March 5, 2006

David Bach and Mortgage Math

I just won't let David Bach off the hook.

Last week, during an extended highway drive, I was listening to the audiobook version of The Automatic Millionaire. Now, I have both the hardback and audiobook versions of Automatic Millionaire, and I've listened to the book, in its entirety, probably twenty times. (Not kidding. To say that "I just don't do radio much anymore," would be putting it mildly.)

I could go on for days about Bach's admonition that "budgeting doesn't work," but I'll pass on that — mostly because I already covered it ("David Bach & Budgeting") last year.

I could hack-n-slash his whole spiel about the "Latte Factor" — but that'd be silly, because I already wrote ("Not Big on Bach") about that, too, back in 2004.

So have I run out of things to browbeat him on? Not hardly.

This time, I'd like to focus on another big selling point from that book:

In order to be rich, you pretty much have to be a homeowner, rather than a renter.

It's not that I disagree with that statement. It's that I disagree with the manner in which Bach makes homeownership so "affordable."

(And no, I haven't yet read The Automatic Millionaire Homeowner. But I imagine that what I'm about to say will apply to it, too.)

The Chart In Question

Because I happen to have it handy, I'm going to flip over to page 171 of Automatic Millionaire. At the bottom of that page is a chart. It looks a great deal like this:

Now, to be fair, these numbers weren't actually created by Bach. As the caption says, they were originally thrown together by the FHA (Federal Housing Administration) or some such related government agency. (Note to Self: Compile list of "Top Ten Ways You Know the Math You're About to See is Shaky.")

Government jokes aside, that won't stop me from calling Bach on this. Because he refers to these figures every chance he gets.

Bad Math: Can You Afford It?

"There's nothing wrong with stretching to make payments," Bach writes in a recent Yahoo! article regarding home ownership. What exactly does he mean by "stretching," anyway?

Well, we're about to find out.

In the chart above (or click here to view it in a new window), scan across the row for the $50k household. We see that, according to these figures, our $50k household should be able to afford a monthly "housing expense" of $1,208. Or, if they have no debt, $1,712.

I'm sorry, but these numbers reek. My household makes more than $50,000 per year. (Quite a bit more.) We live in a very low cost-of-living area. We have no debt other than our home and (now) a car payment. I will state here unequivocally that our house payment is nowhere near $1,200. If it was, we'd be in deep, deep trouble.

How deep? Let's play with some figures (they're not mine, specifically; just estimations):

In the chart above, I'm figuring that our fictitious $50k household has two adults (one is a stay-at-home-mom) and one child. I'm estimating the expenses as best I can from my own experience (and averages from my year 2005-06 expenditures).

What it tells me is that after all the expenses listed, our Fictional Household has $1,343 left with which to buy a home. Taking on the rule-of-thumb $1,208 "monthly housing expense" above, they'll have a whopping $135 left over.

Not much, is it? Well, they'd need that $135 to take care of some ... inconsequential ... items I overlooked, such as:

  1. Student loans.
  2. Car payments.
  3. Credit-card payments.
  4. Auto repair and maintenance.
  5. Medical bills over-and-above insurance and the FSA.
  6. Home repair and maintenance.
  7. Gifts (birthday, wedding, holiday).
  8. Personal, fun, or hobby spending.
  9. Vacations and/or travel.
  10. Anything and everything else unexpected. (Good thing this never happens.)

See what I'm getting at? When real life kicks in, that $1,208 house payment (principal, interest, taxes, and insurance, or 'PITI' for short) is going to bury our $50k family. It'd happen even if you dismiss the top three payments (student loans, car payments, and credit-card payments) above.

Also consider that the numbers I show above are derived from my home area. Here, the cost of living is very low when compared to other areas of the country. In fact, I'm betting that many of my expenses above are, in reality, too low. (And other states may or may not have state income tax. But even if not, rest assured that they're getting the money somewhere.)

Another trap: How's that new house going to be furnished? Where's the money for lawn-maintenance stuff, tools, and miscellaneous other homeowner necessities going to come from? Realistic answer: credit- and department-store cards. Say hello to more and bigger payments.

And another trap: On the "How Much Home Can You Afford?" chart [new window], we're told that our $50k household could, if they have no debt, afford a home payment that matches 41% of their gross pay. That payment would be $1,712.

Now, I'm no math whiz, but $1,712 sure seems like a whole lot more than $1,343 ... which, as we know, is what our Fictional $50k-ers actually have available for their housing expenses, after all other expenses. (Remember: There are no debt payments in their charted expenses.)

And another trap: That smiling author and financial persona who's telling you that you can afford a $1,208 house payment is the same one who's telling you to max-out your retirement contributions. Which would be well more than the 8 percent I'm using above.

What he doesn't tell you: Where all this money is going to come from. (It was supposed to be "automatic," right?)

I Know! The Mortgage Interest Tax Deduction Will Save Us!

No, it won't.

In the next chart, I'll admit to "guesstimating" even more. The first column shows the tax savings our Fictional $50k Household could expect with a ~$1,205 house payment (PITI). The second column shows the tax savings a debt-free Fictional $50k Household could expect with a ~$1,711 payment.

As you'll see, in both cases, it ain't much.

In the chart, I call it "Federal Tax Savings." In reality, when you're talking "mortgage tax deduction," there isn't really any "saving" going on. The federal government is kindly subsidizing your home purchase (see my blog entry entitled "Your Mortgage Interest Deduction" for more) by paying a small portion of your mortgage interest — a portion equal to whatever tax bracket you're in.

My best guess is that the monthly tax "savings" won't come close to assisting our soon-to-be-troubled $50k family in their quest to stay solvent.

But We'll Make More Money Next Year!

Sure you will. And the year after that, too.

And as we all know, the best financial decisions always stem from banking today on the price gains (and pay increases) of tomorrow.

Although, if Bach's readers want to find out just how expensive risk can be, I say, "Have at it."

Just don't let the door hit you on the way to foreclosure.

And the Implications

The financial danger of long-term commitments like mortgage payments is very real. Once you're in over your head — and realize it — you can't just "make a phone call" to bail yourself out.

For years now, I've questioned the wisdom of the FHA guidelines above. Unless there's something I'm missing (which is entirely possible!), I cannot see any way in which they're grounded in reality.

The simple fact is that we don't get to pay our mortgages, or much of anything else, with our gross incomes. But that's what the FHA guidelines are built from. (We pay way too much attention to that beloved homeowner's tax deduction, in my opinion.)

On a micro level, banks will lend money according to their own rules. They will factor for things that the FHA guidelines don't cover. However, when my wife and I purchased our first home, we "qualified" for a much larger mortgage — and thus a much larger monthly payment — than we'd initially thought we could. Thankfully, though, we also knew what we could actually afford ... and we stuck to houses in that price range.

There are large incentives for banks and other mortgage entities to "over-lend" to starry-eyed potential homebuyers. And when financial gurus like David Bach trot out such dicey "affordability guidelines" in their spiels, the situation becomes treacherous: People think he knows what he's talking about. And so they listen. And believe.

As a consumer, you must be vigilant. The government isn't looking out for your best financial interests. And I wouldn't rely on David Bach, either.

In this game, you can really only rely on you.

Michael | March 5, 2006