Oh, in other words if I had invested all that money instead of buying a house, opportunity cost is the interest I could have made on it, eh? Thanks!

Opportunity cost is the after-tax return on the alternative investment you could have made with the downpayment, closing funds, and difference between rent and after-tax PITI payment.

Awesome! I really appreciate your sharing this invaluable formula. For anyone reading along who isn't familiar with the acronym, PITI stands for Principal, Interest, Taxes and Insurance. Seems like anyone who is thinking of buying should work this formula!

Could you explain a bit more about what you mean by "Opportunity cost"? (Opportunity cost on both the down payment, closing costs at purchase and the savings you could have with your lower rent payment.) Thankx again!

Janis,

Even with rents going up, you can calculate what PITI payment is rational, or will beat renting over XYZ years. Here are your parameters:

Current rent
Rent increase average

PITI payment, after tax (count the incremental tax benefit, and add in state taxes that you can now deduct)
Maintenance estimate
Selling costs
Opportunity cost on both the down payment, closing costs at purchase and the savings you could have with your lower rent payment.

See at what point they balance out.

Assuming you can make 8% on investments (say a 10% down payment), and assuming a 3.3% average increase in home prices (and just a 2.5% increase on rent, assuming you're a good long-term tenant and the landlord will cut you a break), 5% selling costs, 1.5% closing costs, and the typical tax brackets, along with estimated maintenace of 0.5%/year, here are some break-even points after 7 years:

Assuming a 30 year FRM at 5 5/8%
$1500/month rent=$410,000
$1800/month rent=$490,000
$2100/month rent=$575,000
$2500/month rent=$685,000

So, if you're renting a house for $1800-$2100, which is pretty typical for nice places in the East Bay, you should look for a house ranging from $490-$575K, assuming you have the down payment, etc all together. OF course, that's just to break even with renting over 7 years. If you want a "cushion" you have to go down from there.

Excellent job, thanks so much, David! Indeed, a big thank you to both Davids. I read the article, which is excellent and helps me understand why not one person who has commented is supporting bailouts.

Janis, this post on seeking alpha references the article:

http://seekingalpha.com/articl...

the article is linked but apparently needs a subscription to view in full.

Thanks for the pointer, David! I wanted to share the URL with readers so cruised over to the WSJ, but I'm not sure I have the right article. Is it "Housing Boom Boosts Incidence of Fraud"?
http://www.realestatejournal.c...

In response to your comment about paying off the house in 10-15 years, the average mortgage in California turns over every 7 years. Of course, part of this is probably refinancings, but still, it tends to support your point.

What about the point that as rents climb over the years, your mortgage payment (assuming you have a 15- or 30-year fixed) remains the same? That would be the case even if you were only in the house five years, yes?

That's rough that you had to move after only 2 years! Did you have to take a loss on the house?

Big article in the Wall Street Journal about all these buyers fraudulently stating they were going to live in the house they were buying.

Again, I do not support a "bailout" in any form because the fraud and foolish practices were endemic on all sides of the housing credit bubble. I believe there are precious few people who are in trouble now due to no fault of their own.

I agree that in 10-15 years your house will probably be worth more than it is now.

However, and this is a huge "however," people are notoriously bad at predicting the future. How do you know that you'll live in the same house for 10-15 years? Do you have a government job? Run your own (very stable) company? Never going to get married/divorced/have more/no kids?

If it takes 10-15 years for you to break even on your house, Murphy's Law states you will be forced to move (job, etc) in less time than that. I sure know I was after I planned to live in particular city for more than a few years. Of course I was forced to move after just 2 years. N

lex, thanks, I'm glad I understood you correctly. Totally agree that loan brokers are suffering, indeed losing their jobs.

David, you're right, renting seems like a good decision now, especially because I believe prices in Contra Costa and Alameda counties will continue to drop throughout 2008, then remain low for four years or so.

So, do like Scott, rent a beautiful house in the neighborhood where you want to live, and you'll be in great shape to see those "For Sale" signs on your way to BART as the prices fall so you can snap up a good deal.

The "home ownership" society that has been pushed by the current administration and everyone else is not all it's cracked up to be. There is nothing wrong with renting, although people instantly think they have "gained" something when they buy a house. The process has already begun reverting back to a somewhat normal one. Renting is a great decision in a lot of cases, and more than not it seems in the current climate!

Scott, great points. I actually thought you were a friend of mine (named Scott) until the part where you said you rented for awhile. But I agree with you 100%.

Janis, if you look at the S&P Case-Shiller home price index, the appreciation rate (after inflation) of houses in the past 100+ years is less than 1%. Depending on what is your starting date for calculating, it differs, but is still a very anemic number. Real estate can very well go back to the way it used to be - buy and hold for the long term while you pay down interest AND principal - OR be a very good timer of the cycles.

Janis - you are correct, but I meant individuals and not businesses, though in that respect many loan brokers are suffering.

