Happy New Year!
I flew down to Florida for Christmas this year to spend time with family, and we ended up playing that game Taboo. It was boys vs girls. The word was “Nike.” The clue was “Prefontaine.” They guessed correctly. We lost. I was dumbfounded.
Right then and there I made a New Year’s resolution to work on my Taboo skills. OK, I’m lying. I made no such resolution. But, with the new year upon us, I thought I would revisit one of those myths in finance that just won’t die – the idea that you should always own your own home and that owning is always superior to renting. This year, hundreds, possibly thousands, of people are resolving to pay off their home. Many are thinking about buying a home for the first time. When it comes to business property (especially buildings and storefronts), many business owners understand the economic benefits of leasing and renting. Yet, when it comes to personal residences, they buy.
Since a house is one of the largest personal purchases you will probably make in your lifetime, you should know what you’re getting yourself into. Seriously. Don’t take your financial planner’s word for it. Don’t take your mortgage broker’s word for it. Don’t take your real estate agent’s word for it. Don’t even take my word for it.
For me, I don’t start to really benefit, economically, from buying a home unless I can find a nice place selling for under $350,000. Ideally, that home would cost about $300,000 or less.
One of the “undeniable” truths we are often told is that it is always better to own a home than to rent an apartment. I disagree with that so-called truth (and have been called all kinds of stupid for it, too). The logic behind this advice is that when you own a home, you are always (or often) building equity, when you rent, all you’re only ever left with are receipts. Blah, blah, blah.
So, here’s the reality of the situation: renting can be, and often is, a better choice. Yes, there are times when buying a home makes a lot sense, but it isn’t as often as you might think. Now, sometimes, it does make sense to buy a home based purely on a qualitative analysis of the situation, even when it doesn’t make sense quantitatively/economically. First, the economics.
The Economics of Buying a Home
When I lived in central New York, I was renting an apartment for $600 per month. It included gas (heat) and water/sewer. The electric was not included. Electric ran me about $80 per month. So, my total household expenses were roughly $680 between rent and basic utilities. Sure, there’s T.V., phone, and Internet, but let’s keep things simple for now.
People used to tell me all the time that I should be buying a home – that I was losing money by renting. But, I was always curious about this idea. I didn’t really know what the market was like. So, I started going to a lot of open houses, I checked the local listings in the newspaper, and I spent some time driving around new housing developments.
What I noticed was this: most of the homes in the area sold for about $100,000. Some of nicer ones went for $150,000 or $200,00, but this was somewhat unusual.
If I purchased a home in the $100,000 range, my mortgage payment would have been about the same as my rent at the time (assuming a 6 percent interest rate on the home loan). However, I would have had to pay for homeowner’s insurance ($35 per month), and I would have been responsible for paying for my own natural gas/heat. What about renter’s insurance? Shouldn’t I be including the cost of renter’s insurance in my analysis when I say I’d have to buy homeowner’s insurance? Well, I was in my 20s – young, dumb, and without anything worth insuring, so no. This wasn’t a cost I was considering at the time. When you take out a massive loan for a house, though, they pretty much make you buy homeowner’s – at least basic fire coverage, so that would have been an increase in outlay for me.
The natural gas would have cost me an additional $100 per month (based on an average of about 20-30 homes I walked through during “open house season”), and taxes on the property would have likely been $225 a month or more (taxes are really high in the Corning/Elmira area). Some of the nicer homes in the new housing developments came with a property tax bill in excess of $10,000.
So, right out of the gate, I figured it would cost me an additional $360 every month to own a home – just in the added cost of the utilities, taxes, and homeowner’s insurance. That doesn’t even include mortgage interest. But, I know what you’re thinking: what about the equity that my house would have been building?
For a moment, let’s assume that I took the standard deduction on my taxes instead of itemizing. If my home appreciated an average of 3-4 percent a year, that gain would have been offset by the additional $360 I would have had to pay over renting. The additional mortgage interest would put me in the red. So, I’d need an appreciation of more than 4 percent annually to make it worthwhile. In Corning/Elmira area, homes don’t really appreciate in value all that quickly. If I continued to rent, I could save and invest that $360 every month and wouldn’t have to worry about the interest on a new mortgage loan – so, I continued to rent.
