Rent vs. Buy – Where Did I Go Wrong?

[(former)FormerSanDiegan]

Simple.

Example: Put down 200K on a million-dollar property.
Case 1. Property value goes up 10%.
You make 100K, 50% of your original investment on a 10% move.

Case 2. Property value declines 10%.
You lose 100K, 50% of your original investment on a 10% move.

50%/10% = 5 => 5 times

[DaCounselor]

“It’s hard enough to estimate what will happen in the next year or 2, much less 10 years down the road.”
______________________

Thank you for reinforcing my general point. It’s all guesswork. That’s why trying to time markets is so difficult. Anybody who has a crystal ball and can see the future sure isn’t wasting their time on this forum. It’s fun to debate the “what if’s”, though, isn’t it?

[Anonymous]

Opportunity Cost of Down Payment

mrwrong, thanks for summarizing periodically.

Regarding your most recent point 6, double counting, you can think of it in two ways. You and qcomer each missed the opposite side of the same coin.

I think you were appropriate to deduct equity paydown each month from the monthly cost of owning, since that becomes an asset for the owner (see my point B above). However, we have to assume that the renter and the owner started from the same spot: they each had $120,000. The renter has decided to keep his/her $120,000 rather than use it as a down payment like the owner. Hence, the renter can generate additional income from this asset. qcomer included this income as an opportunity cost of ownership. You might think of it instead as a monthly benefit for the renter, but I think it’s correctly considered an opportunity cost as in qcomer’s analysis.

Also, the more I think about it, the less likely it looks like the $200 monthly HOA covers real insurance. Condo associations apparently sometimes vary in the quality and quantity of insurance they carry, requiring the condo owners’ policies to pick up the remaining risks.

no_such_reality’s point is good as yet another alternate analysis worth pursuing, although his/her conclusion misses the possibility of alternative investments and doesn’t consider risk premiums. E.g. if you’d do better in CDs or inflation adjusted bonds, those are a lot less risk (and work). His/her analysis is mostly a technical, rather than a fundamental, approach, in the parlance of stock investing. They each have their place.

[sdrealtor]

HOA fees typically include insurance on the structure and common areas. The owner needs insurance for their personal property just as a renter should have the same.

[lamoneyguy]

Double Dipping on the Equity Paydown.

I know this was addressed, but it does not seem that it is clear yet.

The original assumptions took the principal portion out of the calculations because that goes to the equity. This is fine, but you cannot then look at the equity buildup as one of the benefits.

asianautica had it right by comparing the interest only scenario. If you don’t want to use the I/O comparison, put everything back in and don’t skip any steps.

Purchase Price $600,000
Transaction Cost: $18,000 (3%)
Down Payment (DP): $120,000 (20%)
Interest Rate: 6.75% (30 yr fixed) assuming no points.
Property Tax Rate: 1.25%
Return on Down Payment: 7%

Mortgage (PI): $3113
Property Tax: $625
HOA: $200
Maintenance: $100
——————–
Monthly Outlay: $4038
Tax Savings: $1130 (Interest in the first month is $2700. It will decrease every month, but we’ll let this stay in favor of owning)
——————–
Cost of Ownership (before Opp Cost of DP): $2908
Ten Year Equity accumulation: $190,555

Renting:
Rent: $2350
DP invested: $138k at 7% (4.62% after tax) over 10 yrs becomes $216,783.
Investing difference between owning and renting: $76,083 at $500 per month at 7% (4.62% after tax).

At the end of ten years, assuming flat prices and rents, the equity accumulated would be $190,555 for owning, and $292,866.

Of course, if you assume that the townhouse will appreciate and rents will go up, all of this changes. Normally those would be safe assumptions, but right now they are clearly up for debate.

This, of course, also assumes that your original assumptions are reliable. As you can tell by my name, I am not a San Diegan. My brother lives in San Marcos, and because of the “canary in the coal mine” analogy, I watch San Diego with great interest. But I do not know local rental and housing rates as well as most on here.

~lamoneyguy

[rseiser]

sfobserver is right on, and I also agree that equity was not double counted in the initial example. But there are many other costs that make up for the accumulated equity. I mean, the example was for 30 years, and don’t tell me it doesn’t cost continuously more than a few hundred dollars per month if you include occasional remodeling. I have never owned a house, but it is apparent to me what some friends spend time and money on their houses.

REGARDLESS OF ALL THAT:
The main point I think is the one Rich points out in his bubble primers: Houses do occasionally trade at bottoms in terms of mortgage/rent or price/income. You just can’t afford to buy at the top of the range and then see it drop to the bottom. The loss is just too great (unless you don’t care about the money), and will be there regardless of most twists of comparing costs.

