To rent or to buy: That is the question.
At some time in your life, somebody probably told you that renting is like pouring money down a rat-hole. “You have nothing to show for it at the end of the day!” Of course, that’s ridiculous. That rent gets you a roof over your head at the end of the day — and at the beginning of the day and the middle of the day, for that matter. But what they’re trying to say is that you don’t build up equity in a rental, so you’re arguably better off buying. Buying is a “good investment,” these people contend. We’ll get to the bad math required for this argument later. But, suffice it to say that buying a home is less like investing than it is like getting married. You do it because you want to — because it appeals to you on an emotional level. You should know that getting in — as every couple who has ever planned a wedding knows — is expensive. Getting out can be even more so. Like marriage, it’s tough to know at the outset whether it will be an economic boon or bust. That said, if you’re ready for the economic and emotional commitment involved in buying a home, it can be a great way to spend your money and time. If you’re not, you’ll find divorcing your house, like divorcing a spouse, can gut your financial life. So why am I so sure that a home isn’t a great investment? Let’s go through the math.
Sad truth: Rent is almost always cheaper
A few years ago I wrote a column for CBS News called “Dumb Moves that Sound Smart: Buying a House” to detail just how bad you have to be at math — or reality — to make the argument that buying is a better investment than renting. The full story is linked above and, if you’re considering buying a house, you really ought to read it. But, I’ll give you the summary version here: Renting is cheaper, even when the cost of rent is slightly higher than the cost of a mortgage.
Why? Let me count the ways.
- Money down. With a rental, you’ll pay a security deposit that will probably amount to one- to two-month’s rent. So, if your rent is $1,000, you can guess that will set you back $1,500 to $2,000. With a house, you’ll need a down payment that amounts to 20% of the home’s purchase price. So, if you buy a $200,000 home, you’ll need to sink $40,000 into the down payment — conservatively that’s $38,000 more than you had to put up for the rental. In theory, a renter would be able to invest that $38,000 and earn interest. Moreover, unless you trash your rental, you’re going to get all or most of your security deposit back after you move. (Security deposit returns are governed by state laws.) There are no guarantees about whether you’ll get back the amount you put down on your home. If the home appreciates enough, sure, you’ll get that back and maybe more. If it doesn’t, you lose because you’re probably going to need to pay a commission to a real estate agent when you sell and that can eat away at your home equity. Consider what happens to your down payment in a flat market. Assuming the real estate agent takes 5% to 6% of the home’s value as a commission, you’ll pay $10,000 to $12,000. If the home is worth only what you paid, the sales commission wipes out one-quarter or more of your down payment. You walk away with just $188,000 to $190,000. What if the house appreciates? Read the section “Aren’t Homeowners Better Off in the end?” below.
- Repairs. When you rent, your landlord pays for repairs. When you buy, repairs are on you.
- Taxes. When you rent, your landlord pays property taxes. When you buy, you shell out between 1% and 2% of the home’s assessed value each year to county tax authorities. On that $200,000 home, that’s $2,000 – $4,000 annually. Ouch.
- Upkeep & insurance. Your landlord also pays for upkeep. He hires the gardener, the pool man; the painters and roofers needed to keep the home and grounds in ship-shape. Again, when you buy, you either are the gardener, pool man, painter, etc. Or you hire them. And, where you might pay a small premium for renter’s insurance at your apartment, you can expect to pay considerably more to insure your house.
- Interest. Finally, unless you are able to buy your home with cash, you are going to have a mortgage. And very little of your monthly mortgage payment actually buys down the principal balance, particularly in the early years. The vast majority of your monthly mortgage payment is made up of interest charges. (Again, check out the CBS story if you want the gory details.)
But home is where the heart is….
By now, you’re probably thinking, “Okay, killjoy. I want the house anyway. It’s cool. I want to hang pictures and paint the walls whatever color I want; and plant in my yard and live there forever….Happily. Ever. After… Don’t mess with my dream!”
Okay, then. Here’s what you need to be in a position to buy.
- A great credit score. Credit scoring models differ a bit, but you should have a credit score of 720 or more to buy a house. Otherwise, you’ll pay a higher interest rate and, on a big-ticket-item like a home, that’s going to cost you a fortune. To be precise, a borrower with good credit could get a mortgage loan at a 3.5% rate in today’s market. On a $200,000 loan, that makes the monthly payment on a 30-year mortgage $898. If your credit is not so hot, you’d probably have to pay a 4.5% interest rate, which brings your monthly payment up to $1,013 — $115 more per month. For 30 years. That’s a difference of $41,400 over the life of the loan.
- A 20% down payment. You can get a home with a smaller down payment, but only if you do one of two things — get a second loan, likely at a much higher interest rate; or buy private mortgage insurance. Private mortgage insurance costs vary based on your credit score and how much you’re putting down on the home. But, it’s expensive. The lending website HSH.com has a pretty nifty calculator to figure the cost of private mortgage insurance, if you want to estimate the cost for your situation.
