Since the beginning of the financial crisis the media has constantly been repeating that the housing market was key to recovery and that the government had to do things to help prop up house prices.
As someone who would like to own a house in the future, I find it quite unfair that the government is helping to maintain bubble prices. It is yet another way for current homeowners to to extract as much money as possible from the next generation. However, that is even not the main concern for my generation.
Here is an interesting fact: My house whenever I can afford it, will _not_ be the most expensive thing I will have to buy in my life. My retirement savings are.
With lower expected long term investment returns and interest rates, the expected cost of securing a retirement annuity goes up steeply and there is much less money left for everything else.
All the news article I read on the subject of house prices assume that low interest rates prop up prices since they allow for cheaper financing and lower mortgage payments. However, as a 30yo who would like to one day be a homeowner AND also one day retire, this is not the effect low interest rates have on my budget.
The low interest rates are currently more than offset by low expected returns on investments which make it much more difficult to secure retirement.
I decided to try to quantify the effects of low returns on my budget:
I calculated that if I managed to get 4% _real_ returns on my savings, which is what most online savings calculators assume by default and about what the previous generation got, I would need to save 23% of my income to maintain standards of living after retirement (This includes home equity and what the government saves on my behalf, those "entitlements").
If real returns were 3%, I would need to save 27% of my income, if they were 2%, I would need to save 35% and 1% would require saving 42%. This assumes a saving period from the age of 30 to 60 and retirement from 60 to 90. This is a somewhat optimistic scenario but with two equal periods of 30 years, it makes one data-point easy to calculate: With 0% real returns, to maintain standards of living. we would spend half the money before retirement and half after so we'd have to save 50% of our income.
Long term real returns going down from 4% to 2%, increases the amount we need to save by 12% of our income. This means we have this much less money to put on housing and other things. For example, if our after tax household income was $50 000. We would need to save an additional $500 a month ($6000 a year) for retirement.
Is it even possible nowadays to get a safe 2% real (~4% nominal) return? The investment opportunities I see are closer to 0.5% or 1%.
Meanwhile the cost of financing a $200 000 mortgage go down by about $4000 a year or $333 per month when mortgage rates go down by 2%.
If I bought the same house when returns and mortgage rates both went lower by 2%, I would need to find an additional $166 per month ($2000/year) to keep my retirement savings on track. If I decided to recoup this $166 per month by buying a less expensive house, at 4% interest, it would have to be $50 000 cheaper.
I realize that expected returns and mortgage rates don’t necessarily move in sync and it may be that mortgage rates have bigger downward moves than expected returns but this still all makes me uncertain about my ability to spend while saving for retirement.
Here is the math I did for reference (let me know if I made any mistakes):
I : Annual Income
S: savings ratio
The amount saved each year of my working life is I x S
The amount spent each year of my working life is I x (1-S)
For example, if our household after tax income I=50k and we save 10k for retirement, S=0.20, we get to spend 40k that year.
We would like to maintain our standards of living after retirement which means we would like the amount we spend I x (1-S) to be equal the amount of our retirement pension payments. That is, if we save 20%, (spend 40k, save 10k) we would like to get a 40k pension at retirement.
The value of our savings at retirement should be enough to give us this annuity. To calculate S, the proportion of our income we should save to achieve this goal, I take:
Future Value of my savings FV(I x S) = Present Value (at retirement) of the pension annuity PV(I x (1-S))
i is the real (above inflation) returns on my investments which, assuming I don’t take too much risk, should follow the trend of long term real interest rates.
n is number of years we are savings
m is number of years we plan to be retired.
Lets say, that I start saving for retirement at 30, retire at 60 and live to 90. That’s 30 years of savings and 30 years of being retired, a somewhat optimistic scenario (n = m = 30).
The punchline, of course, is that retirement won't be a realistic option for our generation at 60. 25-75 leaves 50 working years, and that's what it'll probably take so we can pay for the boomer generation to retire and also save for our own. And I don't think it's a bad thing. It's patently ridiculous for a person to spend half their life not working, why should it involve less than an unreasonable savings rate to do?
> It's patently ridiculous for a person to spend half their life not working
Why is this ridiculous?