[cooperthedog]

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.

[PerryChase]

The cost of remodeling is worth mentioning as rseiser points out. Bathrooms and kitchens last about 15-20 years. Other major maintenance include roofing, termite, private roads, etc… $200 HOA will definitely not cover these. Additional assessments will come into play as the property gets older.

My dad had a water slab leak and that cost $10,000 to re-route the pipes through walls. Insurance pays for the damage but not the re-route repairs.

My friend lives in a high-rise condo in Chicago and they had $15,000 per window special assessment!! He has 7 or 8 windows. I wonder about all the private communities built in the last 20 years. As properties get to 30-50 years old, those owners will face major repairs.

If you talk about the long run, you have to consider these costs. A renter can just walk away from the headaches and rent the newest most comfortable homes.

Some other things cannot be quantified. Bad neighbors can be a nightmare. If your employer moves your commute could suddenly become hell. If there’s no appreciation, you can’t sell thus can’t get away from an unpleasant situation.

[waiting hawk]

“(since you are building equity), ”
you are not building equity on any condos in CA.

Just go buy it. An IO loan condo is something we would all like to buy on the downcycle from the/ur bank.
While someone thinks that it is ok if they bought while it is losing money, you still have to make that monthly payment as that sucker goes down (could have payed less and saved). All 3 townhomes (IN A ROW) where I lived let them go and bought a home cheaper than what they owed on their townhomes in 1995. My dad’s was one of them. Sounds like a troll post anyways. What are you missing? Everything!

My website tracking Temecula and South Riverside County

[mrwrong]

I agree with cooperthedog’s comments. There are simply too many variables. To answer the question to buy or to rent, you have to plug in your own expectations. If two people can not agree on the basic assumptions, it is impossible to have a meaningful discussion.

Mr. Wrong

[powayseller]

My friend is having trouble logging on to piggington, and asked me to add:
“The AMT tax in many cases knocks down deductions on taxes tied to residences. That needs to be taken into account. It hit me for close the 20k last year alone in extra taxes.”

[qcomer]

sfobserver,
Thanks for pointing out my mistake of not deducting the principal. It is one of those many math blunders that has cost me many grades during college too 🙂

MrWrong,
There maybe gazillion variables at play but only 1 basic/fundamental question. Is housing prices going to go up or come down in next few years? Simple yes/no for this question settles the argument for or against buying.

[Anonymous]

Current monthly payments

mrwrong’s original question, involving current monthly payments, is an important, although of course not the only, factor, in figuring out where the market is and where it is likely to go for now. One observation one might make from the housing, automobile and credit card markets in the past few years is that a large number of consumers will try to maximize their consumption based on their monthly nut.

lamoneyguy’s summary on page 4 of the postings concluded:

Owning: $2908 per month (before opportunity cost of down payment).

Renting: $2350 per month – $517 = $1,833 per month
The $517 is the monthly interest on the $138k that the renter gets to keep that the owner used for the down payment.

So, renting is 37% = 1 – 1833/2908 cheaper than owning, provided you’re not in one of the situations below.

Owning could be up to $1,130 per month more expensive, i.e. up to $4,038, if (a) your salary is below $75k in any tax year, (b) your salary is above $150k in any tax year, or (c) you’re subject to Alternative Minimum Tax (AMT). It’s unlikely you’ll loose all of the $1,130 in mortgage interest deduction benefit, but if you did, renting would be 55% = 1 – 1833/4038 cheaper than owning.

So it looks like *on a current monthly basis* and using the assumptions given renting would be between 37% and 55% cheaper than owning. Regarding the assumptions, one poster thought the tax rate would be 1.8% not 1.25% (which would add another ~3-4% difference between owning and renting), and I still think $200 monthly HOA is too low to include full coverage condo association insurance along with all the other home owner association expenses (one poster thought it would be ~$800 for complete HOA, adding another ~8-9% to the difference). If these two assumptions are off, the real difference could be between 48% and 66%.

I do agree with cooperthedog and qcomer that there’s more to this than just current monthly payments, but the answer to mrwrong’s original question is an important aspect to the housing question. From there, other factors include the appreciation/depreciation rate, what alternate investments are available, where rents are going, inflation, and the all important interest rates. But I leave that for another day. cooperthedog, perhaps you want to post a spreadsheet like you discussed?

[sdduuuude]

This thread should be titled “How to make $120,000 disappear.”

Enough with the splitting hairs over monthly calculations.
20% loss on $600,000 is bad.

It doesn’t matter if you can “ride it out.” Why buy high, then ride it out when you can ride it out in a rental, then buy low.

It’s like saying “I want to buy this stock I know is overvalued just because I want to be an investor.”

[Author]

Posts