Friday, January 28, 2011

Buy or Rent Your Home? Details to Help You Decide

A few of you might remember the 1950s TV quiz show, The $64,000 Question.  In today's dollars, that's closer to the $464,000 question -- and you might be surprised that it's not just for a few select contestants on a television show, but for you and pretty much everyone you know.  So what is this vital question?

The median rent on a home in the United States today is $842 per month.  If inflation averages 3% per year, you will pay well over $1.1 million to rent that home over your lifetime! That's based on renting your first home at age 25 and living 50 more years.  If you live (and rent) longer than that, ... you do the math! 

Or you could buy the home.  If you could pay cash for it, its median price today is $168,800.  But you also have to pay property tax, insurance, repairs and maintenance ... not to mention mortgage interest and possibly private mortgage insurance if you don't happen to have that much cash handy to make the purchase. 

Should I rent my home or buy it?  That is one of the biggest life decisions you will ever make. It's especially hard to make that decision today.
 Buying  initially would  cost around $1,175 monthly (including property tax, insurance, and maintenance that you wouldn't likely pay as a renter) after making a down payment of about $17,000.  Throw in the fact that home prices have been dropping for years now, and it's no wonder many people are pretty hesitant about buying.

The table below summarizes a lot of numbers I have crunched for you that may help you decide.  If it doesn't appear clearly on your screen, please contact me and I'll happily e-mail you a copy.  As you'll see, over your lifetime, the difference between buying and renting is in the $400,000 to $500,000 range -- call it $464,000 for discussion purposes. 


As you can see, the total occupancy cost is $432,000 less with a 30 year mortgage ($751,995 vs. $1,183,995).  If you can afford the extra $338 each month for a 15 year loan, the lower interest you pay makes the total occupancy cost $500,897 less ($683,098 vs. $1,183,995).  But the big savings comes just from making the commitment to buy the home.  You are already paying more monthly to buy than to rent the first several years, which you make up for by locking in your biggest cost (interest) and by eventually finishing paying off the mortgage in full, whereas rent never ends.  So don't feel bad if you can't swing the 15 year loan at first.  You can always increase payments voluntarily later and achieve much of the additional savings anyway.

I will discuss the numbers in this chart further by going through a series of questions that you probably have asked yourself as you have contemplated this giant buy vs rent decision.

How Much Will I Save On My Income Taxes By Owning My Home?

Surprisingly, not much, if any.  If you buy a home somewhere around the median price level at today's interest rates, you are likely to pay about $7,000 the first year in interest costs and $1,600 in property taxes.  Unless you have a lot of other itemized deductions to claim, you may very well be better off claiming the standard deduction -- which means your income taxes would be the same as if you were renting.  Accordingly, I did not include income tax benefits in this analysis, and if you do receive them, that would be an extra bonus in favor of homeownership versus renting.

What If House Prices Drop Some More And I Lose Money?

It is likely that in most geographic areas, house prices are about as low as they will get.  That statement is based on a couple factors.  One is that generally prices have already leveled off.  They did drop again in 2010 below where they were in 2009, but only by about 1%, or less than $2,000 on the average home.  The other factor is that the cost of most building materials have already started going back up.  People have to live somewhere.  Rents have started rising to accomodate demand from former homeowners who have been added to the rental market in this economic downturn.  As available inventory of homes for sale is depleted, building costs will once again form a floor below which home prices will not drop further.

But even if I turn out to be wrong in these projections, you are still prudent to go ahead and buy at current price levels, because interest rates are at historic lows we are not going to see again for many years.  Mortgage interest rates already started going up in the fall of 2010, and projections are they are most likely to gradually continue rising throughout 2011 to a level in 2012 that is about 1% higher than they are now.  Because of the huge impact of interest rates on the total cost of homeownership, it would take a 10% additional drop in home prices to make up for 1% higher interest rates. 

You can see this by comparing the bottom half of the chart to the top half.  For example, note that the total principal and interest cost on a 30 year fixed interest mortgage with 10% down is $308,700 if you buy at current home prices and interest rates.  If you wait one year, and home prices do drop 10% but interest rates rise 1%, the total cost on the same 30 year fixed interest loan with the same 10% down is $308,957 -- virtually identical (slightly higher in fact).  If home prices drop less than 10% and interest rates go up 1%, the increased interest will cause you to pay more over your loan term than if you buy now.

It is more likely that interest rates will go up than that an additional drop in home prices will occur, hence you are prudent to lock in the combination of low prices and low interest rates now.

