Uncle Sam Wants You to Be a Homeowner
The average renter in the United States has less than $5,000 in wealth. The average homeowner has nearly $200,000, which is 40 times as much wealth as a renter. Is this because homeowners earn 40 times what renters earn? No. Homeowners, on average, earn about twice as much as renters, $50,000 a year versus $25,000 a year. The main reason homeowners are 40 times wealthier than renters is because they are homeowners! Most of their wealth is their home and they built up this wealth by owning a home instead of renting one. The easiest way to become wealthy is to become a homeowner. It really is as simple as that.
The government provides a variety of subsidies and tax breaks that make it easy and profitable to become a homeowner. Three of the most important ones are
- You don’t pay taxes on the income you get from your home.
- You pay minimal taxes on the profit you make when you sell your home.
- You can deduct the interest you pay on your mortgage from your taxable income.
Let’s look at these three incentives one by one.
Most people are not aware of the first incentive, which is usually the most important of the three. If you have a savings account or a portfolio of stocks and bonds, your income is the interest and dividends you earn and you have to pay taxes on this income. If you own a home, you get income too, but it is harder to see and it goes untaxed.
The income from your home is the rent you save by being a homeowner. If you pay $1,500 a month to rent a home, this is $1,500 that you no longer have. If you own this home instead of renting it, you keep an extra $1,500 a month. This money is real cash that you can put in your bank account instead of your landlord’s pocket—and you don’t pay a penny of taxes on it. Later in this book, when we examine how owning a home builds your wealth, you will see that this untaxed income is the secret that can make you rich.
The second incentive is that you pay minimal taxes when you sell your home. If you sell a stock for more than you paid for it, your profit is called a capital gain and you have to pay a capital gains tax on your profit. Homeowners, however, get a big tax break. If you live in your home for at least two of the five years before you sell it, your profit is not taxed up to $250,000 if you are single or up to $500,000 if you are married.
So, at the current 15 percent capital gains tax rate, if you sell your stock portfolio for a $500,000 profit, you pay a $75,000 tax. If you are married and sell your home for a $500,000 profit, you don’t pay any capital gains tax. If you sell your home for more than a $500,000 profit, you pay a tax on the excess, but please don’t complain if you make more than a $500,000 profit on your home!
The third incentive is that your mortgage interest is tax–deductible. Suppose you have a $200,000 mortgage at a 6 percent interest rate. In the first year, your mortgage payments will be $14,900, of which about $12,000 is interest. You can report this interest on your federal tax return as an itemized deduction and it might reduce your taxable income by $12,000. (We say “might” because of the Alternative Minimum Tax and other complexities of the tax code). If you are in a 25 percent tax bracket, you will save $3,000 in taxes. That’s right. Uncle Sam will pay a quarter of your interest payments for you. Why? Because the government wants to encourage you to do the right thing and become a homeowner.
What about the $2,900 of your mortgage payment that is not interest? This $2,900 is a “principal payment” that pays down your mortgage and builds up equity in your home. If your home is worth $300,000 and you have a $200,000 mortgage, your equity is the $100,000 you would keep if you sold your home and paid off your mortgage. Principal payments reduce your mortgage balance and increase your equity.
Because principal payments reduce your mortgage, they also reduce the interest you owe on your mortgage. If you have a 6 percent mortgage, every dollar reduction in your mortgage is a dollar you no longer have to pay 6 percent interest on. Because paying down your mortgage saves you 6 percent interest, paying down your mortgage is an investment that earns a 6 percent return.
This remarkable fact bears repeating because it is not well known. Think of your home as a special bank account and think of your principal payments as bank deposits. Your principal payments are savings that build up equity in your home, the same way that savings deposited in a bank build up your bank account. Paying down a mortgage with a 6 percent interest rate is an investment with a 6 percent return.
Thus, when you make mortgage payments, you not only pay the interest on your loan, you are also saving and investing. When your mortgage is paid off, you will have saved and invested a total of $200,000. This is forced saving because you have to do it—you have to make your mortgage payments or the bank will foreclose (sell your home to pay off the mortgage). For many people, this is another advantage of buying a home. It forces you to save money when you might otherwise not be sufficiently disciplined to do so.