A mathematical approach to finding the answer
With more and more hedge funds and investment firms buying up homes, many may be wondering whether it’s their last chance to get the security that comes from home ownership. But when we look at the math of the current housing market, that security may come at a cost that is actually much higher than renting and subjects you to greater life volatility by increasing your personal finance burn rate.
“You can never lose buying real estate! Real estate has only ever gone up in value!” — All dads, every 8.2 minutes
Let’s say you have two options: you can rent a house for $3k/month or you can buy it for 1M dollars. This is fairly realistic in the California housing market.
Let’s say you have 250,000 cash in your bank.
1 year = 3,000 * 12 = 36,000/year.
250k goes into the bank and gets 4% interest. So +10,000 a year in interest.
So that means that your out-of-pocket expense for renting is 26,000 per year (rent minus the interest that you can collect on that downpayment money).
Buy Scenario
The 250k is the deposit. You take out a mortgage for 750k. We’re ignoring things like closing costs for simplicity.
Let’s say you are paying 6% interest — not uncommon for a first-time home buyer.
How much does it cost just in interest to live in this purchased house? 750,000*0.06 = 45,000 or about 3,750/month
But interest on a mortgage is tax deductible. Let’s say you’re getting taxed at 30%, so that means you pay 13,500 less in taxes.
The 250,000 went into the downpayment of the house so you miss out on collecting any kind of interest or investment income on that.
But you do have to pay taxes on your property. In California, you are likely paying around 1.25% in property taxes. Those taxes are tax deductible so for simplicity let’s say 1% in taxes (since some of that cost will be recaptured in tax savings). 1% of 1M is another 10,000 in costs in property taxes.
Net results: 45,000 in interest cost, minus 13,500 in tax savings, plus another 10,000 in cost for property taxes. So you would be paying about 41,500 per year to live there. This number is just the burnt money. It does not include the portion of your mortgage that gets saved as equity.
The Result
You’re not really a homeowner until you’ve paid off the debt. Until you’ve paid off that borrowed money, you are a money renter. At the end of the day, your choice is to be a housing renter or a money renter. And being a money renter seems to cost more money.
That said, there are advantages to having control over such a valuable asset even if you only partially own it. But that’s beyond the scope of this article.
I can hear you saying it now: Hey, but don’t houses appreciate and increase in value? Ideally, yes they do. But once all the math is done, you have to acknowledge that buying means doubling your burn rate in the hope that the property appreciation will outpace your losses.
There are a couple of factors here that muddy the waters a bit.
Say you are able to get a fixed rate mortgage — which not everyone is, some people end up with adjustable rate mortgages. But let’s say yours is fixed rate.
Then you know what your payment will be for the next 30 years. Rent on the other hand can be raised by your landlord. Whether or not your rent goes up and by how much will depend on what rental protections your city, county, and state have in place but there is potentially no limit to it.
Let’s say the landlord raised the rest to 3,500/month. Then your out-of-pocket is 42,000 minus the 10,000 interest, so 32,000 per year getting burned.
Perhaps the interest you’re able to get out of your cash in the bank is lower and you only are able to offset that by 5,000, bringing the cost of renting to 37,000 per year. Now it’s starting to look a little bit closer to the cost of buying.
So yes, based on these variables there is a critical housing market environment where these costs start creeping closer together and where buying (if it’s an option for you) might make more sense.
If you’re looking at condos the math gets even worse because you likely have monthly Home Owners Association (HOA) fees of anywhere from 400 to 600 per month. Which adds an additional 6,000 per year in cost (using 500/month for this example).
Then you also need to look at closing costs and opportunity costs involved in house hunting and the tumultuous process of purchasing.
This article was inspired by Salman Khan’s breakdown of this topic on KhanAcademy.org with a few additions from my own exploration of the topic.
