*Disclaimer* - before you blow a gasket and write me nasty comments or emails please read the full article especially the bottom section labeled "Before You Grab Your Pitchforks". Thanks!
I am generally a pretty chill person and I have learned over the years that it is best not to give advice to those who don't ask for it. But there has always been one thing that really bothers me. It usually goes like this; in a general conversation with a group of friends someone will say, “yeah so I decided to buy me a brand new $60,000 car with nothing down on a 6 year note”… Now this in itself doesn’t bother me. If someone wants to take a hundred dollar bill every morning and wipe their ass with it and flush it down the toilet I could care less. How people spend their money is their business, but this last part is what really gets me going… “I view it as a good investment because blah blah blah”. Okay, hold the damn phone. It is one thing if people just spend money carelessly knowing that what they are doing is stupid. That means it is a temporary thing and one day they can wake up with a financial hangover and drink some Gatorade and eat Lunchables. It is something entirely different if they begin to justify stupid behavior as good financial sense. This is much more dangerous because this can lead to severe long term consequences. Usually I can hold my tongue in those situations, but I feel there is one topic that is so widespread and accepted that it needs to be addressed.
“I VIEW MY HOME AS AN INVESTMENT”
This is generally what people say after they purchase a home that is probably a little (or a lot) bit outside of their price range. But is your home really a good investment? Well let’s look at this logically. Here are some characteristics of a home from an investment point of view:
- You earn no cash flow unless you are renting it out
- It is stuck in one place and solely dependent on that one state, city, neighborhood for its price appreciation
- You have to pay astronomical fees to both buy and sell it
- On top of that it can sometimes take you weeks or even months to sell it
- Long term home appreciation rates barely outpace inflation (sometimes less)
- Most people carry a mortgage which means you can pay double the home price over the life of the loan
- It usually represents a very large portion of the owners net worth which creates for horrible diversification
- It is in need of constant maintenance and upgrades over time to retain it’s value
- It is a cash hog when it comes to taxes, insurance, and upkeep
Does any of those things sound like a good investment to you? Sure, sometimes you can get in a hot market and see some great returns, but realize this is only temporary. Housing markets are not always hot and low or mediocre returns will balance the high returns out later. Remember the long term rate of return just barely outpaces inflation and is sometimes a bit below it.
“BUT RENTING IS JUST THROWING MONEY AWAY”
This one is quite prominent among my generation. It is the idea that if you are renting you’re an idiot and don’t know anything about money. That anyone with sense would buy a house to build equity. And in one sense it is true, owning a home is a very crude and shitty form of a forced savings plan. One of the major problems is that if you ever wanted to get this money out you would need to sell the thing! I don’t count home equity loans because it is just more debt and interest. But apart from that lets look at some numbers. Let’s compare two options and compare the lifetime costs; Option 1: purchase a home, Option 2: rent a similar home. I will use data from where I currently live in the Heights in Houston.
Option 1: 3 bedroom, 4 bath 2455 sq ft. very modern townhouse - $485k
Option 2: 3 bedroom, 3.5 bath 2152 sq ft very modern home- $2390/month rent
There are two things you want to look at in this calculation. First is your yearly cash flow and second is your opportunity costs over time. Here are the numbers:
- 15 year mortgage @2.98%APR with 20% down – $2676/month
- Property tax at 2.17% - $877/month
- Home Insurance - $379/month
- Maintenance - $200/month
- Total cash flow - $4132/month
- Rent – 2390/month
- Renter’s Insurance - $32/month
- Total cash flow - $2422/month
Difference: 4132 – 2422 = $1710/month savings from renting
So we can see that buying is not cheaper than renting on a monthly cash flow basis. “BUT WAIT YOU STUPID IDIOT”… which some of you are saying right now… “what about the built up equity in the home, HA got you now!” Well let’s take a look at that next.
It is true, in the buying case you are building equity in the house over that time where when you are renting you are not. But with renting you are saving on average $1710/ month in cash flow! Also you did not have to put down that $97,000 down payment. So what if you were to invest that difference in the stock market at the market average for the 15 year life of the mortgage as this is your opportunity costs in buying. The stock market over long periods of time has averaged around 10 to 12% return depending on the source you look at so I used 10%. Let’s look at the numbers:
- Home worth after 15 years at 4%/year appreciation - $873,458
- Cost of selling @6% of home value - $52,407
- Total Equity - $821,050
- Investing $1,710/month for 15 years @10% - $717,168
- Investing of $97,000 down payment for 15 years @10% - $405,193
- Total Investment Worth - $1,122,361
So yes, when you buy a home your mortgage payment is building equity. But the question is what else could that money be doing? I didn’t even include the interest you will pay on the home over time which is ~ $94,000. Since I didn’t include that in the opportunity cost I also didn’t include the tax write off for the interest. I also didn’t include the capital gains tax on the stock investment of 15% when you sell but you also have the same capital gains tax on your home equity when you sell so the result would still be the same. I also didn’t include any dividends you would receive on the stock with reinvestment.
