Cost of Debt in Housing

Is it practical to live debt free?  I would say yes, but it will take being a bit clever.   This is an important topic because I will try to show that for most Americans most of our housing cost is debt financing one way or another.    This post will attempt to show housing costs are a major burden on us and that a majority of our housing costs are debt financing.  In another post we will explore ways to live without debt service.

Most of us rent or own where we live, but it is getting to be unaffordable.   Housing is termed “unaffordable” to the US Census Department if we are spending more than 30% on it, but again according to the census, “the cost of housing was 33 percent of the current income for renter occupied units in 2007.” And even for owners, 37% of mortgage holders are spending more than that and those that do not have a mortgage have housing expenses of over 16% of income.    Since over  70% of those of us that own a house have a mortgage on it, and over 31% of households rent, almost 80% of American households are paying housing they can not afford.

Another analysis of this issue is that the average wage earner can not afford the rent of a 2 bedroom apartment, and 60% of wage earners can not even afford a one bedroom in their county.

So we have a problem in housing cost.   Why?   The cost of the debt is a large part of it.  Over half of our cost of housing is paying direct financing costs.

For rentals, this can be demonstrated based on how apartment buildings are sold, and also by the rent.   Apartment buildings are advertized and priced based on “CAP rate”, or capitalization rate.   This is the cost of running the building over the price of the building.   This is typically advertised at 5%, but often sell when they are 6-8%, and fluctuates based on the interest rate of mortgages.    If this amount goes below other investment opportunities, then people would not invest their money in the apartment building.   In other words, if one were investing one’s cash in a building, then it would have to be better than putting the money in something else.  This is typically estimated in a few percentage points above a mortgate rate.   If one were taking out a mortgage to buy the property, then the income we be expected to at least pay back the mortgage (this is sometimes not true in a speculator market, but these do not typically last long).    Analysis of the breakdown of costs to run the building, it is clear that only 1-2% are non-financial operational costs ( sample apartment building in San Francisco).    Therefore since rents are set based on maintaining a “cap rate” of 5-8% and the non-financing cost is 1-2%, then the vast majority of the cost of the apartment building goes into debt financing, or the equivalent calculation for investors putting in cash, where they in turn are financing the building and expecting a return.

In houses that are purchased, the debt service is also the vast majority of the early cost.   With the average cost of a house is around $300,000, and if there were the mortgage amount, then we would be paying about $19,000 for the mortgage.  The taxes are only 1.8%, maintenance may be 1% per year, and insurance is less than 1/3 of 1%.   So the dominant cost, by far is finance cost.

Therefore if we were able to not have direct debt financing costs, then over half of the cost of housing would disappear and would, then, be affordable to the average wage earner in the United States.

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