Interest Rate Matters: A Look into Real Estate Investments

We’ve all heard those stories about people who bought a home in 1980 for a seemingly modest sum and then, several decades later, sold it for an eye-popping amount. While I might be exaggerating a bit with the numbers, the question still remains: does real estate investment pay off in the long run? I believe the answer could very well be a resounding “yes” for you. In fact, it might even be a substantial mistake not to consider real estate, even if you’re looking at a higher interest rate of 7%. Let’s dive into the reasons why.

I’m Marcie Billen, a real estate agent serving the Oklahoma City Metro area, but today, we’re focusing on a fictional character named Jessica. Jessica’s story is a reflection of how buying real estate can be a wise financial move. Born in 1988, Jessica has spent the past decade moving nearly ten times, and she’s reached a point where she’s had enough. She believes that purchasing a home will not only bring her happiness but also be a smart investment. With a budget of $260,000, she’s decided to invest in her first home, making a 5% down payment on a conventional loan with a 7% interest rate.

Now, let’s explore the three significant ways Jessica will save and earn money in her first year of homeownership: home appreciation, tax deductions on interest rate payments, and principal paydown.

The Financial Breakdown: Jessica’s Real Estate Investment

Let’s break down Jessica’s real estate investment. She’s purchasing a home priced at $260,000 and making a 5% down payment, which amounts to $13,000. Keep in mind that her interest rate is 7%. Her total costs associated with purchasing the home, including prepaid expenses, lender costs, title fees, and, of course, the down payment, sum up to $22,300. If you’re new to understanding different closing costs and what they entail, I have a detailed video on that topic for your convenience.

Jessica’s monthly payment, including taxes and insurance, is estimated at $2,300. Now, let’s delve into how her investment will grow over time.

HOME APPRECIATION: A CONSERVATIVE ESTIMATE

Real estate typically appreciates in value over time. To be conservative, we’ll consider a modest appreciation rate of 4%. As of now, the median home price in Oklahoma City is $260,000, precisely the price of the home Jessica has decided to purchase. This means that within her first year of homeownership, Jessica stands to gain $10,400 or more in appreciation on her property.

While 4% may seem like a conservative estimate, it’s essential to note that over the past two years, the average appreciation rate in Oklahoma has been approximately 14.39%. Over the past five years, it’s averaged 5.53%. However, since 2020, Oklahoma’s average appreciation rate has steadied at around 4%. This is why we’re using this more conservative figure in our calculations.

It’s important to understand that this gained value isn’t immediately accessible as cash; it’s a long-term investment. Jessica is essentially allowing her assets to appreciate over time while enjoying the comforts of her home. Additionally, it’s true that since 2021, interest rates have risen from around 3% to approximately 7%. However, I’ve already factored in this interest rate into our calculations.

The key takeaway here is that Jessica’s investment in real estate has the potential to appreciate, regardless of whether her interest rate is 7%, lower, or even higher. The profit generated through property appreciation remains unaffected by the interest rate, making real estate investment a promising endeavor.

In the next section, we’ll explore how tax deductions on interest rate payments can further enhance Jessica’s financial benefits as a homeowner.

WHAT IS TAX DEDUCTION?

First, what exactly is a tax deduction? A tax deduction is a specific amount of money that you subtract from your annual income before calculating the amount of tax you owe. For most homeowners, the good news is that they typically qualify for a full deduction of their mortgage interest payments when it comes to their home. However, it’s crucial to note that I’m not a certified public accountant (CPA), and when it comes to tax matters, it’s always advisable to consult with your CPA or the professional responsible for your taxes.

In Jessica’s case, she’s a single individual earning an annual income of $80,000. This places her in the tax bracket ranging from $40,000 to $85,000, where the tax rate is 22%. Now, let’s see how this affects her financial picture.

Jessica’s Decision and Tax Savings

Jessica decided to purchase a $260,000 house with a 5% down payment through a conventional mortgage. In her first year, the interest she’s paying on her home amounts to a little over $17,210.