The idea that the poor should have leisure has always been shocking to the
rich. In England, in the early nineteenth century, fifteen hours was the
ordinary day's work for a man; children sometimes did as much, and very
commonly did twelve hours a day. When meddlesome busybodies suggested that
perhaps these hours were rather long, they were told that work kept adults from
drink and children from mischief.
Genuinely curious - I'm no economist, and don't understand whether Russell's argument is full of holes, outdated, both, or if rather his proposed reallocation and reduction (through technology) of work is something we should be aspire to.
Let me explain you what the problem is. The concept of work is relatively modern compared to the entire human history. Organized work is something that was needed to scale organized living, and growth of human population. Without agriculture, architecture, transport, communication and health care human kind wouldn't have made it till now. Hunter gatherers had it a little easy, each man for his own or at the max his offspring. But this was not scalable, then extremely unpredictable. To scale we had to get down to staying at one place for long periods of time[read: civilization], and then produce food in bulk quantities[Read: Agriculture/farming]. But no man would work for others, so then came in the concept of doing other kind of work. Like building homes, pottery, carts etc and then people would trade one for the other.
This was still OK, until the kingdoms and kings came along. And then automatically came the concept of slavery, then soldiers who are supposed to die for king. Misery was the norm in this era. A lot of people were stuck building large monuments and cities for kings. Its during this period the notion 'born into richness' and 'born into poverty' evolved and to a very large extent continues till today.
If you are born to some one poor, the world assumes you now have absolutely no 'right' to be rich. And if you do get rich by your work, the rick kids/people think of it as unfair to them. And now matter how lazy, unproductive some rich guy is he considers it unfair to him that he must become poor out of his own actions.
Tribes have specialized warriors, and also would raid other tribes for loot and spoils of war which included slaves. This didn't need the creation of Kingdoms to achieve this. Man will come up with this at the proto-civ stage because other humans beings are the best tools.
You also are drawing some sort of line of intent, that hunter gatherers knew to move towards agriculture, AFAIK the data on how the transition occurred is spotty and is still being debated.
EVEN then, from tribal structures and from studying nomadis/hunter gatherers its clear that "men did work for others", at the very least for the good of the tribe, and often because the village headsman would be able to mobilize people to work on mutually beneficial tasks like say, a granary, or even a juju enhancing spirit walk.
Bulk food also is something of a recent phenomenon, if you look at the chart of human population growth its balooned since around 1950, and before that the total human population of the world was nearly a billion people.
And thats with the invention of the plough, harness, irrigation and so on.
While agriculture was massively advantageous compared to whatever we had before, it wasn't without its own pitfalls - such as famines, droughts, pests, bad crops and so on.
Finally your last para is at odds with the entire ethos of the USA for a large portion of its existence, that you could get somewhere with merit. Matter of fact its only in the recent past that this has stopped being true.
It's patently ridiculous to spend even half your life working, yet alone from 18 to 65 (or whatever the retirement age is now). Why have we automated so many things yet work the same hours? There is no virtue in work what-so-ever. It is a means to an end and nothing more. If I could have robots grow my food, manufacture my appliances and create entertainment for me then I would spend all my life enjoying it and not give that a second thought.
This 'cult of work' needs to go. We're not here to use our hands to modify the structure of matter and energy, we're here to figure out why we're here, enjoy and love each other and have a good time.
Seriously, I don't know about you, but I have a list a million pages long of problems I'd like to see solved by the human race, and I'm pretty sure everyone can chip in on at least one of them. Navel-gazing doesn't get anyone very far.
My list of problems is about as long and I would love to see them solved. I've researched and thought a great deal about why these problems occur and the root cause of them is invariably humanity itself.
We look at how much food the human race produces and see that there is absolutely no reason why anyone should starve, yet many people do. We have plenty of water yet people die of dehydration. Why is this? Our technology is clearly advanced enough that these problems should not exist. Should we keep working to improve our technology?
My argument is that we should drop what we're doing, take a step back and think about how we got into this mess - that we stop working and consider where we're going and how we are getting there. Why, in a huge corporation, are there some employees earning minimum wage and barely making enough to survive while someone working the exact same hours has two houses and three cars? Why are there people living on the streets in what are apparently first world countries? Why is the inequality gap growing instead of decreasing? Shouldn't all this work be improving the situation?
