I wanted to share a picture that changed my mind about how money works. I was turned off of being in long-term debt from when I was in my teens. Maybe it was in math class where we had a very quick unit on interest. Well, I remember seeing an image in a textbook very much like this one (and it shocked the heck out of me):
Compound Interest. I can’t begin to tell you how nuts this is. Basically, this picture shows that if you borrow $200,000 from a bank, say, to start a business or to buy a house, agreeing on a 30-year mortgage and it charges you 6.5% per year (not written on the graph), you end up paying all that PURPLE section in interest! You can’t accurately tell by just looking at this ying-yangish graph, but at 6.5%, this causes your interest payments to be MORE than the loan itself. Overall, you will pay about $450,000 over 30 years, with only 200,000 of that going toward the house / business and 250,000 of that in interest (=the fee to borrow the money)! That’s a ker-azy fee. (Think of what the picture looks like for interest rates of 12% or 18%—those are regular credit card fees!)
In 2012, in Canada, the interest rates are LOWER–at around 3% for people with good credit. So, interest is not as much, but it does end up being about $100,000 over 30 years (if the loan was $200k). This is not even thinking about property tax or any insurance that you also would pay in addition to this, if you’re thinking of buying a house. There are many mortgage calculators online that can help you figure out your situation with info graphics: http://www.mortgagecalculator.org/
Or why not get up to speed on all the basic math required for personal finance: Wise Bread has a great entry for this.
Implications?
We have all heard the long-held “wisdom” that buying is smarter than renting. But, using this case, if you realize that you would have to sell your house or business in 30 years for at least $450,000 (= all the money you put into it), including inflation rates over the years etc. to just break even (meaning zero gain)…you should compare that to the money that you would otherwise have (by NOT paying interest, property tax etc. because you are renting at a cheaper rate) and see that had the savings been invested, if it would be worth MORE than $250,000 over 30 years by the interest it earns for you. (Ack, that was ONE sentence!)
Money Big and Small 
Dennis Riches
April 16, 2012
I think this viewpoint overlooks some of the advantages of going into debt to own a home. Yes, the total amount of interest paid over the term of a mortgage can seem like a huge loss, but the only reason people ever borrow money is because it is worth more to them in the present than it will be in the future. The calculation above didn’t mention the money the non-owner has to pay in rent over the 30 years when he could have been making mortgage payments. And home ownership becomes more worthwhile if you consider that many people continue to live in a house for two or three decades after it is paid off, so this counts for a lot more money saved in rent. The rewards are even greater if the borrower is further motivated to leave the property to his or her descendants.
Home ownership also has social benefits. It encourages pride of ownership and makes people settle into neighborhoods for the long haul. When everyone in a neighborhood is an owner rather than a renter, they are more likely to cooperate with each other, watch out for each other’s children and get involved in local politics etc… And if things get really bad, land is always good because you can raise crops, chickens or pigs in the yard. I don’t know if this applies to condo owners, though. Has anyone ever fattened a pig in a condo?
Furthermore, if everyone followed the advice to not go into debt and instead save and earn interest, returns on investments would decline toward zero as demand for loans dried up. If you want to earn returns on your cash, you also want others to borrow your savings and pay interest to you.
But this positive view of property debt applies only in normal circumstances. At the present time in Canada, when we are at the peak of a long, speculative bubble that is going to be followed by higher interest rates and a demographic crash, it makes no sense for young people to take on mortgage debt.
Green Rabbit
April 21, 2012
Hi Dennis, your endorsement of taking on debt and interest payments starts off on a high and gradually amortizes to zero over the course of your comment 🙂 You must be a long-term homeowner on a 30-year mortgage…
Dennis Riches
April 22, 2012
Green Rabbit, you guessed right, partly. I’m only four years into the mortgage, but it is a long-term fixed rate – which is enviably cheap here in Japan, compared to the rates that Canadians pay. My optimistic view was with regard to owning a house and land, and going in with the attitude that it will be a home for many years rather than a speculative investment to flip after a few years. But the gods laugh at our plans. There are always the big events that no one can predict or control. Owning a home seemed more sensible before the radioactive fallout was spread all over Northern Japan.
My pessimism about debt comes into play when I think about the speculative bubble that is building in Canada, especially in the condo market. After everything that has happened in Japan, Europe and the US, how can Canadians believe they are immune?
Green Rabbit
April 22, 2012
I think a long-term family homestead is a rarity because people will flip homes like they upgrade iPhones and cars so as to increase the cache of their clan or themselves for mating purposes. Or make more room for all the crap they accumulate. Who knows, maybe job instability or globalized work makes it hard for families to stay put anymore. But, what I really think is that real estate has become the speculative bubble it has because people, again, take comfort in their religion of stuff. Real estate, compared to abstract money products, is the one thing that many naive investors can actually see, walk inside and appraise. And condos are hot because they aren’t complex like the older-era houses in the city with mind-numbing inspections to figure out. Condos are new and kinda uniform in standard–a universal template all the New Money can understand. So flipping a home in a few years has become the thing to do for young busy professionals and real estate agents are like financial product hawkers. And as always, in the twisted evolution of such a market, you of course don’t even need to ever SEE the “property” that you bought anymore. Like all the ghost condo units in Dubai, like all the Chinese mainland billionaires who own units on the Toronto Harbourfront.
Hopefully, although it’s a more complex type of “stuff”, people will eventually become wise to why certain property, no matter how well marketed, is a money sinkhole. In a fever, while the heat is killing the virus, it is also baking our brains–so, there will be casualities in our climb up the learning curve.