Honey!! The toilet is running again. The sink also leaks, and the fence needs to be re-stained before winter. Sometimes the Honey-DO list seems infinite and exhausting when you own a home, especially when vermin are in the walls or appliances are breaking. When you rent, you may have some of these issues in your life, but when something goes wrong, you call the property manager or the landlord and they get to fix them. That’s easy and doesn’t cost anything additional out of pocket or take up more of your time.
Several years ago, my friend Cory and I were both considering the same decision on whether to buy a home instead of continuing to rent. We both had our own reasons, but many of those reasons were based on what our parents told us about owning a home and that was when I first developed a worksheet to try to analyze the financial choice. The math is the math, but what we both learned from the discussion was that we had different priorities. My friend was worried more about flexibility and ability to move and I was concerned more with having money to make business investments. We had another friend who was 100% convinced that buying a home as soon as possible was the best financial decision. So, who was right? As it turns out, all of us. Cory left town to go to school, I invested my money in businesses that have done well and our other friend has seen significant gains because of appreciation in the home he purchased. We all made different choices, but understanding our choices was as important to us as trying to make the right choice.
Home ownership in the U.S. is down. This is not surprising given the run up of home prices in major markets, young Americans carrying large student loan debt burdens and the difficulty many people have struggling to save for a down payment and improve their credit so they are eligible for loans. American’s are awash in debt. Auto loan debt is at an all-time high, student loan debt is at an all-time high, credit card debt is at an all time high and mortgage debt is at an all-time high. Not exactly the best environment for more borrowing. But is this really such a bad thing?
In addition to the timing not looking great for purchasing considering the debt correction that is likely to occur, how does the math work out on buying a home versus renting? The answer, as with most financial decisions, is it depends. While most financial professionals say that the majority of family wealth is attached to their home, that doesn’t make it a great choice all the time and that doesn’t necessarily apply to you. Often a home has become like a savings account that is harder to withdraw money from and if it has appreciated over time it becomes a family’s greatest source of wealth. The other reason a home is usually a big source of family wealth is that it is one of the few places that an individual can easily use leverage. While these are several of the good reason to buy a home, they don’t necessarily apply to you and they don’t necessarily apply right now.
One of the not-so-good reasons to buy a home is for emotional reasons. Sometimes, we discuss owning a home as part of our identity, and the moment we close on a home and move in, we like to say, “Look at my home!!”. But that isn’t your home. It doesn’t belong to you until you have made all the payments. As we have discussed in a prior articles, it doesn’t matter what you see, it matters what is paid for and rarely is the home paid for, so it isn’t yours. If we are completely honest we have to say that the home belongs to the bank and we have a right to live there as long as we keep making the payments. That’s the financial reality but doesn’t fit into our emotional identity purchase so we rarely discuss home ownership in that context. Instead, it comes out as “I’m a home owner” even though the truth is you are the owner of a home mortgage.
Whenever someone discusses wanting to buy a home my first question is Why? As in, why do you want to own? Is it because owning is cheaper than renting? Do you want the honey-do list and to handle long term maintenance? Is it because you don’t want to miss out on current market appreciation? Are you looking to make an alternative investment because you are already funding your retirement account? Is this a lifestyle choice, buying somewhere you want to live or in a specific neighborhood where you want to raise your children because of school districts? Are you in pursuit of the American dream? Or sure that you want to live in a place and looking to lock in your monthly payment for decades to come? Are you looking to reduce your rent by being the landlord and renting out rooms to make rent cheap for you?
All of these questions can make the answer to the should I buy or rent question a different answer for each of our situations.
Perhaps the first question before you dig too far into the buying a home question is: can I get financed? Do you have enough money saved for a down payment and the income and credit score to get approved? If not, keep reading to learn about buying a home but you’re not quite ready. If you do have the ability to purchase, then the why’s become more important.