So all in all, renting is not throwing money away. In many cases, it will actually net you a total gain in your net worth as opposed to buying.
BEFORE YOU GRAB YOUR PITCHFORKS
I know there will be many of you that will be reading this and are foaming at the mouth waiting to write me nasty comments about this post. But before you do let me clarify a few things. First, I am not saying that no one should ever buy a home or that it is ALWAYS cheaper to rent. You need to run the numbers for your personal case to determine this. You can find multiple links to different calculators at the end of this article. The idea behind the calculators is simple. They make some estimates on mortgage info, property taxes, insurance, and maintenance. With those costs split out on a monthly basis it then compares that to what your monthly rent is including insurance. It then takes the difference and assumes you can invest it. You can use this to determine what is best in your case/area. Next, even if it is financially cheaper to rent that might not be what you want to do. There are more reasons than just money to buy a home. Maybe you like the idea of putting down roots and raising children in one house. Maybe you want to move there for the school district. Maybe you feel you really got in a hot market and got a bargain (it can happen, but I caution you to put some serious numbers to it and weight out all the costs). Maybe you just really fall in love with a house and want to be able to have something you call yours and do projects and all of that jazz. All those things are great reasons to buy a home instead of renting. Personally I do plan on buying a home some day. My point with this article was to bring to light the fact that renting is not throwing your money away and that you cannot justify a massively large home purchase with the idea that it is an “investment”. It is a home for you and your family and that it is. If you want an investment you can buy rental real estate or invest in the stock market. But your actual home is not an investment.
TIPS FOR MAKING A SMARTER PURCHASE
Although it may not be possible to really make a ton of money in owning a home vs. renting, there are some simple ways to make this move a much, much smarter and cheaper one.
- Use the purchase rules:
- No debt whatsoever!
- 3 to 6 month emergency fund in place
- 20% down to avoid PMI
- 15 year fixed-rate mortgage to lower interest rate
- Mortgage payment (including other costs) no more than 25% of take home pay so you aren’t house poor
- Pay off as soon as possible for larger cash flow
- Be at a place in your life where you are ready to stay for at least 5 to 10 years
This does a couple things for you. First it locks in your home purchase price that will make the most sense in your budget. You don’t want to be house poor because your home is not the best investment you can make (as shown above). Instead you want to get all the emotional benefits of home ownership without handicapping yourself. With having no debt and your emergency fund in place you are set to handle the unexpected expenses that the house can cause.
All in all, buying a home is a very personal choice. There is lots of cultural pressure to buy a home (and a large one at that). It is sold to us that this is the only way to wealth and the American Dream and if you don’t think so then you are a moron. Realize this is all nonsense. You must run the numbers for your case and determine what is best. Understand all of the costs and consequences that go into this purchase as it is the single largest purchase you will likely make in your entire life. If you are young, single, and don’t have any kids then it is likely that buying a home is not the best idea financially and possibly emotionally. This ties you down to one location and life can be quite turbulent in your early years. It is not uncommon for people to have great job opportunities in other parts of the city or even in a completely different state or country. Renting is a perfectly suitable alternative and IS NOT throwing money away. Don’t let anyone tell otherwise. If you are reading this and still think I am a nut job then below I have posted resources from other nut jobs coming to the same conclusion.
OTHER NUT JOBS
Priced Out Forever - http://pricedoutforever.com/more-rent-vs-purch.html
CALCULATORS AND OTHER SOURCES
NYTimes Rent vs Own Calculator - http://www.nytimes.com/interactive/2014/upshot/buy-rent-calculator.html
Dave Ramsey Investing Calculator - https://www.daveramsey.com/blog/investing-calculator/#/entry_form
Realtor.com Rent Vs Own Calculator - http://www.realtor.com/mortgage/tools/rent-or-buy-calculator/
Realtor.com Mortgage Calculator - http://www.realtor.com/mortgage/tools/mortgage-calculator/#iid=finance:nav_menu:mortgage_calculator
Zillow Home and Rent Pricing – www.zillow.com
Neighborhood Scout Home Appreciation Rates - http://www.neighborhoodscout.com/tx/houston/rates/
It was pointed out to me that I did not include the tax write-off that you get on the mortgage interest and the property taxes. Although doing something for the sole purpose of getting a tax write-off doesn't make much sense, I have updated the numbers to reflect this. You will see that it does not make a difference in the overall outcome.
Mortgage interest payment: 3%388/12=$970/month
Mortgage principle payment: $2676 (from above)-$970 = $1709/month
Property Taxes: 2.17%485/12=$877/month
Tax writeoff benefit: -$5541 (From your calculation)/12=-461.75
Insurance (To stay consistent): $32/month
$1251.25 cash flow premium to live in the home.
If we were to invest the monthly difference of 1251.25/month at 10% for 15 years it would yield $524,770.21. Adding this to the invested return of the 97k ($405,193) we have $929,963 compared to the $821,050 of the home. Therefore the decision is still the same from a numbers standpoint. Both in cash flow and total net worth after 15 years renting still wins out.