Rent Or Buy – A look at the Numbers
While taking into consideration that there are many factors affecting one’s decision to rent over buy and vice versa, I wanted to eliminate the emotional element of the decision, and jump into more of an analytical mindset to display just how much money is going to waste for those who rent over the long-term.
You rent a home for $2,500 a month vs. purchasing a $400,000 property with 5% down at an interest rate at 4.5% over 30 years.
The Short Story:
Buying a home in this scenario would result in $47,554 in savings over five years. Renting at $2,500 a month, you will “throw away” over $159 thousand dollars!
The Long Story:
Again, there are a lot of assumptions that need to be made about a scenario, and I have outlined them below. Many of these numbers are taken from national averages, and general rules of thumb.
Property Tax Rate = 1.3% of Purchase Price
Annual Property Tax increase = 1.5%
Annual Rental Increase = 3%
Annual Homeowners Insurance = $800/yr
Maintenance and Repairs = 1% of Purchase Price
Mortgage Insurance = .8% of Purchase Price
Tax Bracket of Borrower = 30%
(I realize there is no 30% bracket, but for the sake of simplicity, we’ll use 30%)
The principal amount is determined from an amortization schedule based on the above scenario. (Buying a property for $400,000 with a 5% ($20,000) down payment at an interest rate of 4.5% over 30 years.) The amounts are added up for the year, and are less than one might think if paying $1,925.40 for a mortgage every month. What’s the reason for this? Interest is front-loaded on your mortgage payments. As you’ll see, your principal payment goes up over the years, and your interest payment will reduce every year.
Now you can see, that interest takes up the majority of your payments. As a result, your first year interest payments will be nearly $17,000. Sure, the money is not going into your pocket, it’s going into the bank’s. There is a silver lining, you get to take advantage of tax deductions for interest on your mortgage come tax time. We’ll get to that soon.
Going off the assumption that your tax rate is 1.3% of the purchase price, your taxes will be $5,200 for the first year. Tax appreciation for years thereafter are multiplied against the annual tax appreciation rate assumption we made of 1.5%.
Mortgage insurance is going to be a necessity if you are not coming in with at least 20% down. This number is calculated by taking the average mortgage insurance rate 0.8%, and multiplying it by the loan amount of $380,000. (Remember, we have put 5% down, which is $20,000. Although the home is worth $400,000, your loan is only for $380,000)
We’re assuming homeowners insurance is around $800 a year, and every subsequent year is calculated based on year past multiplied by the inflation rate assumption of 2%.
General Maintenance and Repairs
Any rent vs. buy scenario must take into consideration the amount of maintenance and upkeep required by the property. Typical rule of thumb is to allocate 1% of the purchase price for property repairs over the course of the year. In a perfect world, any excess money from the allocation should be rolled over into the next year as opposed to being spent. This way, once that $12,000 roof needs to be replaced, you won’t be forced to dish out $8,000 out of pocket for the year when your budget is $4,000. Ideally you would have a buffer built up to account for this repair.
As you can see, you will get a total amount for the year, however this is not taking into consideration the tax deductions you can apply for with your primary residence.
This is the fun part. Now it’s your turn to extort the government out of your hard earned cash in the form of deductions. Interest on your mortgage, property taxes, and mortgage insurance are typically all deductions, and in this case, total over $25,000 for the first year. Again, assuming your tax bracket is a fictional 30% (Click here for 2014 tax brackets) you would essentially be saving 30% of that $25,215. That comes out to $7,564. Pretty cool right? So that number, $7,564 can be deducted from your pre-tax deduction cost of $36,145, to bring your total cost for owning a home in the first year to $28,580.
Your total monthly cost is $2,382 for the first month.
As you can see, although your monthly payment for buying a house is going to be higher initially by $512 a month, those after tax savings of $630 a month will actually lower your monthly payments.
Results Up to 5 Years
The benefits for the first five years are even more impressive than the first year. After a mere five years, you will save $13,954 on monthly payments alone (after tax deductions) and by that time, you will have accrued $33,600 in equity from paying on your property. This brings your grand total savings to $47,554.
Or a better way to look at it would be this – If you buy, you will pay $145,320 after deductions, and pocket $47,554 compared to renting, where you will pocket $0 after five years after having paid $159,274 in rent.
So jumping back up to the chart at the top of the screen, the more rent you pay, the more money you’re throwing away. Rent returns nothing back to you at the end of your tenure. Your landlord gets the benefits of appreciation of the property, tax deductions from your rental income, and the accrual of equity, again fueled by your generous donations.
Beyond 5 Years
If you were to extrapolate this out even further, the numbers get quite staggering. Over time, more and more of your payments on your mortgage will go towards increasing your equity, and less and less of your money will go towards paying off the interest on your loan. You’ll start to accrue equity faster than ever. It’s like a savings account you’re obligated to pay into.
“But I don’t plan to stay in one place very long, I should probably rent right?”
The reality is that people are moving every 5-7 years now, and most people still buy into 30-year mortgages. The numbers would indicate that two years is the breakeven point for when owning becomes more financially advisable than renting. Remember, buying a home is just the first step, if you buy and have to move away, consider keeping the property as a rental to accrue equity, and pocket a little extra money each month. Do keep in mind however, that a property management company will be advisable if you’re not close enough (or willing) to manage it yourself.
Again, renting vs. buying is a more complex question than can be explained in this post, as it really does depend on a variety of factors. Not the least of which is the buyer. If you’re a buyer reading this, our best advice is to sit down and talk to a lender about what is possible. There are great programs available out there to aid you in qualifying for a home. There’s no obligation, and it it helps tremendously to know your options.
Which would you prefer? Rent or Buy?