My contention is that we cannot work ourselves out of this problem. We need to sit down, think and talk. We need to empathise with each other and share. I believe that the solution to the problems that plague people will find their remedy on the social level. That is, information, and access to that information, is the key to resolving them, not working hard to keep the streets clean or developing the newest iPhone or building new houses. Don't get me wrong, those things are important too, but we have the capability to automate a lot of them yet we have not done so. Why are robots not roaming the streets and keeping them spotless? Why are people working for pennies in factories to make our smartphones?
I believe that answering these questions and doing something about them will go a lot further than turning up to a 9-5 every day. It's all very good having an engine that can produce a thousand horsepower but if the steering wheel is not used to aim the car in the right direction, it will crash. The engine is already good enough - the direction seems to be terribly wrong.
Sitting around and navel-gazing still isn't going to solve any of those problems. You won't know what the solutions are for sure until you try them, and that takes work.
> Why are people working for pennies in factories to make our smartphones?
Because it's a better alternative to subsistence farming, usually. I mean, whatever caused them to voluntarily choose to work for pennies in a factory must have been even worse. Now you want to put them out of a job?
Even if you want to redistribute the wealth, it still needs to be generated in the first place or the whole thing collapses. And you're not going to stumble upon a better social and economic system by not producing as much wealth anymore.
I couldn't agree more. I'm in good company too: "road to happiness and prosperity lies in an organized diminution of work" (Bertrand Russell - In Prise of Idleness, http://www.zpub.com/notes/idle.html). The trouble is that the organized diminution of (human) work requires so much work itself :).
That's all fine and well for people like us that don't necessarily do hard labor for 30-40 years. But those that have to do physical labor aren't actually living longer. The rise in life expectancy is due to a fall in infant death rates and the wealthy living longer because they have access to really good health care.
Work keeps your brain sharp. I've met 80+ year old judges that can keep young lawyers on their toes peppering them with questions to test their arguments.
...as long as you don't run into any health issues that affect your cognitive capacity, and you are able to maintain a position that matches your -likely declining- abilities.
I would like to think that I can look forward to retirement - travel, family, personal projects, etc. - without having to also continually worry over my status at work. But I'm not terribly optimistic.
I think the best plan is try to evolve your work over time into an area that you're happy. My goal by 70 is to be able to get up and go to a job where I'm excited and happy to be even at 70. My Dad is almost 70 and that's how he feels, his ambition is to keep doing the work he loves until he dies.
To still code at 70, you may need to code a little less now.
By that, I mean make sure to get up from your computer from time to time and get plenty of physical exercise.
Why do you want to own a house? Is it as an impediment to relocating? For the risk of a highly leveraged investment? Or so that you can spend time and money fixing leaking pipes on Tuesday evening and patching the gypsum board on Saturday?
Ever notice how most small businesses deal with real-estate? Hint: they don't negotiate a thirty year lock-in.
This is probably a contentious topic, but housing security is a useful thing. Owning a residence, and perhaps more saliently owning it without debt, provides a certain level of housing security that is quite precious when you are older. The other benefit of owning property is that you can use it to generate income when you're not using it. While being a landlord is a pain, if you're willing to give up some of the return you can negotiate that out to a third party and that provides a bit of income security.
Sometimes having one less thing to worry about can be the difference between taking a risk that changes your life in a positive way and not taking it.
The bottom line for me is that I've never heard anyone say "I wish I had more things to worry about."
I cannot understand why leasing (or renting) can be considered superior to owning your own place. Sure it does prevent you from just moving on a whim - something i don't think people should be doing anyhow - but the money paid as rent is like throwing it into the sea!
> the money paid as rent is like throwing it into the sea!
The same can be said of mortgage interest. The fair comparison to the renter with no savings is the homeowner owing the full value of the house to the bank, and the fair comparison to a mortgage-less homeowner is a renter with investments and savings equal to the price of the house they're in.
Better arguments for your position might be
1. Mortgage rates are lower than rental prices in many places,
2. Paying off a mortgage is "enforced savings". People leasing property mostly spend the difference instead of investing it.
