Hi Quint / Daniel,
Thank you in advance for all the episodes that you’ve posted!
My wife and I are juggling with the idea of buying a house, but housing prices in Denver is quite high (and potentially climbing higher) and I was wondering if you could address whether it’s worth it to save 20% on a down payment (~$400-$450K) or if it’d be worth it to just pay PMI every month? Saving around $80 – 90K would take a long time (projecting 4-5 years with our current savings) and we are curious if you could address the value of buying now vs. later
This is one of the most widely discussed subjects within the financial world today. If the generally accepted idea that buying is a better financial decision than renting, one has to ask just why it is debated at all? Ah, well there’s the rub. Depending on how you run the numbers, it is not that obvious.
A few years ago, I was listening to a podcast by one of my favorites, James Altucher, on this very subject. James was making the argument that home ownership was no longer a smart financial investment. He mentioned many things including, the size of a down payment, the annual taxes, insurance, and maintenance. It was a compelling argument; so, after the episode, I decided to take a hard look at the numbers. As a homeowner, I was curious as to whether or not I was actually making a wise financial decision.
To compare apples to apples, I used a median home price, in our area, compared to median rent. The average 3/2 home price is $230,000 while the equivalent rent is $1,450.00. To properly compare the two, I looked at the total costs of each and summed the totals. Next, I brought back a home sale price at the end of the time period, regardless of whether it was sold at life expectancy or sometime earlier, and used both a 0% growth rate for the property as well as a standard inflationary rate of 3%. I also looked at 20 years of home ownership as well as 55 years, assuming someone were to buy a home at or around the age of 30 and live to life expectancy at the age of 85. Finally, I added back the assumed future value of any down payments. In renting, this would be the deposit; in home purchasing, this would be the down payment. In each instance, I used a standard 6% rate of return. More on this later.
Calculating the cumulative rent was easy, as I took the $1,450.00 base rent with a 3% inflation rate or annual rent increase. I also felt it important to take the standard down payment of a first and last month’s rent and calculate the lost investment opportunity on this money, thus adding back in the ending value. I used a 6% hypothetical rate of return on this deposit.
Over the course of 20 years, rent payments would equal $467,544.52 with a future value of the deposit equaling $9,301 for a total of $476,845.21. If someone were to forgo home ownership their entire life and simply rent, they would pay $2,367,646.18 over their 55 years of renting with a lost opportunity cost, on their deposit, of another $71,485.93 for a grand total of $2,439,132.12.
Now, immediately, you may think to yourself that this is clearly why owning is a better financial decision. Don’t be too quick to make that assumption as the real cost of ownership may surprise you.
Let’s cite a median priced home at $230,000. For our first calculation, we’re going to assume a 20% down payment, thus financing $184,000, at an average interest rate of 4.5% (Rates are now lower, which will improve this calculation but may not be that way forever; thus, I prefer the more conservative amount). We’re going to use a 30-year loan. In addition to the principal and interest payment, we’re going to factor in a 1.2% tax rate, or $2,760, and a 2% average annual maintenance cost. According to Zillow, the average homeowner’s insurance premium is $35 per $100,000 of home value each month; thus, I used a $966 base premium which increases each year by the rate of inflation or 3%.
Taking all these variables into consideration, 20 years of home ownership will cost approximately $428,512.74. This is close to $40,000 cheaper than renting, and we haven’t yet added back in the future value of down payment. Assuming a hypothetical growth rate or lost opportunity cost on this money, we must consider an additional $147,528.23 for a grand total of $576,040.97. Comparing only these numbers, we see that, clearly, the general cost of home ownership over 20 years is almost $100,000 more expensive than renting; however, let us not forget that an asset is actually owned or, in the case of our 20-year scenario, nearly owned.
This is where it can get a little sticky; so, let us take a look at two scenarios. One, in which the home is sold for the same amount it was acquired 20 years earlier, and another where the home appreciates at the inflation rate of 3%. In the former, the house would sell for $230,000, but it would still have $111,876.12 left on the loan for a net proceed amount of $118,123.88. When you deduct this from the total cost of $576,040.97, you see that the net cost for home ownership is $457,917.09. This is only a $18,928.12 savings. Now, if we assume that the house appreciates at 3% per year and ultimately sells at the end of year 20, less the amount left on the loan, the total home ownership cost goes down to a total of $272,511.50, for a savings of $204,333.71.