Yes, exactly, David! Your breakdown of the budget issues is spot-on.

I think Red has summed it up nicely, "Let the home prices drop back to affordable values and then people will be able to buy a home and still put some money into savings."

I also agree that Scott's point is excellent, and it seems to me that you, Scott, are now in an excellent position to wait until prices reach reasonable levels and then buy. Yes?

Finally, I'm fascinated by Scott's comment, "A house is a huge asset and cannot be easily diversified in the way that a stock portfolio can. In some ways this makes owning a home more risky than investing in stocks."

I understand what you mean in context, but isn't it also like owning stock in that you should buy for the long-term, not the short-term? I bought a house not because I expected it to appreciate, but because I didn't want my rent to keep going up every year and because I had a possibility of getting some of the money I spent on my house back when I leave, whereas a renter has no such hope.

And don't you think that if you buy a house in Northern California, eventually the value will go up, even now? Say, in 10 or 15 years? Or do you think the values were so overinflated, as with the dotcom boom, it would take 50 years to get back there, or never?

Scott brings up a good point. Those huge housing payments might have been bearable if your house is going up, AND you have money left over for $2/gallon (remember those days?) gas and a grocery trip for 2.5 people that costs less than $200. Now that gas is $3.30+ and I can't for the life of me spend less than $700/month on groceries (and no, I don't even eat meat much, and it sure as heck ain't steak when I do; I bake my own bread and make my own beer), even higher income people are taking a look at their budgets again and saying, wait a minute, a payment that's 40+% of our gross income just isn't going let us eat, never mind enjoy our lives. Also, you might not like "Bush's" tax cuts, but just wait until taxes get raised...Again, you make $175K--You're going to get the AMT or pay at least 37%+Cali=nearly 50% marginal rates, and these are the people buying houses (as no one else can yet afford them). So, now you're paying 50% of your income on taxes, more on food and gas and utilities, never mind private school tuition because public schools generally are terrible here...how again are you going to pay 40% of your gross income on housing?

All this equals no buyers until prices drop. No gov't bailout is going to help the fact that housing is just plain and simple unaffordable at current prices. Around here, it's the same darn house it was when it was built in 1924, why does it cost 500X as much? It's certainly not intrinsically worth 3X more than 7 years ago, which even with the recent drop, you still see.

Ok, sure, bail out those poor folks. And who should pay? Who benefited by the price run up?

* Lenders: might just be paying plenty already...
* Homeowners: BIG untaxed gains here. Lets revoke the homeowners exemption on gain! I'll bet that can happen in an election year...
* Speculators: Huge gains, yet the "long term" capital gains taxes are currently 15%, far less than the rates on earned income. Think there's any chance of getting an increase past Bush?

So as much as I might cry for these folks who believed that housing prices always go up, I don't feel like bailing them (and the lenders) out. Let the home prices drop back to affordable values and then people will be able to buy a home and still put some money into savings.

My wife & I were working with a Realtor last August when we decided to not buy a home because the conditions weren't right: our $175k+ incomes, 10% down-payment, and excellent credit scores still lead to an uncomfortably high monthly payment for a modest-sized home in a modest area of Oakland. We decided to rent a house in the same Oakland neighborhood we'd been considering to buy in. Our rent is $2000 less per month than the monthly mortgage payment we'd been evaluating.

We made a decision to rent a house because the conditions - our personal finances, and the conditions of the market - were not right. It seems that same people who are pleading for a bail-out are the same people calling their home "their largest investment." If it truly is an investment, then they should realize the risk they assumed and absorb the loss from their poor decision making. A house is a huge asset and cannot be easily diversified in the way that a stock portfolio can. In some ways this makes owning a home more risky than investing in stocks.

I think that the majority of people who are now facing foreclosure were content to ignore any risk and chose to focus on the potential 20% year-over-year price appreciation they stood to profit from. That amount of appreciation is unsustainable and requires a correction in the market prices.

Oh, that's brilliant, David, An excellent explication, and I'm so glad you mentioned "liar's loans," which hadn't come up earlier.

Just for those of you to whom this may be new, a stated income loan means that instead of giving the lender actual proof of your income such as a paystub, you simply state your income. Hence, the lender doesn't really have any proof of your income, just your word. Not surprisingly, most of such loans were shaky and in the industry are referred to as "liar's loans," for obvious reasons.

I shouldn't have said that the exotic loans like interest-only and adjustable-rate should "never" be used. Much too sweeping a generalization, and you pointed out an example of an individual using such a loan responsibly.

ARMs and I/O and even pay option loans have their place. For example, I/O loans work great for those of us who get a huge chunk of our compensation as a year-end bonus. We pay just the interest during the year and chuck the bonus in as a way to pay the principle.