3. Some kind of projection of house and rental prices rising more quickly than the market.
> 1. Mortgage rates are lower than rental prices in many places
When this is true, this actually is a very convincing argument. Not only that, but you can effectively arbitrage yourself into a lot of wealth this way. You buy a house and move into it for awhile, but then you buy a new house, move into the new house, and rent out the old house. (You get better mortgage terms that way.) Rinse and repeat whenever you can afford to do so and you eventually end up with a large portfolio of profitable properties.
Of course, it's arbitrage--if enough people do it, it stops working. You can keep it going with more money, if you can make larger down payments, since at that point you're turning a one time lump sum into an ongoing cash flow. But eventually you have to have more money to make money, so not even this might be workable.
> Mortgage rates are lower than rental prices in many places,
its unlikely that mortgage payments are lower than rent - otherwise, it'd be better to pay the mortgage than renting! You would buy a place, and rent out a room or two, and have the rent income plus your own money to pay the mortgage.
I m not against renting - but i just don't want people to think that a mortgage is some baggage that they are better off not having, and instead just pay rent. I want people to make the smartest choices, so that the only way rent rises is because costs to build houses rise, not because the landlord got greedy. To me, rent is like a tax on being alive.
There are various times where dislocations in the market make this more true than others. For example over the last 3 years due to the high foreclosure rate in Las Vegas Nevada you could buy a property for $125,000, leverage it at a 4% rate, an immediately rent it out for $1500 a month making it cash flow positive from the day you bought it. However, that situation was created by the mortgage crisis where these same houses had $300,000 mortgages with $2500 mortgage payments. Having watched prices in the bay area fluctuate I've seen the markets on both sides (renting was cheaper than buying and buying was cheaper than renting) at various times.
>its unlikely that mortgage payments are lower than rent - otherwise, it'd be better to pay the mortgage than renting!
In some places, they are, and it is. However, I would be incredibly surprised if there is anywhere where the mortgage payments on a 100% LTV mortgage are lower than rent; and this is one of the reasons why many settled people don't own their own home. They can't (yet) afford a sufficient deposit to make the repayments affordable.
In my city (a) renting is with very, very few exceptions uniformly explicitly forbidden by home owner association agreements (bans that are now backed by recent state supreme court victories, the only places you can rent are in the small regions of the city that predate the explosive subdivision-based growth that started in the 70's--presumably driven by white flight, but I don't know for certain), (b) renting is made very unpalatable by a number of policies made by the city itself and (c) homestead property tax exemptions for homeowners that make owning very, very expensive if they don't live in their house themselves.
>its unlikely that mortgage payments are lower than rent - otherwise, it'd be better to pay the mortgage than renting! You would buy a place, and rent out a room or two, and have the rent income plus your own money to pay the mortgage.
I have friends doing just that. All it takes is the initial deposit capital (which many people don't have, or take years to save up) and credit rating.
Rent and interest are both taxes on not being rich. I don't really see any reason one is intrinsically better than the other, but rent entails a lot less risk.
The idea that people shouldn't be "moving on a whim" probably isn't much consolation to people in economically depressed areas who can't move to where the jobs are because they're stuck to their house.
In any case, if you buy a house at age 30, and you get the standard 30 year mortgage, you'll effectively be paying rent to the bank until you're 60 anyway. You would be very fortunate to own a home outright for most of your life. Some people never do.
This is not true in every case, it's magical thinking.
You can make a rational calculation of what works out better using local rental rates vs property prices (sometimes one of them is grossly out of proportion to the other), applying a liquidity and mobility premium and your expectations of what the rental and property markets will do long term.
You rent your clothes, your food, your transport, everything. You pay some money and when it's done, you have nothing to show for it. What's so special about rent that you consider that wasted money, but not the money spent on clothes, food, transport, and everything else that has a short effect or wears out?
I never find this answer convincing. Firstly, most renters are unlikely to invest the difference - we are a nation of spenders. Secondly, that rent will creep up, whereas my mortgage payment stays the same - eventually that difference will disappear, or even open up in the other direction. Thirdly, I'll have paid off my mortgage in another 12 years or so, at which point I can invest my entire payment every month whilst rent still needs to be paid. Over the time period I intend to stay in my house, I am confident I'll make out like a bandit compared to if I'd rented it.
Didn't we just learn that "investing" in real estate isn't always the best idea, either? Buying a house to live in on credit is part spending, part leveraged speculation.
