With the recent news of year-over-year home value gains in the 20% range and rents rising at record levels, it made me think about the benefits and drawbacks of home ownership and all of the nuances that go into answering the question, “should I buy a home now?”.
It’s important to remember that the purchase of a home is a lifestyle choice as much as it is an investment. It is not just a commodity to negotiate but also the place you’ll come home to each day and make your own. Yes, it is important to buy wisely and stay within your means. It is equally as important to do what is right for you and your lifestyle now. If you know you’ll be staying in the same place for years to come, you have much more latitude than you would if you might need to relocate in the next couple of years. Having purchased 11 homes over the past 30 years, I’ve learned a few things about good home investments and bad ones. I hope to share a few words of wisdom on the concept of homeownership that might help answer the questions of whether or not it’s right for you.
As you evaluate your options, you’ll want to consider things like initial out-of-pocket expenses, monthly expenses, maintenance and upkeep costs, tax deductions, and appreciation.
Initial out-of-pocket expenses. In a home purchase, this is the down payment & closing costs. Depending on the loan program and purchasers credit rating, a typical down payment is 5-20% of the purchase price (of course, more is always an option) and a good ballpark for closing costs is about 3% of the loan amount. Closing costs generally include lender fees, appraisal, title insurance, escrow and reserves. In a rental, this is typically first & last month’s rent plus security deposit.
BUY: A $500,000 home with 5% down equates to about $40,000 ($25,000 down and $15,000 in closing costs) in initial out-of-pocket expenses.
RENT: A $3,000 per month rental might cost $9,000 in initial expenses ($6,000 first and last plus a $3,000 security deposit).
Monthly expenses. In a home purchase, this is the mortgage payment plus property taxes, homeowner’s insurance and depending on the amount of the down payment, mortgage insurance. In a rental, this is typically just the rent.
BUY: A $500,000 home with 5% down works out to a $2,233 mortgage payment at today’s 3.875% fixed interest rate, plus an estimated $425 in property taxes, $40 in homeowner’s insurance and possibly $290 in mortgage insurance for a total of $2988 per month.
RENT: $3,000 per month.
One important consideration is that the monthly payment in a purchase is essentially fixed for the term of the loan. The property taxes and homeowner’s insurance may increase slightly each year but the mortgage payment stays the same while rent will likely increase each year to keep pace with inflation.
Maintenance and upkeep. In a home purchase, you are responsible for everything from the roof to the foundation, plus the grounds and utility and sewer lines. In a condo, you are individually responsible for the interior of your unit and collectively responsible for the entire structure and grounds. The cost of maintenance depends on the age of the home or condo, how well it was built and maintained, and its exposure to the elements. In a rental, the landlord pays for maintenance and upkeep.
BUY: Plan for 1-2% of the home’s value per year in typical maintenance plus the cost of major components (roof, furnace/AC, paint, flooring, appliances, decks, etc.) based on their life span. These items are easily researchable via inspectors, contractor bids and even google searches.
RENT: Landlord pays for maintenance and upkeep.
Tax deductions. In a home purchase, you can write off the mortgage interest (up to a $1M loan), property taxes and mortgage insurance paid. In a rental, there are no tax benefits.
BUY: On our $500,000 home, the tax deduction might work out to $17,663 in mortgage interest $5,000 in property taxes, and $3,480 in mortgage insurance for a total of $26,143 in annual write-offs to offset your ordinary income.
RENT: Landlord gets the tax deduction.
Appreciation. In a home purchase, your investment is leveraged. That means you gain appreciation based on the entire value of your home, not just the amount you put down. That’s like earning interest on $500,000 even though you only deposited $40,000 in the bank.
BUY: A 4% appreciation rate is a good average to benchmark. Last year’s 20% appreciation rate was unusual and is balanced by several years of negative appreciation between 2008 and 2011. Assuming a 4% rate of appreciation per year, our $500,000 home would gain $108,000 in value over five years.
RENT: The landlord gains the appreciation.
The bottom line. There’s a lot more to consider than just the monthly outgo. A homeowner can maximize their investment by purchasing in a highly desirable area and completing timely maintenance and upgrades or they can waste away their equity by purchasing in a declining or over-built area and allowing their home to fall in disrepair. Only you know you. Are you up for the pleasure, independence, headache, and heartache of owning your own home or would you prefer the comfort and ease of renting someone else’s home with no strings attached, even if it costs more over time. Building wealth through homeownership is an incredible opportunity—but it’s only worth it if you enjoy the ride.
Looking back at the numbers, here’s how a 5-year analysis might pencil out:
BUY: Your $500,000 home costs about $40,000 in initial out-of-pocket expenses, about $180,000 in monthly payments, and $40,000 in maintenance and upkeep over 5 years for a grand total of $260,000. This is offset by $130,000 in tax write-offs (the net benefit to you depends on your tax bracket) and $108,000 in appreciation.
RENT: A $3,000 per month rental would cost $194,988 in rent payments over 5 years assuming a 4% rent increase each year (a good long-range, though conservative, benchmark, given the double digit rent increases over the past several years).
So there you have it. The decision to opt for home ownership is a lot more than a quick judgement call. To do it right, you have to consider all of its aspects—financial, emotional, and even physical and spiritual—and weigh those against your long-range goals and plans. By taking the time to do a thorough analysis of the numbers and an assessment of yourself, you’ll make the best decisions possible and avoid costly mistakes.