I don't think there are nearly as many people who were "taken advantage of." I don't care if your command of English is limited, I'm sure that those people knew that they weren't making $100,000/year or whatever they claimed to be making to "qualify" for the loan. (How am I certain? Try paying an immigrant less money than they really earned; all of a sudden their grasp of English gets a lot better). Heck, I managed to bargain just fine in Arabic (a language I know all of 5 words or so) when I was in Morocco.

The real problem isn't subprime, or people being taken advantage of or I/O loans (which as you point out have been around for awhile) or even securitization. The real problem has been these "stated income" loans (aka liars' loans), no money down, and related products. Those products really goosed the boom, bringing in marginal "buyers." These products were then enabled by securitization and hunger for higher-yielding securities on the part of foreign (and domestic) bond buyers.

Simply restoring "prudent" lending--little things like verifying income and charging penalty rates for no down payment (which has the benefit of requiring the buyer to have a higher income to qualify, which of course the loan officer would have to verify, etc) would go quite far to prevent as large of a recurrence (it will not prevent another R.E. bubble, any more than the SEC act of 1932 prevented the stock market boom and bust of 1968-1974 or 1998-2002).

lex, I think your point is excellent about the government helping the banks more than the businesses. When it looked like it was just individuals losing their homes, the government was, like, yawn. It was only when Countryside and other lenders started hurting that the economic stimulus package got underway. Or, do I misunderstand you? Please correct me if I'm wrong.

And Slappy, that's an excellent point. Interestingly, instruments like adjustable ARMs, balloon payments, interest-only loans have actually been around a long time. In the 1980s when mortgage interests reached 15 and 16 percent, people would use ARMs as a way to buy a house whose payments would otherwise be too high. (ARMs came into being in 1982, to be exact.)

As we now see only too clearly, as you said, these instruments never should have been used in the first place.

I think the moral hazard argument really needs to be brought to the fore. Maybe there was confusion on the buyers part but the whole problem is that the "products" they were purchasing should never have been created in the first place. The banks knew they were creating a ponzi scheme by repackaging the loans, the brokers knew that the loan payments were unsustainable and unless the buyers are completely stupid they must have known what they were getting is too good to be true. And if they didn't, then why should my tax dollars cover their stupidity?

My savings is being weakened by the increase in inflation, the reduction in interest rates paid to savers and the slowing of the economy. The people and organizations who caused the pain (ALL of them) should feel some, too.

The government is really helping the banks more than the borrowers. Lowering the rates for a short period of time really only helps people become further in debt on something they just shouldn't buy to begin with.

And Bernanke's cut of short term rates are only trying to aggravate a bubble that has burst. He's really trying to get the entry level buyers back into the market with the tried but failed low ARM rates. Some people just never learn.

"(And maybe you would like to take a deep breath and release the caps lock key before you respond. K?)"

Janis, my infrequent use of CAPS was meant to highlight something forcefully and was entirely within reason. Using ONLY CAPS WHEN WRITING IS CONSIDERED BAD MANNERS as it analagous to shouting. I did not do this so your request makes absolutely no sense. OK?

David, I think you are right about the people who didn't put any money down. They can walk away, because they have little to lose, especially if they are investors who don't live in the house.

If we're talking about investors as opposed to hardworking families who saw this as their once-in-a-lifetime chance to grab the American Dream, it's a whole 'nother story and I say no bailouts. Because investors really did take a calculated financial risk, counting on prices to continue to rise.

The people I feel bad for are those who didn't know better, whose command of English is limited or who are old and not thinking as clearly as they might be, and were taken advantage of by mortgage brokers or agents. Not everybody is as savvy about real estate as you guyz!

According to Webster's New World Dictionary, "moral hazard" is "risk (to an insurance company) arising from the possible dishonesty or imprudence of the insured." Wikipedia defines it as "the prospect that a party insulated from risk may behave differently from the way it would behave if fully exposed to the risk."

It seems to me, Doug, that you are suggesting that those buyers were imprudent when they took out those loans, just as when an individual purchases a risky stock. If the stock tumbles, the investor loses the money, because he or she was imprudent.

And, you feel, if they don't have to pay the price, they won't learn the lesson and might do it again. Yes? (And maybe you would like to take a deep breath and release the caps lock key before you respond. K?)

Gee Janis, I already mentioned in your blog posts several times about MORAL HAZARD. why don't you look it up and make a new post about that?

And your description about those families who will lose every dime they had from their down payment (what 1%?) and have to pick up and RENT. Oh my, RENT. The inhumanity! And to top it off, the rental deposit. How on earth will they manage? Might as well be living on the streets. Tears are welling up as I write this. Crocodile tears that is.

A good portion of these people didn't put a penny down.

How will they pay a deposit? Please. They don't pay any housing costs for 6 months while they get foreclosed on, that should be plenty of money to pay for a deposit, find a rental and move.

As for the hit to the economy, no good economic purpose is served by propping up home prices to unaffordable levels. It'd be better for the economy to wash it out as quickly as possible in order to begin to recover.