There are a lot of good reasons to rent too, especially if the rent is cheaper than the mortgage (fully loaded – we will get to that). Renting gives you flexibility to move to another side of town or another state or city if you get a better job opportunity. Renting means you will likely not have to deal with any home ownership duties such as taking care of a lawn or meeting the plumber or buying new appliances. If renting is cheaper it could mean investing your down payment money into something else, maybe starting a business or buying into a business. Many of these other opportunities look even more advantageous if you can find cheap rent.
Let’s start with just a financial look at rent versus buy. This starts with the monthly math of current cost to rent versus paying the mortgage (and mortgage insurance if you don’t put 20% down), property taxes, insurance. If you have a roommate and would plan on renting out a room in your home then you can include that income as part of the equation. There may be some tax savings, but this is likely much less of a benefit after the last changes to the tax code. We also have to make some assumptions about how much appreciation the home will have as well as how much you will need to spend on repairs and maintenance (and whatever you think repairs and maintenance will cost – I promise it will be more). If we do the math and include our assumptions, then we can look at the rent or buy decision strictly from financial decision.
After the math we have to factor in the other reasons. If we rent, we maintain on flexibility, especially after a year when typical leases go month to month. There is also the freedom of time. If you are trying to get a business off the ground and have to go deal with household issues that may not be a good situation for you. If you need money for business opportunities, a home may not be the best long-term return on your money. But a home could also be the best performing asset that you purchase. We don’t know the future, so we do the math, evaluate all the things that are important to us, and then make an informed decision.
Using the average home price in America of $226,000 and average rent of $1,200 per month we can start a discussion about rent or buy from a strictly financial perspective and then we can mix in some of the other factors in our decision making. We have a lot of information to collect to perform a proper analysis, and your situation is yours. Here is a list of the information you will need:
o Price of home
o Interest rate & term of loan
o Down Payment (if less than 20%, what will the PMI cost be?)
o Property Taxes (don’t use prior year unless the assessment is the same as purchase price)
o Insurance Cost
o Annual repairs and maintenance expense
o State and Federal Tax Rates (that you currently pay)
To perform this analysis on an apples to apples method, we will look at just the home loan as though it is an interest only loan. This allows us just to analyze the cash cost each month of owning versus renting. When we pay down a loan over time, as is normal with mortgages, the interest expenses reduces each month but that money is also not earning any addition return. So first we can analyze on interest only loan and then we can do the same analysis on a standard loan. If this seems confusing, don’t worry about it, as we go through the worksheets it will make more sense.
The analysis can get really tricky with some of the other assumptions that we have to make regarding home appreciation and market returns. Market returns is a bit easier as there is a lot of data about the average return of the S&P 500 that can be used. Your local real estate market, and estimating home price increases can dramatically affect the outcome of this analysis. As with all assumptions, if they change, the result can be drastically different.
When I help people with starting their business there is always a moment of laughter when we plug in sales growth and BAM; everyone just became a billionaire in the Excel worksheet. Since we don’t know what is going to happen in the future, our best estimates are usually based on the past, but it will not be the same, so know that these are ASSUMPTIONS, and that reality will be different. That could work out for you on the good or bad side, but this is an exercise in options for you and not intended to be the tool that you use to decide. Again, other factors are just as important as a return on your money, especially if we are talking about school districts or lifestyle choices that make you want to keep working every day.
Enough with the caveats and onto the math. Using the average home price of $226,000 and average rent of $1,200 per month, we can begin to look at the rent vs buy option. I’ve put in some assumptions of property taxes and insurance as well as a 4% interest rate, an appreciation rate of 3% and a rate of return on investments of 7%. In the first scenario we will assume a 20% down payment and no PMI. PMI is mortgage insurance that you have to buy if you put down less than 20%. If all of these assumptions hold true, on an interest only loan, the total cost to buy versus rent is almost the same.
Why? We just sold the house, 30 years later, for a profit of over $300,000. The answer is what if you had taken the down payment money and invested that in the S&P 500 that returned 7% annualized returns for that same 30 years? It is just a different use of the money. Now we can change a few things and the math can be dramatically different.
