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What happens when housing depreciates

How much a home might appreciate or depreciate is a factor in determining whether the best choice is to rent vs. buy. Created by Sal Khan.

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Video transcript

Welcome back. I now want to play a little bit of devil's advocate with myself. I made this argument where I show that for the exact identical house, if these are the numbers -- I mean you'd have to work it out based on your market, and what the numbers are at the time. But if this is the comparable rent for a $1 million house, I showed you that for the $1 million house you're burning $40,000 a year. This is not money that is going to build equity. This not money that's going to the principal of your house. This is money that just going out of your pocket, you'll never see again. In a way, and actually not in a way, in reality, you can view this $40,000 as rent on the money that you borrowed. Interest is nothing but rent. So when you have an asset, if the asset is cash, the rent on it is interest. If the asset is a house, the rent on it is your monthly rent payment. So when you think of it this way, when people say home ownership, they really aren't homeowners yet. You're not a homeowner until you don't have debt. You are a money renter. So your choice is either to be a money renter here, or to be a house renter here. And I show that you are burning almost double the money. But then there's the argument of well, there are advantages, still, to buying this house. And what are they? Well one example is, in this situation, if I did get a fixed-rate mortgage -- and we learned, when you look at all those adjustable-rate mortgages, we know that a lot of people didn't. But if I have a fixed-rate mortgage, I know what my payment is for the foreseeable future, for the next 30 years. While my landlord, in this case, they could keep raising my rent. So this might look good right now, but what if my landlord raised the rent to, I don't know, $3,500 a month. Well then, out of your pocket, 0.5 times 12, you'd be spending $42,000 a year. And then of course you get the interest from the money that you put in the bank. Plus 10. Oh, minus 10 actually, sorry. So in that case, if the rent goes up, then out of your pocket is $32,000 every year. Right? Or what if the interest that you get on your cash in the bank goes down? Then this $10,000 thousand will become lower. But as we can see, the rent would have to go up a lot to make up for $41,000, to make this a break-even situation. Let's figure out how much it would have to go up. So in this first scenario, in order for your net outflow to be $41,500, assuming you're getting $10,000 from the money in the bank, your rent would have to be $51,500. Right? Because you're getting $10,000 from the bank. And so divided by 12, your rent would have to be $4,300 in this situation to make this a break-even proposition. This is another way to view it. If I were to buy the house, and if I were to move, how much would I have to rent this house out for, in order to not be losing money every month? Well I would have to rent it out for $4,300 a month, even though maybe the market rents are only at $3,000. And there is another devil's advocate argument. And that's, well, housing -- and this is something that you heard a lot about three years ago. And a lot of these people aren't talking as much now. But they would say, housing has never -- housing has done nothing but gone up, and I will build equity just from housing appreciation. So how much does my house have to appreciate every year? Well, to make up this difference-- $41,500 minus 26-- so to make up that $15,500 difference every year, this is $15,500 favorable. My house would have to appreciate by a comparable amount, right? So how much appreciation is that on my house? Well that's a $1 million house, right? So $15,500 appreciation on a $1 million house. I'm doing everything in thousands, so 1,000 thousands is a million. So that's only 1.5% appreciation. So if my house appreciates by 1.5%, that's it-- 1.5%. If my house just appreciates by 1.5%, I'm going to make up this $15,500. And so it is worth it for me. It is worth it for me to blow this money by having kind of an increased -- by renting the money for more than I would have to pay to rent the house. And that might sound like a very reasonable proposition, that the house will appreciate by 1.5%. From 2001 to 2005, 2006, houses were appreciating like 10%, 15% a year. So it seemed -- and a real estate agent would often do this very math with you, and say, well, you're definitely going to get 1.5%. In fact, you're probably going to get 10% appreciation. And you're going to make much more than this. But think about, in the presentation of the balance sheet and leverage, what happens if housing prices go down by 1.5%? What happens if it's minus 1.5%? Well, then you're going to spend this much to rent the money, right? And you're not going to gain this much. You're going to lose this much every year. And so the proposition becomes even worse. So this is a big deal. Now that, I think, on a nationwide basis, a lot of the housing indices show that housing prices have gone down, I think by 6%. That's what the Case-Shiller index says. 6% is a lot. Especially on a $1 million house, that's $60,000 a year that's just evaporating. That's wealth that someone thought they had, that's just disappearing out of their equity. So this is rationale of pay more to rent the money for a house than to rent the house is justified if housing prices go up. It becomes 10 times worse when housing prices are flat. Or, God forbid, if housing prices actually go down. And now we see that housing prices actually go down. In the last couple of years especially, in the areas where, like the Bay Area, or Florida, or California, especially Southern California, where this is happening. And back even two or three years ago, when people used to make this argument. People used to make the argument, well you know, my house just has to go up 1% or 2% percent, and I'm going to make up the difference. I'd say well, why is your house going to go up 1% or 2% percent? I mean, there has to be some reason why next year someone's willing to pay 2% more for that house. Is it because rents are going up 2% a year, so the income stream is going to be 2% higher? And actually in the Bay Area, from 2001 to roughly 2003, rents were going down. And there were actually people moving out. All the tech workers were getting laid off. You had a lot of programming jobs being outsourced to India and wherever else. So you had this whole situation where the population was actually decreasing. Demand for housing was going down. But for some reason housing prices were going up. So people said well, they've been going up for the last five years, so they'll continue. And they've never gone down, et cetera, et cetera. But it didn't make an economic argument. And I'll show in a future video that the only reason why housing prices did go up is that it just became easier and easier and easier to buy a house. The standards that banks used for giving out a loan became lower and lower and lower. There are actually examples in Southern California, and in San Jose and some of the suburbs, where people who had incomes of $30,000 or $40,000 a year. The bank actually gave them a $1 million loan to buy a $1 million house, based on stated income. There's things called stated income loans, where you just tell the bank what you earn. You don't have to prove it to them. And so every year that went by, it just became easier and easier and easier. More and more people just thought that housing always appreciates. So that's why they want to pay more and more to essentially rent the money for a house. And this became a self-fulfilling prophecy. But as we see on the way down, it works completely against you. So in the situation where we are now, where nationwide housing prices are actually declining-- and actually they will decline until this rent-versus-buy equation starts to make a little bit more sense-- it really hurts the home buyer. And what's even worse, and this is kind of adding insult to injury, is that this guy, if I bought this house, and all of a sudden I lose my job, and I can't pay the house back, I might lose my entire $250,000 down payment because maybe I can't sell the house, or the house is selling for less. Or maybe I want to move, and there's no one out there who can buy a house because the banks all of a sudden got smart again, and realized that they should become more serious in terms of who they give money to. And so I'm stuck holding this house, and my flexibility in terms of where I can move is limited. Actually a friend of mine was telling me that they've actually done studies. And there's a correlation between unemployment and home ownership. Because when you own a home, you have less flexibility in looking for a job. If I have a house in San Jose but there's a job in LA, I might not be able to take that job because I can't sell my house. Or I might not even want to look for a job in LA. While the renter, of course, my lease ends and I leave. So this is just a rough sense of the rent versus buy. And I know I get very impassioned about this. But that's just because I explain this a lot. And when I'm at parties and I start talking about the calculations, people's eyes glaze over. But I made this video now and I'll just tell people to watch it. See you in the next video.