In response to the clear, but oversimplified view of using an I/O loan, where tax savings would remain constant:

When using an amortized loan, the scenario becomes more complex, but with significant changes. As tax savings decline due to less interest paid, equity is increasing at a faster rate. This should be accounted in a long term analysis (very long term, as I think it takes ~23 years before the halfway point is met in a 30 year loan). Also, as rents rise (and more equity is “paid”), there will come a point where the monthly rent payment is equal to the mortgage. Of course, you have to compare the whole timeline of events, otherwise its apples to oranges.

Since jumping into the market (any market) results in risk, and as a previous post stated, you will be highly leveraged, I would take the time to build a spredsheet to model all these costs and variables and plot the data over the life of a 30 year loan.

Your goal is to have a core sheet with variable inputs (home appreciation/depreciation over the next X years, increase in rents per year, investment return, marginal tax rates, etc.) that will determine the growth of each scenario, basing everything relative to a fixed mortgage paymnet & 120K in capital (so you’ll have a chart with rent vs. buy over the years, adjusting variables to give you best & worst case scenarios, with a crossover line to determine how long you will need to own to be better off than renting (or how long before you can sell without a loss).

This core sheet will be fed by three others; tax projections, costs, & rates of return.

To be accurate, you should build a tax sheet to estimate your taxes as a renter, and each year as a buyer, since your interest expense declines each year. Assume your income, tax rates, etc. all remain constant… though you could tweak these too to see what happens during a big promotion or job loss (tax “savings” disappear, but the mortgage payment doesn’t…). Also, be sure to evaluate whether the Alternative Minimum Tax (AMT) will affect you (you may get a surprise when you find the AMT disallows a big chunk of your interest deduction). You will now have the difference between your taxes as a renter and buyer over 30 years.

Build a cost sheet to calculate the increase in rents per year and the increase in all ownership costs (insurance, HOA (they will go up), property tax, routine maintenance, major repairs, etc.). You must subtract the tax savings (step above) from the home ownership costs, but leave the princpal in (since this is accounted for elsewhere). The difference between these will be used each year to determine the amount of savings (or loss) that can be used by the renter for investment.

Build a return sheet that tracks the renters 120K investment in some financial instrument (initial amount + savings/loss from renting (step above), multiplied by what rate of return you expect, less tax (use a rate that accounts for long term cap gains vs. short term income, dependent on your investment/trading style). You will end up with the value of the investment at years end, which you will use as the start for the next year (inputing the new savings/loss from renter & upping the marginal tax rates as the compounding accelerates). Do this for each of the 30 years. Plot this as your rental return on 120K.

For the buy scenario return, fully amortize the loan into a table that records the remaining debt each year. Then, determine the rate of appreication on housing, using your purchase price as the base. I would set your appreciation rate variables in two 5 year chunks & a 20 year. This will allow you to test how a downturn vs. flattening will affect you in the near term, and a rebound would in the intermediate term. For the remaining 20 years, use a historical growth average for your geographic market. You should now have the market value for the house over 30 years. Subtract the debt from these amounts (amortization table) to come up with your equity. Now subtract 5-7% of the market value for sales costs (broker fees, transfer tax, closing, house prep, etc). You now have your true equity should you decide to sell (if your market value exceeds you purchase price by > 250k (500k married) you will need to subtract tax from the amount over (remember, tax laws change, and the huge deduction may be reduced or disappear)). Plot these values, which tracks the growth of your 120K downpayment. You should now have to plots that compare rent vs. buy on 120K. You should tweak the variables in your core sheet to evaluate various scenarios.

I think you’ll find that owning will take a few years to exceed renting even with the most optimistic of housing market growth (up 5-10% by 2008 – good luck there). Near term price declines or even flattening will paint a very bleak picture, but over the very long term housing will be the clear winner (even if housing only returns at the rate of inflation, you’re still better off since you’ve fixed your payments for housing, which you always have to incur (vs. a true investment property, which could be a poor choice if it doesn’t exceed inflation). Of course, most people do not stay in a home for 20-30 years, and life circumstances could force a move. Conversely, owning a house is forced savings, as most renters will not save the difference between a rent & mortgage payment.

I guess you could liken it to investing in the stock market. Someone on the sidelines, never jumping in will suffer from sub-standard returns. Someone jumping in at the worst possible time will severly overpay, but over the long haul you will come out ahead, even if investing at a market top. On the other hand, why wait 5 years for a rebound to break even. You definitely want to reap the benefits of home ownership sometime in your life, but why not wait and see what the market does? If prices decline or even remain flat, stay put and enjoy the spread on rent savings, update your spreadsheet with new prices, and patiently wait until there is proof of a bottoming out or accelerating gain.

I know this is alot of information, but hopefully it will help.