What if I get a 2 bedroom apartment and have a roommate, reducing my rent. Well, you could also get a roommate in the home you purchased and the math works out about the same because you reduced your expenses anyway. So roommates on either side of the equation will have a big impact. We all know that if we get a roommate our rent will go down. So what are the other major factors that are hard to consider on a 30 year window? Will rent go up? Assuming that the value of the property you purchase goes up an average of 3% over the next 30 years, it is likely that rent will also increase at about the same rate. That could make owning a home a great investment because in 30 years your mortgage (assuming interest rates don’t rise) will be less than the cost to rent.
When we move to the next worksheet, buying a home and paying off the loan over the next 30 years, assuming we could lock in a long term rent at the same price, then the math switches a little. This is because current market returns are higher than the interest rate, so as a home owner your money goes to pay down your loan while the renter’s money goes into investments that are growing faster. This is actually the normal way of buying a home, and again, the assumption that rent will not rise is a big one, but if you can keep your rent cost the same, then financially you will be better off after 30 years investing your money versus buying a home.
But that is just the math. We need to look at life more practically because what are the odds that you will be diligent and save all of the difference that you would have paid to own versus rent? In America, the statistics say it is very small that you will save all that money, so the home because your required savings account, and that is the reason it is often the best investment for most people, because it is the driver that changes behavior to save because you have to pay the rent to keep the house. But this can also go sideways if you take out a Home Equity Line of Credit and spend all of the savings.
The things that often make the biggest difference are the hardest to calculate. What will the home appreciation be? Future interest rates? Future rent costs? Return on investments? We just don’t know.
Unless the math indicates something dramatically different, for example, the cost of home ownership is significantly better than the cost to rent, then the biggest reason to buy a home is as personal lifestyle choice. Especially if you want to raise a family and would like some grass in the backyard and rent that doesn’t rise (but your repairs costs, property taxes and insurance may), home ownership can be a logical choice. Even more so if you want your children to be in a specific school district. Beyond lifestyle choice, the next best reason is leverage. Understanding leverage, and your ability to leverage your money when buying a home is critical to understanding why buying a home may be a good choice for your long-term wealth.
However, depending on your situation and if you have the discipline to invest the money you would otherwise save on buying, renting could be a better choice financially. If you want the flexibility to move easily or don’t plan to stay in an area, then it’s an easy decision as selling a home will typically cost almost 6% in realtor fees and could take many months. There is no one answer that fits for everyone and none of us can predict the future, so none of us know for sure what is best to do. But if we go through the analysis at least we have an understanding of our options and we can have a more clear picture of why we are making the specific choice we choose.
Now the follow up and the potential issues with our choices. There can be a lot more expenses to buying a home than just the price, interest, taxes and insurance. We discussed repairs, but what about when you decide to renovate? Is that in the analysis? Typically when we own we spend more on furnishing and renovate more frequently because it is our space. We think we will get the money out of the property, but because similar tastes are rare, we usually don’t.
The biggest potential pitfall is the same as most financial transactions, buying more than you can afford. Real estate agents should be shot for this, but they do it all the time. You tell them your budget is for a $300,000 home and they start off by showing you home that cost $325,000 to $350,000. Of course you like the bigger, nicer home. Just like we prefer to drive the nicer car and buy the nicer clothes, but if you cannot afford it, then you are putting your down payment at risk as well as your mental health. If you really want the bigger, nicer home, then you need to wait until you have a bigger, nicer down payment and a bigger, nicer paycheck. Overextending yourself financially is the most likely reason people will lose their home and often their entire investment.
Bottom line, is it’s a personal choice with many factors, and only you know what’s really the right decision for you.. I suggest you look at the worksheet here and also listen to the podcast on this here to help you with this major life decision. I’m also open to answering your questions via email! Hit me up at dave@keepyours.org.