Is buying a home really less expensive than renting? With both rents and home prices going up faster than they have in years, this is becoming an extremely important question for many folks.
For years Real Estate agents have used a common analysis that accounts for the tax advantages of home ownership to show that indeed, owning a home is as cheap, or nearly as cheap, as renting the same home. I’ve built a similar analysis and used it a number of times myself.
Because I work with a lot of Silicon Valley engineers, however, I always like to look deeper. (Because my clients do, and I need to keep up with them.) Consequently, I have two different ways of addresssing the topic of this article.
First, the simple method
The classic way of looking at this question is to acknowledge that there are tax benefits to home ownership, and to account for them to compare the net, after-tax monthly cost of home ownership versus the monthly cost of rental.
Let’s use the following example:
We’ll assume we are currently renting home in a middle class neighborhood. The identical home next door is for sale and we’re wondering how much more it would cost us each month to own it than we currently pay in rent.
We currently pay a monthly rent of $1,050. Nowadays most renters have renter’s insurance to cover their personal belongings and liability, so we’ll assume that we have a renter’s insurance policy with an annual premium of $360, or $30 per month.
The identical home next door is listed with an asking price of $250,000. We have enough cash on hand to put 20% down, and we can qualify for a 30 year fixed mortgage at 5.000%. (I realize that today’s rates are much better than this, but this article could be on the internet forever, so I’m assuming an interest rate that I think will be relevant longer.) The monthly payment on this loan will be $1,073.64, slightly more than the rent we need to pay on the rental home. However, we’ll also need to pay for homeowner’s insurance and property taxes, which boost our monthly pre-tax housing cost well above the cost of renting.
When we apply our tax benefits, however, we find that the net after-tax cost of ownership is about the same as renting. The easiest way to see this is visually, so here’s what the analysis looks like:
You’ll note that the monthly payment (Principal and Interest, or P&I) has two parts: Principal, and Interest. The interest is deductible, the principal portion is not. Property taxes are also deductible, but homeowner’s insurance is not. (All of these guidelines are subject to change and may or may not apply to your circumstances. Consult your tax advisor.)
Your total pre-tax housing payment is $1,394.06 per month, over $300 more than renting. But assuming a 28% marginal tax rate (consult your tax advisor) you’ll see that Uncle Sam pays for $233 of your interest and $73 of your property tax. Your net after-tax housing payment is only $8 more in this example than renting.
There are other considerations, but in this example the monthly cost of ownership works out to about the same as renting. This type of analysis has been used for decades to illustrate the cost of ownership relative to renting.
Now, the more complex method
Any good Silicon Valley engineer considering buying a home would tell you, however, that there are several deficiencies in this analysis.
First, the amount of interest you pay declines over time: slowly at first, but eventually your tax benefits are reduced considerably. So, in time the benefits of owning are overstated.
Second, we’re not taking into account inflation. Even with the relatively benign inflation we’ve had over the last decade, over time most costs rise by about 3% per year. Which costs will rise? Property taxes for sure and insurance almost certainly. But here’s the kicker: rent will certainly rise, and your mortgage payment will not. In fact, eventually your mortgage payment will drop to zero when you pay off your loan. In the long view, the above analysis significantly understates the financial benefits of home ownership.
It’s complicated, but let’s see if we can clarify it. First, here’s the analysis taking into account inflation.
Using the same assumptions, we add in an assumed average annual inflation rate of 3%. (I have no magic crystal ball; it could be less, or more.) What you’ll notice in the results section is that because of the rising cost of rent after only five years the annual cost of renting will exceed the annual cost of owning a home, even though your property taxes and insurance costs are rising too. After 9 years you will have cumulatively spent less on owning your home than renting.
But look what happens after 40 years! How could this be? Because after 30 years you are still paying property taxes and insurance, but you are no longer paying a mortgage payment. This is most easily seen graphically.
If you continue to rent, your housing costs will rise throughout your lifetime. Even with a relatively benign inflation rate of 3%, you will be spending almost three times as much on your annual housing expense in 40 years than you do today.
If you buy a home your housing costs still rise because taxes and insurance costs rise, but since your mortgage payment stays the same the total net costs rise much more slowly. And look what happens in year 31 when your mortgage is paid off! When you need it most – in retirement, when your income becomes fixed – your annual housing costs are next to nothing.
Going back to the analysis above, you’ll see that over 40 years the cost of renting is estimated to be $964,456, while the cost of owning a home is estimated at $527,333.
So compare the two analyses.
The first analysis shows that buying a home will cost you about $8 per month more than renting.
The second analysis shows that buying a home will save you $437,123 over the next 40 years.
They are both “right” in that the numbers are correct. Which is more meaningful to you?
© Casey Fleming 2013
To download a free copy of the Simple Analysis used in this article click here.
For a free copy of the more complex analysis used in this article click here.
If you would like me to prepare a custom analysis for you, please call or email.
Casey Fleming, Mortgage Advisor NMLS 344375 / DRE 00889527