these different tax considerations… but there’s a fair amount of private behaviour/unregulated behaviour that makes home buying more complex, too.
Whatever the causes, if you moved in slightly less exalted circles, and didn’t have national-level economists in your phone book, you could pay for this advice (if you trust the institutions that might provide that service), or you could just take your best guess and dive in. You either pay the financial advisor, or you accept a slightly higher load of risk. This is the kind of thing that progressives like to fix! Because home ownership is generally good, if it is relatively inaccessible to those with limited resources, that’s a bad thing.
The question is what kind of institutions we should have, or what kind of social systems would be best, so that most people can benefit from the things that their money can buy? (And then, what’s the best way to get there – which may well not be government action.)
I should note that this comment isn’t an argument for anything. I often talk about “half an argument”, which means noticing the problems with system A. The fact that system A has problems is not a reason to use system B. All I’ve done here is point out a problem with our current set up, and that’s not a reason to adopt any particular alternative yet. I’m just saying, that one looks like a pretty big problem, and it seems worth looking hard for good alternatives.
David Henderson
Mar 22 2020 at 12:09pm
You wrote:
As you know from reading this blog, I’m someone who often blames the government and I think I’m almost always right. But in this case, no. You would have to know my dear friend and if you did, you would see that the government is not to blame. Unless, of course, we blame the government school system for his not learning the basics of finance. Even then, though, with good instruction, I doubt that he would have retained it. See the work on education of my EconLog co-blogger Bryan Caplan. In this case blaming the government for my friend’s lack of financial acumen would be like blaming the government for the fact that I don’t know thing one about playing a guitar.
You wrote:
Absolutely! And here I DO blame the government, not for the situation of my friend but for the fact that the government’s restrictions on building have priced low-income, middle-income, and even some higher-income people out of the coastal California housing market.
Phil H
Mar 22 2020 at 8:39pm
“the government’s restrictions on building have priced low-income, middle-income, and even some higher-income people out of the coastal California housing market”
I’m going to make it a policy never to let comments like this pass without responding.
The theory that drives this is (1) if there were fewer restrictions, the density of housing would rise, and the supply of housing would rise; (2) if the supply of housing rises, then the price falls.
This theory is highly questionable, because house prices are in general *positively* correlated with housing density. Prices in the cities are higher than prices in the country; prices in the densest cities are highest. The suggestion that increasing density will reduce prices sounds like blind insistence on theory, despite all evidence to the contrary.
David Henderson
Mar 22 2020 at 8:53pm
Actually, all the evidence is in favor.
Check out pretty much anything by Glaeser and Gyourko.
Phil H
Mar 22 2020 at 9:20pm
Check out New York. It’s easier to find on a map than Glaser and Gyourko.
Michael
Apr 9 2020 at 3:58am
Look at Tokyo.
The city decided to build more housing units.
What happened?
Housing prices stabilized then dropped.
The ‘magic’ of supply and demand
Fred_in_PA
Mar 22 2020 at 9:36pm
You say, “house prices are in general *positively* correlated with housing density.”
Isn’t this confounding correlation and causality?
If a lot of people want to live in a place, won’t that lead to both high prices and high density?
I agree with the model as you postulated it: that increasing supply will (admittedly) increase density but that it should lead to decreasing the price paid.  I suspect (as a non-economist) that the trick to this puzzle in noting that the increase in supply will be working against a fixed level of demand. That is, the building of more housing there does not increase the desirability of the locale. Indeed, my own bias is that the resulting greater density will make it less desirable.
Fred _in_PA
Mar 22 2020 at 9:44pm
Another thought;
Isn’t your correlation between housing prices and housing density drawn from comparisons across cities.
While the postulated negative correlation between greater supply (and hence density) with housing prices would be within one city?
David Henderson
Mar 22 2020 at 10:47pm
Phil,
I don’t think you should settle for looking at maps. There’s a well-developed literature on this.
Conscience of a Citizen
Mar 23 2020 at 1:35am
Phil H’s worst error is supposing that if California loosened restrictions on housing construction, density would rise.  The chief way that California drives up housing prices is by preventing suburban, lower-density housing construction.  See, e.g., Randal O’Toole:
https://www.cato.org/publications/commentary/want-make-housing-affordable-ditch-urban-growth-boundaries
and this current (March 20, 2020) weblog post in which O’Toole explains how California got its urban-growth boundaries without any public debate:
https://ti.org/antiplanner/?p=16952#more-16952
Phil H
Mar 23 2020 at 10:03am
David: That’s a fair comment. I clearly am applying a simplistic model. But so are you! I will try to go and read and understand G&G. But in the meantime, when you comment on this issue, I hope you will hint at a pathway to lower prices that makes sense. Because reducing prices by increasing density is just wrong. That cannot be the mechanism by which reduced regulation will lead to lower prices.
Citizen: Absurd. My worst error is my continued love for Kenny Loggins, simply because he’s on the Top Gun soundtrack. But on topic, note that building out suburbs does increase the average density of a large area.
KevinDC
Mar 24 2020 at 5:25pm
Hey Phil –
There’s a lot in your response that fails what Caplan calls the Ideological Turing Test. Although I suppose we can replace the word “ideological” with the word “theoretical” in this case, but still. Your attempt to represent the theory that David is referring to is really, really bad. Examples:
No. No, no, no, no, no, no, no. Not even remotely close, no. No economist worth their salt has ever held any theory that says “if the supply of X rises, then the price falls.” Just….no! You’re missing something so, so fundamental in this description. All else equal. This may sound like a trivial point, but it’s really not. The correct description of the theory is “if the supply of X rises and the demand for X remains constant, then the price falls.” You can’t critique the implications of supply and demand analysis while leaving one half of the process out. Well, I guess you can, technically. People can say pretty much whatever they want 😛 But you can’t do that and expect you’re giving an argument that other people will have any obligation to take seriously.
