Rent vs. Own –Comparing ROI

Casey Fleming

We know from my post of October 2nd that we can calculate (using a few reasonable assumptions) when you will spend more on your annual housing cost if you purchase a home, compared to renting, and about what the difference will be over your lifetime.

Your net worth grows rapidly when you own your own home
Your net worth grows rapidly when you own your own home

But in our analysis of rent vs. own, how does home ownership affect your net worth? When you buy a home you invest your down payment in a highly illiquid investment – your home. If you do not buy your home and instead continue to rent you could invest that money, or blow it on a new sailboat. (My addiction of choice.)

Just like with lifetime housing costs, using a few reasonable assumptions we can calculate your relative net worth over time to compare rent versus own.

Let’s set this up with a few assumptions:

You are going to buy a home, and your brother (the one who never listened to your mother) decides to rent an identical home next door. You settle on a purchase price of $250,000. You are going to put 20% ($50,000) down, and get a $200,000 30-year fixed mortgage at 5.000%. Your brother rents the home next door for $1,050 per month.

We will further assume that inflation will run an average of 3% per year for the foreseeable future, and that your brother’s rent and the value of your home will increase by that much every year.

While you have to spend your savings on a down payment and closing costs, your brother has some options for his savings. He really wants that sailboat, but instead finds a very safe investment that will pay him 6% indefinitely. (Yes, that’s ridiculously high by today’s standards, but I’m stacking the deck in favor of renting.)

We have to make some reasonable assumptions
We have to make some reasonable assumptions

So, looking at the analysis to the left, you can see where we’ve plugged these assumptions into the analysis. We’re going to make one more assumption to make the two options as equivalent as possible. At first you will be spending $1,394.06 per month on housing, while your brother will be spending $1,050. Since he is spending less on housing, we’ll assume that he invests the savings every year for as long as his housing is less expensive, rather than using the difference to pay berth rent for his sailboat.

However, once he is spending more in his monthly housing costs than you, we’ll assume that he pulls money from his savings account to make up the difference.  His annual housing outlay will thus always be the same as your, so we can compare apples to apples.  The monthly housing cost break-even occurs in year six (as we discussed in my blog post of Oct. 2nd) so sometime in year six he’ll have to start using his savings to supplement his housing costs.

Your equity grows slowly at first, but eventually rockets
Your equity grows slowly at first, but eventually rockets

Even so, his savings continue to grow for many years, as he has enough money saved by year six ($81,149) that his interest earnings outstrip the amount he needs to withdraw to supplement his housing costs. Let’s use the beginning of year six as a milestone. Your brother has $81,149 in a liquid, safe bank account earning 6% interest. You have $106,161 in equity in your home which is appreciating at 3% annually. Your money isn’t liquid, but it is growing rapidly through the power of leverage. (See my post about leverage.)

You have more equity than your brother, but it is illiquid and there is a cost to liquidate the investment, so it ends up being about a wash. After five years your monthly housing obligation is about the same, and you have a little more net worth, but by the time you liquidate it you are about even.

After ten years your brother has $117,238 in the bank, so his interest income is still greater than the amount he has to use to supplement his monthly housing cost, but the growth of his savings is slowing down. You, on the other hand, now have $173,295 in equity in your home. It’s still not liquid, but you have a clear advantage.

At the end of 20 years your brother has $191,635 in the bank, and you have about $350,303 in equity. Clearly, you are way ahead at this point, and your brother’s monthly housing expense is quite a bit higher than yours.

At the end of 30 years your brother’s savings has quit growing, as he has to take so much out to subsidize his monthly housing expense that it eats up all his interest. He has $254,993 in the bank. You, on the other hand, have $606,816 in equity.

After 30 years your mortgage payment disappears, and your brother has to drain his savings at a very fast rate in order to subsidize his monthly housing cost to equal yours.

By the end of 40 years your brother’s savings are down to $103,244 and dwindling fast, while your equity is up to $982,227 and growing.

Most folks don’t calculate the ROI on the investment in their home, and they shouldn’t. They are buying a home in which to raise their children. But if you do want to understand the financial return on investment of buying a home, then it is very nice to know that after about five years you have earned enough extra on appreciation to pay for transaction costs, and after that you are significantly ahead of your brother; the one who never listened to your mother.

Lessons:

  1. Real estate is a long-term investment.  You can make money flipping houses, but most folks don’t.
  2. Understand the power of leverage.  If your home appreciates at 3% per year, you could be earning 10% or more.
  3. Understand all of your costs, going in, getting out, and along the way.  There are surprising costs that are often ignored.
  4. Buy a home because you want to live there.  The money you make on it is important, but not the reason you buy.

Casey Fleming, Author The Loan Guide: How to Get the Best Possible Mortgage (On Amazon)

Mortgage Advisor, C2 FINANCIAL CORPORATION
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