We all know that the three essentials for living are food, clothing, and shelter. We definitely rent our food. Do we rent or own our clothing? Hmmm.
Part of the American dream is to own your own home. And there are good reasons to do so. For instance, a Federal Reserve study[pdf] shows that the average family that owns a home has a net worth of nearly $625,000 while families who rent have a net worth of just a little over $54,000.
Homeowners on the move
We’ve seen an interesting statistic bantered about, but we haven’t been able to pin down a reliable source. If this statistic is true, American homeowners move once every five years or so, on average.
So we thought we’d consider what that does to the buy vs. rent equation. We’ll use some averages and national statistics to create an example. However, what really matters is your own situation and your local real estate market. Only you, working with your financial advisors, can determine what’s in your best interest.
When I was younger, one of my bosses in radio told me that I was just throwing away money by renting. I remember thinking that it made sense. I’d reached an age where maybe I should consider buying. So I did. As often happens in the radio business, less than a year later, I lost my gig. So I had to sell my house to move to a different market. I lost a lot of money by buying. If only I had had a crystal ball!
Putting buy vs. rent to the test
We created a fictional purchase to see if we would be better off renting or owning a house for five years. We assumed that:
- We bought an average-priced house for $314,000.
- We put 20% down (approximately $63,000).
- We financed the rest with a 30-year mortgage
- The interest rate would be 6.50%, slightly above the current rate.
- Our house would appreciate 4% per year, slightly below the recent average.
- Property taxes would cost us 1% of the value of the home.
- Insurance would run 0.50% of the value of the home. (Renters and homeowners have to insure the contents. We have the added burden of insuring the building.)
- Repairs & maintenance would consume 1.50% of the value of the home.
Over the first five years, 83% of our total mortgage payments would go for interest. In other words, for the most part, we’ve traded renting property for renting money. If the interest rate is higher, the portion that would go to interest would also be higher. Of course, the reverse is also true.
During this period, we would pay $2,171 per month as “rental costs” for our home. We call them rental costs because they have no value once they’re paid. They only allow us to keep owning. So if we could rent a similar property for less than this, we would be better off renting instead of buying.
Of course, if we had made a down payment of less than $63,000, our cost would go up because we would be paying even more interest.
Where’s the break-even?
We also looked at how it would take before we would break-even. After all, it costs money to sell a house. We would have to pay commissions to our realtor, closing costs, and the like. We assumed these costs would total 8% of the selling price.
Given our assumptions, we looked at what would happen if we sold after one year. Our house would now be worth $326,560. From that, we would pay $26,125 in selling costs. After a year, our mortgage balance would be $248,392.
So we would be able to take out $52,043 in cash. But remember, we invested $63,000. So we lose about $11,000 if we sell after one year.
But that’s not the whole story …
We haven’t yet considered the opportunity cost of tying up that $63,000 in a house. Because if we didn’t invest it in this house, we could have invested in something else. We assumed we could have earned 6% by investing in some portfolio of financial assets.
That would have returned nearly $3,800. So by buying this house and selling it in a year, we would put ourselves in the hole nearly $15,000.
Even after 2 years, we’d still be about $3,500 behind, given our assumptions. Of course, one of those assumptions is that real estate prices are rising. It’s almost certain they will in the long run, but will they rise in the next year or two? They may not in some markets.
What’s the bottom-line?
We concluded that if we didn’t plan to own a house for at least two years, we’d rather rent. We also saw that the longer our holding period, the better we would do. For instance, in the last five years of the mortgage, only 15% of the mortgage payment would go to interest. It seems like buy-and-hold is rewarded in real estate investing.
How to get around it …
We have two friends who have been able to get around the short-term ownership problem. One of them is in the military, so he moves frequently. He only buys a house that he knows would make a good rental property. If he gets transferred, he hires a local property manager and rents it out. Until he decides where he wants to retire, he plans to hold a number of his houses.
Another friend doubled-down on this strategy. He moved quite frequently as he climbed the corporate ladder. Not only does he own houses in a number of cities, he bought additional rental properties, so he has a diversified portfolio across a number of cities. Now he’s retired living off the rents!
So you can get around the disadvantages of short-term ownership by having an alternative exit strategy!
Next time, we’ll discuss how a toy that you probably played with as a kid can help you manage your time. Until then, here’s to your bigg success!