First time home buyers inevitably compare the monthly cost of owning a home against the cost of renting. This is natural, but the greatest mistake that most make in doing so, is thinking in terms of the monthly cost only, and not the lifetime costs. Well-meaning real estate agents usually encourage this thinking, and that’s a shame. Let me explain.
The Quandry – Rent vs. Own
Let’s say you are a prospective first-time home buyer. You have $50,000 to put down on a $250,000 home. You are currently renting a similar home for $1,050 per month, so your choice is to invest your $50,000 into a good money market or mutual fund, or to buy a home. Which is a better financial move?
Most folks start by pointing out the tax benefits of buying a home. There are some great benefits to be sure, but that analysis can be very misleading. First, you have to understand your marginal tax rate – the rate you pay on the last dollar that you earned – which is not the same as your average tax rate. Second, most folks that do not own a home don’t itemize their deductions. This means that they already get a standard deduction. The deduction you will realize from your new home will (in most cases) be less than you think, because you’re already getting some of it anyway (in the form of the standard deduction.)
Your tax advisor should be able to help you through an analysis on your particular situation, but in most cases the result is that you’ll get some benefit, but not all of it. This makes a dollar comparison difficult at best, and that’s good, because you shouldn’t be looking at the monthly cost anyway.
When you ignore the tax benefits (as they are typically presented) it will (almost) always be more expensive to own than to rent, your down payment is locked up in an illiquid investment, and there are heavy transactions costs going in, and huge transaction costs going out. Why would anyone buy a home?
Because your mother said so, that’s why. But for those of you who never listened to your mother, there is another reason. In the long-term view, owning a home is cheaper than renting and will build wealth more effectively than renting as well.
Long-Term Benefits of Home Ownership
I will deal with the wealth-building consideration in another post. For now, let’s look at a comparison of your long-term costs of renting a home versus owning a home with three questions in mind:
- At what point do I break even on my monthly cost?
- At what point do I break even on my cumulative cost?
- After the break-even what are my savings each year?
Here are the principles you must keep in mind and some assumptions we make in our analysis:
- Your rent will most likely continue to rise. We’ll assume that your rent will increase about 3% per year.
- Your mortgage payment, however, will not rise, as we’re assuming a 30-year fixed rate mortgage
- Your property taxes will rise. In California they will go up 2% per year.
- Your homeowner’s insurance will rise. We’ll assume 3% per year.
In this analysis you’ll see that in the 5th year the total cost of owning your home is about the same as the total cost of renting would be. So, in this example you’ll pay more for your housing each month to own your home than you would to rent it initially, but after five years owning becomes less expensive than renting.
After 9 years, as a homeowner you’ll have saved enough on your monthly housing cost in years six through nine that you will have spent about the same amount cumulatively as if you had been renting.
By the end of 30 years you will have spent $495,318 owning your home, and $610,250 renting!
You can really see what a difference this makes when we look at it graphically. And here’s where it gets interesting. After 30 years a renter is spending more than $30,000 a year on housing cost, but the homeowner is spending less than $10,000 per year.
And remember, this assumes that your rent rises by only 3% per year. The difference could be greater than that.
Your rent / buy decision is one of the most important decisions in your life – right up there with which school to go to, whom to marry, and your hairstyle in your senior portrait. (Some pain never dies.) Don’t make this decision (rent vs. own, not the hairstyle) based on the difference it will make in your housing cost next month; make this decision based on the difference it will make in your life.