While people may relocate throughout their lives, I’m going to assume that a decision to rent or buy will remain consistent; hence, it is worthwhile to consider a longer time frame as well. Furthermore, at the end I will note some of my personal observations and outliers.
Taking into consideration the same variables mentioned in our 20-year scenario for a 55-year scenario, the total rental expense will now equal $2,367,646.18, with a lost opportunity cost on the deposit at the end of 55 years of $71,485.93, for a total expense of $2,439,132.12.
Home ownership, on the other hand and using the same variables mentioned in our earlier example, will result in $1,290,802.98. This is a considerable savings, until you add back in the lost opportunity cost on the 20% down payment of $1,133,914.79, for a grand total of $2,424,717.78. This mere $14,414.34 savings is probably not as great as many believe it would be, and, it mandates that, in order for home ownership to make sense, we must add back in the value of the property. Once we do that, it drops the total home ownership cost down to $2,194,717.78, at a break even sale, and $1,255,823.60 if the house were to appreciate by 3% per year.
At the end of the day, these calculations tell me that the difference between the cost in ownership versus the cost of renting is not nearly as great as most would have us believe, and that definitely makes it a much more difficult decision than ever before.
Furthermore, here’s something else to consider. Note, that in all examples above, I used a 6% rate of interest for the compounding of the down payment and the lost opportunity cost. You won’t believe what happens if you increase this to 8%. This simply means that, rather than putting that 20% deposit down on your home, you invest it in an outside account. In our 20-year scenario, this takes the future value of your down payment from $147k to $214k, and in our 55-year example from $1.1MM to $3.1MM. In both scenarios, it makes home ownership look ridiculous compared to renting to the tune of $44k in the 20-year scenario and $1.6MM in our 55-year scenario. The bottom line here is the power of compound interest and just how much that down payment would grow over time, especially in the later years of each example.
Now, let me say that I am a homeowner and, despite the math, I have chosen to pay off my mortgage. Looking at my investment returns, over the last several years, this makes me cringe. However, for me, there is a value in having no debt, that is beyond quantifiable measure, so that I won’t second guess this decision.
That being said, if you are considering home ownership, or are stuck in the difficult position on whether or not you should save for the down payment and financing as much as you can, or continue to rent, I would offer the following:
- Home prices are on average extremely high, but you can still find deals if you are patient and willing to look at the possibility of what a house can be rather than what it is currently. Each time my wife and I bought a home, we always did the best when buying something that needed a little TLC. It wasn’t always fun; but, financially, it was worth it.
- Finance as much as you’re comfortable with. Clearly, the numbers say that the big difference is on the lost opportunity cost of the down payment. This does, however, mean that you have the money to make the down payment. If you don’t have that money, then it doesn’t really matter as it won’t be invested otherwise.
- When all is said and done, I’m still a believer in debt reduction. There is something to be said for the peace of mind that comes from having no payments, and I strongly believe that a reduced loan payment term and an aggressive payment schedule is key to financial peace of mind. Despite what the numbers tell us, financial stress can destroy a family.
- Take a deep breath. If you’re renting and feeling anxious, take a second look at these numbers and realize there is absolutely NO rush! Somehow, we’re conditioned to believe that renting is throwing our money away when, in reality, nothing could be further from the truth. If you are not, yet, in a position to buy a home don’t rush it, and relax, knowing that it doesn’t make that much financial sense anyway. When people question your sanity, ask if they’ve ever really run the numbers, and then point them to this article and see what they say.
Side note – Yes, there are a million other variables I could have considered for this article. I realize that housing prices can appreciate more as well as depreciate. I realize taxes can go up considerably and maybe markets can crash. I went with some standard variables to keep things simple and to review against the previous several decades, which included one of the greatest ‘corrections’ in both real estate and the stock market.
For those interested you can download the spreadsheet where I ran all these numbers HERE.