Real Estate and Inflation (cont.)
What if there was a way to lock in what you paid, at today’s prices, what you spent on necessities such as food, gas, or health care? And what if the price of any of those things ever dropped, you could – for a relatively nominal fee — switch to the new, lower price? Best of all, what if, after paying a fixed price for any of these items long enough, they suddenly became . .. free?
You’d be crazy not to take advantage of such an opportunity, right?
While there’s no way to insulate yourself from rising prices generally (at least not without resorting to complicated, expensive hedges), there’s one key item in almost every household’s budget that offers this potential price protection: it’s called “housing.” To take advantage of it, all you have to do is buy a house (or condo or townhome), using a fixed-rate mortgage.
Pot of Gold — or Lead?
Of course, the foregoing oversimplifies things a bit. Refinancing to take advantage of lower rates only works if you have equity in your home. If you put nothing down and the price of your home drops 20% or more — as it has for millions of home owners in Florida, Las Vegas, and parts of California — good luck trying to get a new, cheaper loan. If circumstances force you to unexpectedly sell, you may be facing a (non-deductible) loss.
Another wrinkle is that housing comes with carrying costs and maintenance expenses. While a fixed-rate mortgage locks in the “P” and “I” (principal and interest) in “PITI,” the “T” and “I” (taxes and insurance) can and do tend to increase over time.
Like any physical asset, housing depreciates. In layman’s terms, things wear out. Every 8-10 years, depending on the exterior, most homes need to be painted. Every 20 years, give or take, the roof will need to be replaced. Furnaces, windows, and flooring all eventually wear out or break — not to mention pedestrian things like window shades, door knobs, etc. Depending on the climate, tasks such as shoveling, mowing, and raking are seasonal necessities.
And yet . . . for most Americans, home ownership historically has been the single-best wealth building vehicle there is — and eventually, will be again. There are three reasons: 1) the mortgage interest deduction; 2) principal amortization; and 3) capital gains treatment.
Each payment on a plain-vanilla, fixed rate mortgage is split between interest and principal. At first very little of each payment goes toward principal amortization (reduction), but over time that percentage accelerates. By the end of the loan’s term, 100% of the home’s fair market value is equity. For many homeowners, the result is a significant nest egg that, magically, can now be used to generate monthly payments for retirement and other living expenses (it’s called a “reverse mortgage”).
Like a Refund
To put this in perspective, imagine if, after 30 years of monthly food bills, the process suddenly reversed, and every month thereafter you got back what you’d previously paid, plus inflation???
Homeowners who instead choose to cash out by selling outright likely can do so tax-free. Thanks to generous capital gains treatment, couples can exclude up to $500k on the sale of their primary residence; singles, $250k. Assuming that one buys the “average” U.S. home (now about $200k) and enjoys historically average appreciation (3%-4%) over 30 years of ownership, the home’s value at sale would be in the mid-$500’s. Capital gains tax due at closing? Zero.
In between buying and selling, the tax code provides homeowners with a significant subsidy. Because mortgage interest is deductible, the effective interest rate on mortgage debt –typically, the least expensive consumer debt — is effectively 20%-30% lower for homeowners who itemize.
In the final analysis, for the majority of home buyers the decision to buy is an emotional, not economic one. However, especially in today’ volatile, increasingly inflationary environment, it’s nice to know that housing prices are one of the few expenses you can control, and that long-term, the housing deck is stacked in your favor.