Why A Fixed Rate Is Preferable To An Adjustable Rate Mortgage

Again, interest rates are much more likely to be higher in the future than they are to stay the same or drop.  Even if rates stay the same for 2 or 3 more years before they go up, over the length of a mortgage loan, you will be very glad you made today's low interest rates permanent on your home purchase.  Every 1% increase in interest rates on an adjustable loan would add about $50,000 in lifetime interest to the cost of the loan -- just think about the impact of a 2%, 3% or larger increase.  Then think about the interest rates we saw over the last several decades.  It is certainly possible they will go up from here in a way that would cost you many thousands of dollars.  The bank will win on the adjustable mortgage in the end.  That's why they promote them.

If I Am Old Enough To Qualify for "Senior Discounts" Is It Too Late For Me?

Are you kidding me?  Sure, slow cooking is a recurrent theme in good financial planning.  It is truly amazing the power that compound interest has over a lifetime.  But let's look at the numbers for someone who for whatever reasons wait until they are 50+ to buy a home.  The important part is to choose a home and a location where you can be comfortable and your total monthly housing expense fits in your budget.   If you don't spend too much when you buy the home in the first place, then don't be afraid of paying a mortgage in retirement years if your alternative is paying rent.  Over 20-30 years, you will still pay more for rent than you will to own.

Don't Think of Your Home as an "Investment"

This one may surprise you, but you will notice that nowhere here have I talked about how much money you will make by selling your home some day.  Maybe you will, but as too many folks have learned in recent years, maybe you won't.  Whether you own your home or rent your home, you should think of it as occupancy expense -- the cost of living in a comfortable home in the neighborhood and perhaps the school system of your choice. 

An important thing to remember though is that when you own you do have an asset with value when you are done using it.  With rent, you have a stack of receipts, memories, and ... (you get the idea).

I have found that one of the key ways to develop wealth is to keep more of the money you earn and give less of it to banks, insurance companies, the government, etc.  What I am presenting here is a very powerful way to reduce those costs and thus keep more of your money.  In general, you should own what you are going to use long term and rent what you are going to use short term, which means ... 

Don't Buy a Home If You Aren't Going to Keep it at Least 5 Years

It costs a lot of money to make your initial home purchase.  Even though the seller generally pays most of the closing costs, make no mistake, in the end the buyer pays everything -- it's just included in the total.  Mortgages have expensive fees and often points to "buy" a lower interest rate.  You've got appraisals, title insurance, recording fees, and much more, not to mention the biggest one of all - your real estate agent's commission.  If you aren't going to keep the home at least 5 years, you probably will wind up paying more than had you rented.

Which leads me to ask you to carefully consider the hidden costs of moving often, whether to advance your career or for whatever reason.  Yes, you may eventually need a larger home, or a smaller home, and there can be good reasons why you don't stay in the same home your entire life.  One solution can sometimes be to consider keeping your starter home as a rental when your family grows and you need more room.  Bottom line, there are both financial and non-financial benefits in setting down roots in one place -- if you ignore this in your long-term planning you do so at your peril, trust me.

This Is A Sample Illustration - Your Circumstances Will Be Different - Why This Was Worth Looking At Anyway!

Obviously, you are going to have to make your own calculations using homes that are actually available in your area that meet your needs.  I am simply trying to illustrate why it is worthwhile to make this comparison, how much it could mean to you over a lifetime, and some things to consider when doing it.  I'm also trying to give you another example of why you need to build an ongoing relationship with a passionate personal financial advisor who is going to take the time to look at all the angles of these kinds of decisions, and visit with that advisor regularly -- not just once a year.

For Those of You Who Would Like To See The Details and My Sources ...

The National Association of Realtors reported that "the national median existing-home price for all housing types was $168,800 in December 2010" (see http://tinyurl.com/66mttw4). This was virtually unchanged (down 1%) from December 2009.

The national average mortgage interest rate as of January 22, 2011, as reported by money.msn.com, is 4.80% for a 30 year fixed interest loan and 4.15% for a 15 year fixed interest loan.  You need to put at least 20% down, which is about $34,000 on the average home, to get these rates.  It is possible to get a mortgage with 10% down, or about $17,000 on the average home, but you will be required to purchase PMI (private mortgage insurance) which will add about 0.50% to the interest rate.  In my chart, I show how many months it will take to reduce the balance owed sufficiently so that you have 20% equity. At that point the PMI will stop and you will just pay the base interest rate.  For purposes of that illustration, I assume that the price of the house will remain the same for the length of time that PMI is paid. 