To determine Jessica’s new taxable income, we subtract the interest paid, approximately $17,210, from her total income of $80,000, bringing it down to $62,789. Therefore, when reporting her income to the government for the first year of homeownership, she’ll declare an income of just a little over $62,000. This adjustment is significant because it places her in a lower tax bracket.

Now, if Jessica were taxed at the original 22% on her $80,000 income, she would owe the government more than $70,000 in taxes. However, with the full tax deduction available to homeowners, she will only owe the government $3,786 and some change.

Let’s summarize Jessica’s financial gains: In her first year, she’s gained $10,400 from the appreciation of her home and saved an additional $3,786 through tax deductions. Considering the initial amount she needed to purchase the house, which was $20,300, Jessica has now saved or made over $14,000 in just the first year of homeownership.

These financial benefits make a compelling case for the value of investing in real estate, even when interest rates may be at 7%. In the following section, we’ll discuss the third way Jessica will financially benefit from her home purchase: principal paydown.

WHAT IS PRINCIPAL PAYDOWN?

As Jessica continues to make her monthly mortgage payments, she’s not only covering the interest but also contributing to the principal paydown. While the allocation toward the principal will increase as time goes on, in the initial years, it’s a bit more modest, amounting to just over $2,509.

Principal paydown is a crucial aspect of building equity in a property, and it’s sometimes the only aspect that people focus on when discussing property equity. To provide some perspective, when you’re paying rent to a landlord, none of that payment goes toward your own equity in the house or property you’re living in. While it can be disheartening that a significant portion of your initial mortgage payments doesn’t directly contribute to your principal, it’s important to remember that you have the option to make additional payments toward your principal if you wish to accelerate your equity growth.

So, to recap, there are three key ways to save or gain money through homeownership: home appreciation, tax deductions, and principal paydown. In the first year of owning her property, Jessica will either make or save OVER $16,695. This impressive amount comes after bringing just $22,300 to closing. It’s worth noting that while she may not be directly making money from paying down the principal, renting often means that you’re paying a landlord without building any equity. In comparison, Jessica’s situation is marginally better.

It’s important to understand that appreciation takes time to accumulate, and you need to be patient. However, during this time, you not only build wealth but also enjoy the benefits of living in your own home. Now, let’s shift our perspective to a five-year view for Jessica.

5- YEAR VIEW FOR JESSICA

So, if Jessica decides to reside in her home for five years, having purchased it for $260,000, we can reasonably expect that with a 4% annual appreciation rate, the house will be worth a little over $360,000 at the end of those five years, and hopefully, even more. This 4% appreciation rate is a conservative estimate.

Regarding the tax deduction on her mortgage interest, in the first year, Jessica will have paid over $17,000 in mortgage interest, and over the five-year period, her average annual tax deduction savings will be approximately $3,800.

Over the span of five years, she will have paid a total of over $84,000 in interest. While this may sound disheartening, the tax deduction is a valuable benefit of homeownership for Jessica. In terms of principal payments, she will have paid a little over $14,000 over those five years. Consequently, if Jessica decides to sell her home for a little over $316,000 at the end of five years, she should walk away from the closing table with over $60,000 in her pocket, and yes, this calculation includes basic selling costs such as title fees and realtor fees.

It’s important to note that I haven’t factored in any repairs or maintenance that Jessica might incur on her house. This simplification was made for the sake of clarity, but in reality, homeowners should budget for these expenses.

So, despite Jessica’s 7% interest rate, do you believe that buying a personal home to live in was a wise financial decision for her? Those older individuals who frequently reminisce about high-interest rates in 1980 generally understand the long-term value of property ownership, even if it can be financially challenging in the initial stages. It’s important to recognize that there are numerous ways to build wealth besides real estate, and homeownership is a deeply personal decision. Both renting and buying have their pros and cons. We didn’t even delve into the topic of private mortgage insurance, which was included in Jessica’s $2,300 monthly payment.

I would love to hear your opinions on whether it’s preferable to purchase personal property or rent personal property for living. Please share your thoughts in the comments section and watch my video on closing costs!