If the theory of supply and demand suggested that housing prices would be negatively correlated with density, this would be a relevant observation. But this is not at all suggested by supply and demand analysis, so the observation is meaningless. The idea that housing prices and density can be positively correlated is perfectly consistent with standard, econ 101 level supply and demand theory. Any freshman who didn’t understand this would absolutely flunk out of their introductory course.
Again, the insistence isn’t that increasing density reduces prices. The idea is that increasing density will reduce prices for a given level of demand, all else equal. Simple thought experiment – the town of Exampleburg suddenly becomes the hot new place to live, because reasons. Lots and lots of people want to live there. However, a nefarious Luddite has massively sabotaged most of the home building equipment in the area. New housing is still built, but not as rapidly as it otherwise would be. Demand to live in Exampleburg rises rapidly, but the supply of new housing rises slowly. Since demand is growing faster than supply, we would expect to see both increases in supply, increases in density, and increases in prices, all simultaneously. Indeed, in the real world, we should expect to see that sort of thing happen all the time. Demand can rise much faster than supply, especially with housing, because building things is hard and time consuming, but wanting things is easy and instant. So when we step out of theory and look into the real world, we should expect to see lots of places where new housing is being built rapidly, but still see prices rising rapidly as well, because demand is rising faster than supply can increase. If someone tried to point to such a place and simply said “See! Supply is rising rapidly but prices are also high and still rising, this refutes the idea that increasing supply lowers prices” I’d be genuinely aghast. Saying something like that falls into the rarely achieved category of “not even wrong.”
Alan Goldhammer
Mar 22 2020 at 9:55am
Good thought experiment but a problem in the analysis is the value of the 403(b) plan. One needs to know how this is invested (equity/bond ratio). It it is an aggressive investment, you might want to take 1/3 off the value based on current valuation.
For someone who has health issues as you note, figuring in access to care and cost is important. Is the potential home in an area where there are good MDs and hospitals putting aside the current pandemic. I would put this up as a very important consideration. I would also add to the calculation of cost the year the house was built and potential upkeep costs. these are often overlooked and in some cases fall into the ‘money pit’ category.
David Henderson
Mar 22 2020 at 10:46pm
You wrote:
True. He’s way more into bonds than I am.
He gave me a $1.3 million number and I figured he hadn’t checked lately, and so I dialed it down to $1.1 million.
You asked:
Yes. Berkeley, CA.
You wrote:
True.
Steve
Mar 22 2020 at 12:18pm
There’s no mention of the opportunity cost associated with taking $200k of liquid, investable assets and sinking it into a down payment. If that money were to stay in a money market fund regardless, then of course this opportunity cost is minimal. But if this could be allocated even to an investment grade corporate bond portfolio earning 3% annually, then the opportunity costs becomes $6,000 in the first year. This tips the scales back in favor of renting since it’s greater than the $2,000 of annual savings you’ve calculated.
David Henderson
Mar 22 2020 at 10:50pm
You wrote:
There’s no mention, not because you’re wrong, but because he does have it in the money market. So whereas you and I would invest it differently, for the last 5 years at least, he hasn’t.
Remember the question he asked. I tend to answer the question asked. He did not ask what he should do. He asked, given his rent, if he could afford it.
MarkW
Mar 22 2020 at 2:06pm
Yes, he can afford it, but the savings of ownership vs rent are not that great. My advice would be to rent until retirement or at least until long enough to see what Covid-19 is going to do to the housing market (I have a hard time imagining a scenario where housing prices are going to go up rapidly once the real-estate market resumes activity). And does he have to stay in CA post retirement? He could live SO much better on his income in a lot of other places.
zeke5123
Mar 22 2020 at 3:15pm
Prof. Henderson — one issue with the math is the tax shield created by the interest payments decreases when he shift to post retirement. Did you factor that in to the analysis?
Also, is he worried about inheritance (might be too personal here). That likely factors in whether buying the home or more liquid assets.
David Henderson
Mar 22 2020 at 4:03pm
You wrote:
Good question. Yes. He is single and the tax brackets I used–24% for federal and 9.3% for state–apply over the income he’ll be in when retired. The 24% federal rate applies for taxable income between $84,201 and $160,725. The 9.3% California income tax rate applies to income from $57,825 to $295,373.
You wrote:
Thanks for acknowledging that it’s personal. He does have a bequest motive but wants to leave on the order of $200K to $300K to one sibling.
Vivian Darkbloom
Mar 23 2020 at 12:23pm
“Property tax on house (given Prop. 13 1% limit): About $10K annually.
……
So his net annual cost = $13,024 (principle (sic)) + $22,120 = $35,144.
To this we need to add home insurance. I somewhat arbitrarily chose $2K annually.
So his net annual cost is $37,144.”
I believe that you forgot to add the 10K in property tax to the total cost.
David Henderson
Mar 23 2020 at 12:52pm
Holy cow! You’re right. Thanks so much, Vivian.
Correction made and I’ll contact my friend immediately, in case this gives him pause.
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