If you’re still doubting the benefits of renting, consider this: most people don’t take out just one mortgage on a house. Electrical wires fray, furnaces break, plumbing leaks, roofs sag. That’s just a fact of life. The interest on the original mortgage alone (assuming a $100,000 home at 6 percent interest) amounts to $116,000 over the life of the loan, or $3,866 per year (average over 30 years). Now, add in any additional interest from a second or even a third mortgage that you take out to do remodeling or repairs. When I add the $360 per month extra over renting ($4,320/yr) to the $3,800 in interest per year, I end up with a total of roughly $8,120 a year that I have to overcome for the house to be more profitable than renting. Even if I let my hypothetical house deteriorate over time, and do no repairs on it, my home would have had to consistently appreciate faster than 8 percent a year, every year. That’s just not realistic.
Now that I’m living in Raleigh, has the story changed any? Sort of. I used Michael Bluejay’s awesome rent vs buy calculator to help me get a rough idea as to when it makes sense to buy a home. Right now, I live in a comfortable townhouse, nestled in the middle of a wooded area. We have a nice pool and dog named Shep. OK, the dog’s name is actually Maximus, not Shep. And, he’s not a herding dog. He’s a rather lazy Rotty/Mastiff, but he’s at least as loyal as Shep.
Anyway, I lease the home I live in now, but the landlord has made at least one offer to sell it to me. I won’t buy it though because it doesn’t have a room that I can convert to a home gym and we need another room in the house that can be converted to an office. So, realistically, what I need is a 3-bedroom home with a finished basement. Alternatively, I need a 2 bedroom home with a den that can be used as an office for me. If I want to have kids (which I do), then I’ll need a 4-bedroom home.
Something like that (the 4-bedroom) is going to run me anywhere between $65,000 for something slightly below average to $3 million for something really very amazing. Really, I can find something OK for about $200,000 to $350,000 in OK neighborhoods. If I were to buy, the mortgage payment would be around $1,500/month with a 5 percent interest rate. If I were to pay rent on a 4-bedroom home, it’ll run me around $1,200 on average.
Yes, there are the $3,000 rents – but those are high-rent districts. According to Bluejay’s calculator, I really need a home under $350,000 to benefit, economically. At $350,000 or more, it takes more than 30 years for buying a home to be more profitable than renting. Even at $325,000, it takes a good 19 years for the home purchase to pay off – and that’s assuming I earn no more than 5.5 percent on my investments (remember, I will save the money I’m not spending on mortgage interest, taxes, etc.).
I am pretty confident in my ability to earn 5.75 to 6 percent annually over the long-term. This means that I really need a cheaper house – somewhere in the $300,000 range – for buying to become profitable.
You want to know what’s weird? Even if buying a home eventually does start to pay off, there’s no guarantee that it will always pay off in the long-run. If I I adjust the calculator to show what would happen if I earned 8 percent annually on my investments over the long-term, instead of 5 to 6 percent, I end up with a scenario where buying a home is a better deal than renting after 12 years – but that deal eventually turns sour on me. In year 19, renting becomes more profitable again. Ouch.
Now, while I know my situation is unique to me, I’d wager a guess that there are many scenarios under which renting would work out to be a better deal for you too. Now, onto the qualitative side of things.
The Qualitative Aspect of Buying a Home
Qualitative factors include things like your own personal needs, optional objective values, and rational wants. So, for example, I work out. Currently, I pay a membership to a gym. Really, it’s not that much money, and it would actually cost me a lot more to set up a proper gym in my own home. But, I want the ability and freedom to lift weights on my own schedule. I don’t really like the idea of waiting around for some guy who’s hogging the squat rack so he can do bicep curls (which is a universal annoyance in a public gym). It wastes my time, and that is presumably a real cost though not something I bother to sit down and calculate.
I also would like to have a larger yard for a future child to play in. How do you quantify joy? I don’t know. Finally, I want my own garage so I can do “guy stuff” like change the oil in my car and sit around and use foul language with other guys while we eat chicken wings and drink beer. Having a garage with a rental is difficult to impossible. So, all of those things are big benefits of buying a home.
Should You Buy?
Quantitatively, it’s probably a bad idea if you’re moving into a larger home and you don’t really need the space. Qualitatively, it might make sense. What you really have to do is come up with a ballpark figure, a price range, where it makes sense to buy a house (economically) and then figure out whether that price range comes with all of the qualitative stuff you want from a house. If it doesn’t, then you have to rethink how much weight you want to give to the qualitative stuff. Sometimes, it makes sense to buy a home that’s unprofitable just so you can have what you want – the home is clearly not an investment in this scenario. It’s a consumer good. Other times, it’s just not worth it to buy. Sometimes, it does make sense economically but it’s a bad idea because all of the homes in your price range are utter garbage._________________________
January 1st, 2014 | by David | No Comments