Meh, I don't consider my house an investment (in that I don't expect it to generate a return), it's somewhere to live. Most people understand that a car is a terrible 'investment', but if you intend to drive the same one for a decade you're better off buying it than leasing it. Same thing, but different scale.
When I was backpacking through San Francisco I met a white-haired septugenarian in the hostel. He had a house in Connecticut that he rented out - and he'd spent the last 15 years of his life constantly travelling about the place on the proceeds. It wasn't opulence, but it was travel and he loved it.
I'm not against investing in real estate, but you have to be honest with yourself that that's what you're doing, and that it's not a risk-free investment, especially when you leverage it with debt.
The problem is that everyone casts it as an argument between renting and owning property fee simple. Actually, it's either an argument between renting housing and renting money, or it's an argument between having six to seven figures invested in residential real estate and having six to seven figures invested in anything else. Either way, it's not clear cut.
-The max quality or size of rental properties is not that high, you may not be able to rent a nice freestanding house in some places because culturally speaking, people with more than $X usually buy.
-Landlord-tenant law may be very favourable to the landlord and not to the tenant. That motivates people to buy rather than rent and deal with shitty landlords.
In addition to that, people like being able to invest their time and money into improving their home to just the way they like it.
Having a long term place that is "home" is very important and comforting to many people. There is a reason that residences have all kinds of special legal protections and treatment that commercial real estate doesn't neccesarily have.
I think this is a very important point. In most places outside of the big cities (basically NY, SF, and Chicago), there is very little housing stock available for rent, aside from in low-income neighborhoods and near schools. Furthermore, what you do find is mostly people who are simple looking to sell but can't and are renting in the meantime--you had better bet that they will sell it out from under you at the first opportunity they get, and moving is not cheap.
Even if you are able to find a place to rent that is stable, now you have to deal with a landlord and (possibly) other tenants. You can't do what you want to the place, when you want to. I think this weighs on people.
I completely agree that too many people that shouldn't end up buying a place, and that buying a place is a lot of work. But it's about the only choice in most of the country.
A lot of other things can be an obstacle to relocating: wanting to have family close by, having put roots into a community you love. There are definitely tradeoffs to owning a home, but I've decided for me there's more upside than down.
I'm around halfway through the mortgage on my place and relish the thought that once it's paid, even if I eventually find myself between a rock and a financial hard place I'll have four walls and a roof and no obligation to anyone for them. I'll have a good 30 years (give or take) of earning potential left in me by that point which means I'll have plenty of disposable income on top of what I've been squirreling away all along for a retirement. Yeah, I've had to fix leaky pipes (and cursed the time spent doing it) but overall I find comfort in the thought that if current trends continue, I'll have a place to park FOREVER.
> Or so that you can spend time and money fixing leaking pipes on Tuesday evening and patching the gypsum board on Saturday?
Oh god, yes! Do I ever! I would love to have a pipe spring a leak on Tuesday and fix it on Tuesday, instead of spending Tuesday, Wednesday, and Thursday calling the maintenance guy every two hours to nag him to come fix it.
We spent 48 hours without a working toilet once because maintenance was too busy to come over and unclog it. When I owned my home, I would just go out to the garage, get the auger, and clear out the clog.
The Realtor.com app has replaced pornography for me. I can't wait for our lease to be up. Just six more months to go...
I completely understand where you're coming from. I'm in Canada, and all the above is reasons why I rent right now.
"Why do you want to own a house?"
It's actually not a bad proposition now in the US. Housing starts are heading up, prices are rock-bottom but starting to budge upwards again, and the common wisdom on real estate is now strongly negative.
What I'm saying is that someone would likely be able to get their money back (+ inflation) if they get a house these days and sell it later. Of course, they've got to deal with the headaches you mention, which personally still turns me off.
There are all sorts of US government incentives to own. For one the mortgage interest is federally tax deductible which amounts to effectively a ~30% discount on the beginning years of the mortgage (depending on your income, etc).
It's also a predictability thing. In lots of metro areas rents can fluctuate pretty substantially, even if you're getting a good return on the money you're investing instead of buying moving is still a pain in the ass.
the media has constantly been repeating that the housing market was key to recovery and that the government had to do things to help prop up house prices.