Michele Lerner of Investopedia quoted the Mortgage Bankers Association and others in an article published January 11, 2011 (see http://tinyurl.com/2djbg3v).  Those industry experts expect mortgage rates to gradually rise by about 1% to somewhere near 6% on a 30 year fixed interest mortgage by 2012.  For sake of this article, we will assume an increase of exactly 1%, which would make a 15 year fixed interest loan 5.15% and a 30 year fixed loan 5.80%.  I emphasize no one knows for sure exactly what will happen to these rates, but my own personal outlook mirrors this based on the amount the government is borrowing,  as well as growth occuring in the money supply and the consumer price index.  Oil and food are the early indicators of inflation in my observations, and I think you will agree that those are already headed up.  Other prices are likely to follow their lead.

A useful source for average property tax paid by U.S. homeowners is a detailed study published in 2007 by Natalia Siniavskaia, PhD, with the cooperation of HousingEconomics.com and the National Association of Home Builders.  For many states, the averages come reasonable close to what you would actually expect to pay -- the national average is $1,614 per year paid on a median home value of $167,500.  But there are wide variations, so I encourage you to look at this study (see http://tinyurl.com/4huq9rv), particularly Tables 1 and 2 found near the top right.  Table 1 gives the median home property values and taxes paid in each of the 50 states plus the District of Columbia as well as the nation as a whole.  New Jersey has the highest median real estate tax by a wide margin at $5,352 per year over New Hampshire and Connecticut in second and third place.  At the other end of the spectrum, the median real estate tax paid by Louisiana homeowners is just $175 per year.  Table 2 gives the high and low county in each state, so that you can see the range within your own state if you would like. 

I used the same 3% assumed average yearly cost of living increase on property tax (as well as homeowners insurance and repairs/maintenance) in my chart as I applied to rent.  The difference between buying and renting will be less if inflation averages lower than 3% and the difference will be higher if inflation averages more than 3%.  Of course, you will have to make your own decision how much inflation you believe there will be in future years.

I based the average $669 yearly homeowners insurance figure I used on the October 2010 figures at http://homeinsurance.com/rates-in-your-state/, with a "smell check" from figures I have seen from an admittedly unscientific sample of my own clients in a variety of states and locations.  You may also be interested in the pamphlet, 12 Ways to Lower Your Homeowners Insurance Costs, published by the Insurance Information Institute and available online from the U.S. Government General Services Agency at http://tinyurl.com/2n2z3p.

Joe Hammer writes a very helpful blog on all aspects of home maintenance.  In his January 6, 2010 blog post, he writes that "the average cost in home maintenance each year is $750 to $1,500.  This figure can vary from year to year based on what maintenance issues you would like to address."  You can read the whole article, and also subscribe to his blog for free at http://tinyurl.com/4zoonorI used the high end of his range, at $1,500 per year, and suggest that whatever portion of that amount you don't use in a given year - keep it in a specially designated emergency savings account to use when the air conditioner/heater breaks down or the roof starts leaking at the worst possible time.  Those events won't happen in most years, but they will happen, and as a homeowner you will be glad you don't have to borrow at high interest rates to pay for them -- build up that emergency reserve just like you will build up the escrow account for yearly property taxes and homeowners insurance.

I did not address utilities here thinking that for the most part you will pay those whether you are a homeowner or a renter -- you need them in your personal budget either way, but they don't need to enter into a comparison of buying or renting your home.

The most recent national statistics on average rent were published by the U. S. Census Bureau in October 2010 for the year 2009 (see http://www.census.gov/prod/2010pubs/acsbr09-7.pdf).  On page 2 of that report we learn that the national median gross rent in 2009 was $842. 

The Census Bureau also reports that median family income in the United States in 2008 was $61,521 per year (see http://tinyurl.com/4vr6agz) in a report published as part of their 2011 Statistical Abstract (see http://tinyurl.com/396z2m5).  This encourages me, because you should try to keep your home occupancy expense in the range of 25% to 30% of gross income in order to avoid financial stress.  At that income level the average family can afford the average home -- something we sadly don't always see, and another reason in my mind to encourage you to act while that affordability continues to exist.

Want to Learn More?

Let's start a discussion in the comment section here, where we can learn from each other.  Please ask a question, make a comment, or do both!  I will respond, and we can have a valuable conversation here!  I also welcome your specific personal questions.  I offer a free 30-minute initial consultation to any of my readers that is interested. Please e-mail me at dougbeecher@gmail.com to request yours.  Thanks for reading, participating, and sharing this with your friends!

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