- An emergency fund. In the past, you might have needed an emergency fund just in case you lost your job or had a major car repair. With a house, many things can turn into costly emergencies. A leaky roof. A busted water-heater. Plumbing….so many things can go wrong with the plumbing. Suffice it to say that if you figured 3 months of living expenses gave you an adequate cushion for emergencies in the past, you’d probably want to double that amount once you become a homeowner.
- A good job, with income 3-times higher than the monthly mortgage. The rule of thumb is that you should never spend more than one-third of your income on mortgage payments, property taxes and homeowner’s insurance. And that’s the rule of thumb because most lenders won’t give you a loan that exceeds that amount. If you’re not sure how much of a home that allows you to buy, go to a bank and get “pre-qualified.” Talking to a banker can help you figure out your home-buying price range, which will make you much more popular with real estate agents.
- A settled life. If you think you’re likely to get transferred for work or would want to move for fun in a year or two, seriously consider renting instead of buying. The reason goes back to the real estate commission and the fickle nature of the real estate markets. Real estate prices move in spurts and stops (and, sometimes, retreats).If your home has not appreciated enough to make up for the 5% to 6% you’re likely to pay a real estate agent, you take an economic hit. Since it’s impossible to predict what will happen to prices over short periods, it’s smarter to delay home purchases until you’re ready to settle down.
Aren’t homeowners better off in the end?
Some past studies have shown that people who owned homes accumulated more wealth that people who rented. However, that’s probably not because they made a fortune on their home. A home isn’t a great investment. It’s a great forced savings plan. If renters were forced to sock an equally large portion of their disposable income into, say, the stock market, they would probably end up far wealthier than homeowners in the long run. But they’re not. So good number of them probably spent all or a portion of the money that they didn’t have to “invest” in their homes on things like boats and vacations and dinners out. You would probably do things like that too, if you weren’t stuck under the sink fixing the plumbing. (But, hey, you are getting good at it. It’s a new skill that you wouldn’t have if you weren’t a homeowner. There’s always a bright side.) Don’t believe me? Let’s run through the math. Let’s say you bought the $200,000 home mentioned above; financed it at 4%; remained there for 30 years; and then sold the home for $600,000. You made a 300% profit, right? Not so fast. After putting $40,000 down 30 years ago, you made 360 monthly payments of $763.86 each, or $274,991 total. Add that to the down payment and your total investment in the home is $314,991. Still, you say you almost doubled your money? Again, not quite. You also had to pay property tax, insurance and all of those home maintenance expenses that the renter didn’t have.
But let’s even set that aside and imagine, for example’s sake, that a similarly situated renter paid almost exactly the same monthly payments as you, at least averaged out over time. Chances are, his payments started lower but he had to deal with rent increases over the years. We’ll imagine that those rent increases added up to what you were paying in property taxes, insurance and repairs each year. (They probably were a lot less, but let’s give the homeowner every advantage here.) Anyway, so now the only difference is the down payment difference. If this renter took the $38,000 difference between his rental deposit and your down payment, and invested that in a broad basket of stocks and bonds in a tax-favored retirement plan. Over the 30 year period he could reasonably expect to earn 9% on that money. He ends up with $559,762 — a $521,762 profit compared to your profit of $285,009.
But what about the tax breaks?
In a higher interest rate environment, the tax breaks can be substantial. In today’s interest rate environment, the tax breaks really only help people with big mortgages. Again, it’s important to resort to a little math to illustrate. Let’s say you bought the $240,000 house with a $200,000 mortgage. Your monthly payments are $898. You get to deduct the interest portion of that payment, which you can find by using the handy “amortization schedule” at BankRate.com. On this loan, your annual interest payment adds to $7,511 in the first year. (The total will drop incrementally in subsequent years, so this is as good as your mortgage interest deduction is going to get.) You also get to deduct the amount you pay in property taxes, which we will estimate at 1.5% of your home’s value, or $3,600. Total home-related deductions: $11,111.
That’s good, right? Only if you’re single. The reason? The tax code already allows you to take a standard deduction. You only itemize deductions if your itemized deductions amount to more than the standard deduction. In 2016, the standard deduction for married couples is $12,600, according to the IRS. The standard deduction for a head-of-household – essentially a single person with a dependent – is $9,300; for singles without children, the standard deduction is $6,300.
So….If you’re married, your standard deduction is higher than your housing-related itemized deductions, so you get no tax benefit at all; if you’re a single parent, the itemized deductions exceed your standard deduction by $1,811. Assuming you pay 25% of your income in federal and state taxes, that saves you a whopping $453 annually. If you are single, assuming the 25% combined bracket, you save about $1,202 in tax.
So why buy?
So why would anyone buy a home? Because it’s not about who has the biggest pile of cash in the end. It’s about who is living the best life. Savvy money management is about using money as a tool to get the things you want. If you want to settle down, you want to plant in your own garden and paint your own walls — even fix your own plumbing — awesome. Do it. Don’t do it because you imagine your home is going to be a wonderful investment. Do it because it makes you happy. That’s what your money is for.