It is interesting how many people are misinformed about this. The government hasn't and can't do anything to "prop up" house prices. It only sets the prime interest rate, which affects the ability of people to borrow money (specifically does it affect ARM mortgages), essentially the ability of people to "afford" housing, or the rate at which they'll be able to convert the debt behind their mortgage into equity.
Here is an interesting fact: My house whenever I can afford it, will _not_ be the most expensive thing I will have to buy in my life. My retirement savings are.
Again, not true. As you get older, as you're converting larger and larger portions of that debt behind your mortgage into equity, it should be close to being paid off by the time you reach retirement (the theoretical pie in the sky for our generation). So the amount of "retirement savings" one needs depends on what kind of housing situation one is in at the beginning of retirement. The sub-prime lending crisis occurred because people who HAD worked their whole lives, had accumulated their retirement savings in their houses or whatnot were literally swindled out of that savings by real estate people selling them "refinance" lemon loans and banking on the commissions.
> The government hasn't and can't do anything to "prop up" house prices. It only sets the prime interest rate, which affects the ability of people to borrow money (specifically does it affect ARM mortgages), essentially the ability of people to "afford" housing, or the rate at which they'll be able to convert the debt behind their mortgage into equity.
What about implicit and explicitly guaranteeing higher risk mortgage through Fannie Mae and bank bail outs? By taking on some of the risks the government lowers costs which increases the number of people in the housing market increase price.
>Following their mission to meet federal Housing and Urban Development (HUD) housing goals, GSEs such as Fannie Mae, Freddie Mac and the Federal Home Loan Banks (FHLBanks) have striven to improve home ownership of low and middle income families, underserved areas, and generally through special affordable methods such as "the ability to obtain a 30-year fixed-rate mortgage with a low down payment
http://en.wikipedia.org/wiki/Fannie_Mae
Not quite. The prime rate isn't set by the government but by the federal reserve which should be mostly independent from the government.
Propping up house prices was done through the bailout by helping banks with the mortgage backed securities, sometimes helping underwater mortgage holders and through fannie mae and freddy mac.
Also the equity on my house will be just a small part of my retirement savings. This part should cover housing during my retirement. I also expect to need food and such.
> It only sets the prime interest rate, which affects the ability of people to borrow money (specifically does it affect ARM mortgages)
It's even less than that. The Fed targets the Fed Funds Rate, which is the rate at which banks lend to each other overnight. ARMs are not based on overnight rates, but rather on rates of debt of duration of 1,5,7,10 yrs etc. (Granted the overnight rate may pull down the short end of the yield curve, but not necessarily.)
I wish more people understood these issues with this clarity. Fed policy has had negative consequences for savers at the benefit of borrowers.
I wrote a simple app which compares 12 month CPI to current Treasury yields. What is scary is in the past year CPI (which many claim underestimates true inflation) at times has been higher than the returns on 30 year Treasuries. This is a rare event, and is the result of the FED buying Treasuries on the long end of the curve to artificially depress interest rates. Typically investors wouldn't tolerate such a low rate of return on their investments. Historical bond yields vs CPI can be viewed here: http://yield.io/
You can achieve 4% investing in large cap dividend payers. The dividends alone can be 4%, and any price appreciation on top of that is gravy. Though of course, you have to diversify and thus put an immense amount of research in many companies.
Yeah if you are smart with your money you can still get close to 4% nominal which is about 2% real (inflation adjusted) and is what I used in my calculations. The previous generation used to be able to get 6% to 7% nominal.
My point is the Fed is significantly screwing around with the debt market which hurting anyone that invests in low risk loans (Treasuries, savings accounts, CDs, etc.). This doesn't have to be the case. Sure you might be "smart" and figure out how to get a 6% return, but reward for that 6% vs the risk is also lowered by fed activity.
Investing in large cap dividend stocks is not a "risk free" investment. Not that treasuries are either, but there is a built in assumption that the treasury will not default. If I adjusted the returns for taxes the situation would look much worse.
It's a good simple model, but I think it's TOO simple. If you own a house and pay off the mortgage, two massive changes occur: 1) You free up that monthly payment for investment, and 2) the amount of money required to maintain your standard of living nosedives. The same standard of living you get for $40k probably costs <$25k once the mortgage is paid.
