A decision to rent or buy a home must take into account a lot of often confusing variables – interest rates, income tax rates, rental rates, credit scores, and real estate market dynamics. Understandably people need help, and perhaps because I like this stuff, I am sometimes asked for advice on these matters.
In hearing casual conversations about purchasing a personal home, I find that most people ask the wrong question – How do I buy a house? That answer is a basic function of adding the principal, interest, taxes, insurance, and maintenance payment requirements. Is there enough income, cash and credit to cover the expense? Then you
can buy a home.
The more important (and interesting) question is –
Should I buy a house? Most people assume the answer is “If you can, you should.” To justify such a recommendation, I frequently hear statements that sound something like this:
- “You should buy a house, because at least you will be keeping some of your money”
- “I just hate throwing away money on rent each month”
In a market that has low home prices and relatively high rents, some of these sentiments may be true. But where I live and in many other markets, high home prices and relatively low rental rates makes buying vs. renting a much more complex decision.
Here’s why:
1) Let’s say $400,000 will buy a 2 bed/2 bath condo.
2) To rent this condo will cost ~$1,500 in a good area.
3) Assume 5% ($20,000) down, 6% on 1st mortgage, 7% 2nd mortgage, 30% Income Tax rate and 1.1% property tax, $250 HOA
4) Pretax, the condo will cost $2934.41/month. After the 30% tax deduction, the cost will be $2239.41.
5) The $2239.41 is the number to compare with rent, since rent is not deductible in most cases.
6) Of the $2239.41, $367.74 is principal that builds the owner’s equity.
7) $2239.41 - $367.74 = $1871.67 which is the amount the condo owner is “throwing away” each month. The renter "throws away" $1,500.
8) On a monthly basis, the condo owner is “throwing away” $371.67 more each month than the renter. This is ~$4,500/year.
From an investment standpoint, the main benefit the owner has over the renter is the appreciation of the condo’s value. If the prospective buyer is confident the house will rise in value by at least 2-3% annually (which is not guaranteed by any means), buying is the right way to go. Otherwise, renting is a great choice, not just a concession or settlement.
Misunderstanding this concept causes the following confusion:
- People who own homes believe they are saving something they are not
- People who don’t own homes think they are losing something they are not
Bottom line? The monthly "throw away" is often higher for home owners than renters. Renting, especially in the short term, is often more cost effective than buying.