You’ve heard all the reasons that people want to stop renting. “I don’t want to waste my money.” Heck, you may have even said them yourself. Many of my friends are reaching that point in their lives where they’re considering buying a home. However it’s unfortunate that so many choose to buy over rent, especially in this expensive market, because many well-intentioned people are buying homes that are actually damaging their finances.
Despite the fact that many people disagree with me that the real estate market is going to deflate, there is a rule of thumb that I use that should give you an idea about how much you should spend on a home even if the market is in a slump.
For every $100 you spend in rent a month, you’d be better off buying up to $12,500 in property instead.
For example, I live in Northern New Jersey, and currently pay $1,000/mn for my 1 bedroom apartment. I would be better of financially if I were to buy a condo that cost up to $125,000. The only problem is that where I live, there’s nothing habitable that I can buy for under $125,000, and if I spend much more than that, it’ll actually cost me more money to buy than rent!!! Unfortunately this is a problem shared by my friends in major cities around the country.
Okay, you’re skeptical. I know it and I don’t blame you. So I’m going to prove to you right now, why my rule of thumb works.
The Proof is in the PITI
The great thing about a home is that you get to build equity. It’s like your home becomes this great big piggy bank and with every mortgage payment you’re saving more money. But, this privilege is not free. Unless you can pay for the entire cost of your house in cash, which is rare, banks offer loans to help individuals purchase the properties in exchange for interest.
Like rent money, mortgage interest is essentially “wasted.” It goes neither to improving the property nor to building equity. It’s simply a fee for the privilege of living in your house. And in addition to interest, you’re also required to pay property taxes and insurance every month as well. All these payments are known as the PITI payment, which stands for Principle, Interest, Taxes and Insurance, and is a single payment you pay to your bank, who then distributes your money to the government and insurance company.
Houses also have additional expenses, such as lawn care, maintenance, and big ticket expenses like a new roof, new appliances, or a new furnace. As renters we don’t have to worry about any of these expenses because most leases include them as part of your rent, meaning no extra money out of your pocket when the freezer stops freezing, and someone will install it for you! A responsible homeowner should set aside some money every month to pay for these expenses when they eventually occur (and they always do).
So there are a lot of extra expenses that are essentially wasted when you buy a home. Wasted in the sense that they don’t build equity, which aside from taxes and appreciation is the only real advantage to owning a home.
So let’s compare renting and buying
Buying a home should not be about what you can afford. It should be about wasting as little money as possible. For example, let’s say you can afford to pay $1,200/mn for a condo, but rents in your area are only $800/mn for a nice 1-bedroom. You’d actually be building more assets if you rented, and saved the extra $400/mn in a mutual fund.
So again, how do you determine when you should rent and when you should buy? When the combined home expenses, interest, taxes, and insurance equals your rent, that’s the point when you can and should buy a home.
I’ve run all kinds of numbers to prove out my theory, and when I look at it 125:1 seems to be the ratio I keep coming up with. If I pay more than that (especially as I near the $1400 level), I would actually be spending more money on my home than if I were renting. Of course this number isn’t totally exact, and unforseen situations can arise so, I’ve also built a comfortable cushion in this ratio to cover the wide range of circumstances.
This ratio is different for each person based on variables such as how much they can afford as a downpayment and local property taxes. For more information on how I calculated this ratio and a calculator to determine your ratio, see my article How much should you spend on a home?
What about taxes, appreciation and multi-families?
Look, I like being appreciated just like the next guy, but this rule of thumb takes into account two assumptions. First, we can’t take into account taxes or price appreciation. With few exceptions, a home purchase should first make financial sense without taking appreciation into account, so that no matter what the price of your home does, you won’t be perched precariously over a financial disaster.
Because personal mortgage interest is deductible on your taxes, your overall tax burden is minimized at the end of the year. Because most of the interest in a mortgage is paid at the beginning of loan, your first year you would receive the greatest benefit. For a typical mortgage on a $125,000 house at today’s interest rates, you’d be spending about $7,400 on interest for the first year (it drops to $7300 in year 2). Of the deductible amount, the standard deduction may chop off a good hunk of that right away, so you’d be saving maybe an extra $1,200 on your taxes, and that’s for only the first year! The longer you have a mortgage the less you pay in interest a year, and the more inflation will eat away at your deduction. In either case, I don’t believe you should spend more money to have a bigger deduction.
In terms of appreciation, I think most people agree that the real estate market is going to slow. I personally believe that we’re going to experience serious price drops in major metropolitan areas, such as here in New Jersey. Renting is just too attractive an option for consumers, and the rents are too low for investors. If the prices of housing at the very least stagnate, we’ll see appreciation of less than 5% for the next few years, if not longer. That being the case, you’d be better off buying a mutual fund making 8 to 12%, even if you’d be affected by long-term capital gains taxes. Unless the real estate market is red hot in your area and you want to flip your property, don’t rely too much on appreciation.
[NOTE] Home price appreciation is magnified by leverage. If housing prices increase 5% and you only put 5% down, you’ve doubled your money your first year on paper. With a mutual fund, though, a 10% return is always 10% no matter how much you invest. In real estate taking control of a property for less than its value is known as leverage, and can lead to serious returns in booming markets. However housing prices are softening in many areas, and selling your home with a real estate agent can cost as much 6% of the value of your home, eating away at your sale price. For Sale By Owner (FSBO – “Fiz’ bow”) will help you avoid those costs, but in a buyer’s market can also lead to a significantly lower sale price. Is it possible to make a lot of money with price appreciation in the next 5 years? Of course. But don’t bank on it unless it’s a sure thing.
Additionally, this discussion only makes sense if you’re talking about buying a single family home (house/condo). When you throw multi-family into the mix, the discussion gets more complicated, so since the vast majority of people start off with a one-family we’ll use that as our basis. Becoming a landlord can be very financially rewarding and hopefully more people will choose that as an option to first-time home ownership.
Wrapping it up
If you take away anything from this article, I hope it’s the fact that there are many expenses involved in owning a home, especially when you’re just starting out and are struggling to afford a place to live. While it may be easy to think that home ownership is a way out of the rent trap, consider how much money (and don’t forget time) you’d actually be wasting every month just to own your home.
Unfortunately in most major cities these days, buying property is so darned expensive it doesn’t make sense for many of us to own until we get married and start families. But how bad is that really? Sure you have to deal with your neighbors, but renting means that someone else worries about your leaky faucet and broken washer, and that kind of good night’s rest is truly money in the bank.
Don’t get me wrong. I think homeownership is a wonderful thing, but think long and hard about the decision before you make the leap. Unless you can find a cheap condo somewhere or live in a market that hasn’t had the kind of price runups we’ve seen in the past 10 years, I think it makes more sense to start saving for your downpayment in a diversified mutual fund, and wait for prices to stabalize.
FAQ on Deducting Mortgage Interest. Quicken.com