As someone who would like to own a house in the future, I find it quite unfair that the government is helping to maintain bubble prices. It is yet another way for current homeowners to to extract as much money as possible from the next generation. However, that is even not the main concern for my generation.
Here is an interesting fact: My house whenever I can afford it, will _not_ be the most expensive thing I will have to buy in my life. My retirement savings are.
With lower expected long term investment returns and interest rates, the expected cost of securing a retirement annuity goes up steeply and there is much less money left for everything else.
All the news article I read on the subject of house prices assume that low interest rates prop up prices since they allow for cheaper financing and lower mortgage payments. However, as a 30yo who would like to one day be a homeowner AND also one day retire, this is not the effect low interest rates have on my budget.
The low interest rates are currently more than offset by low expected returns on investments which make it much more difficult to secure retirement.
I decided to try to quantify the effects of low returns on my budget:
I calculated that if I managed to get 4% _real_ returns on my savings, which is what most online savings calculators assume by default and about what the previous generation got, I would need to save 23% of my income to maintain standards of living after retirement (This includes home equity and what the government saves on my behalf, those "entitlements").
If real returns were 3%, I would need to save 27% of my income, if they were 2%, I would need to save 35% and 1% would require saving 42%. This assumes a saving period from the age of 30 to 60 and retirement from 60 to 90. This is a somewhat optimistic scenario but with two equal periods of 30 years, it makes one data-point easy to calculate: With 0% real returns, to maintain standards of living. we would spend half the money before retirement and half after so we'd have to save 50% of our income.
Long term real returns going down from 4% to 2%, increases the amount we need to save by 12% of our income. This means we have this much less money to put on housing and other things. For example, if our after tax household income was $50 000. We would need to save an additional $500 a month ($6000 a year) for retirement.
Is it even possible nowadays to get a safe 2% real (~4% nominal) return? The investment opportunities I see are closer to 0.5% or 1%.
Meanwhile the cost of financing a $200 000 mortgage go down by about $4000 a year or $333 per month when mortgage rates go down by 2%.
If I bought the same house when returns and mortgage rates both went lower by 2%, I would need to find an additional $166 per month ($2000/year) to keep my retirement savings on track. If I decided to recoup this $166 per month by buying a less expensive house, at 4% interest, it would have to be $50 000 cheaper.
I realize that expected returns and mortgage rates don’t necessarily move in sync and it may be that mortgage rates have bigger downward moves than expected returns but this still all makes me uncertain about my ability to spend while saving for retirement.
Here is the graph I made showing how much we have to save relative to long term real returns on investments to maintain standards of living at retirement( https://picasaweb.google.com/lh/photo/d4vj9i43MIPd8H7MqUq_Bt... ).
Here is the math I did for reference (let me know if I made any mistakes):
I : Annual Income S: savings ratio
The amount saved each year of my working life is I x S The amount spent each year of my working life is I x (1-S)
For example, if our household after tax income I=50k and we save 10k for retirement, S=0.20, we get to spend 40k that year.
We would like to maintain our standards of living after retirement which means we would like the amount we spend I x (1-S) to be equal the amount of our retirement pension payments. That is, if we save 20%, (spend 40k, save 10k) we would like to get a 40k pension at retirement.
The value of our savings at retirement should be enough to give us this annuity. To calculate S, the proportion of our income we should save to achieve this goal, I take:
Future Value of my savings FV(I x S) = Present Value (at retirement) of the pension annuity PV(I x (1-S))
Taking the formulas from here: http://en.wikipedia.org/wiki/Time_value_of_money
I arrive at
S = 1/( x + 1 ) where x=1/((1-1/(1+i)^m)/((1+i)^n - 1))
(See https://picasaweb.google.com/lh/photo/rdEbvkw5wx78_dnqZuL4Qt... )
i is the real (above inflation) returns on my investments which, assuming I don’t take too much risk, should follow the trend of long term real interest rates. n is number of years we are savings m is number of years we plan to be retired.
Lets say, that I start saving for retirement at 30, retire at 60 and live to 90. That’s 30 years of savings and 30 years of being retired, a somewhat optimistic scenario (n = m = 30).
Here is the graph showing how much we should save relative to long term real returns on investments ( https://picasaweb.google.com/lh/photo/d4vj9i43MIPd8H7MqUq_Bt... ).