Rent or Buy

You have to live someplace.                    Rent or Own a Condo Unless you're okay with living in your parent's basement indefinitely, you'll have to make a decision regarding your housing options, and once you're making a steady income, the main question is whether you should rent or buy.

Building Personal Wealth

For a long time, people have built personal wealth in their primary residences. There are many middle aged people in America today that have a net worth of over a million dollars, simply because they bought a house for $100K in their twenties. Over a long period of time, these homes have gone up in value due to inflation and the law of supply and demand. There are more people than ever.

These “millionaires next door” often sell their homes and move to cheaper markets when they retire and not pay taxes on $500K of the gain. That's a half a million dollars of income with no taxes! Now that's a good way to start retirement. But that's not the only way to benefit on the equity in one's home at the time of retirement. The other option that is growing in popularity is to stay put, but get a reverse mortgage that turns into cash flow back to the homeowners in their retirement years. In either case, buying a house can be the right financial decision, especially since the federal and state governments let you deduct the interest on the loans. This is particularly helpful in the first few years when your payments are mostly interest, and therefore mostly tax deductible.

Doing the Numbers

The calculator below will help you know if you can afford to buy verses rent. It takes into consideration the personal income tax deductions, and will give you a good estimate of the real out of pocket monthly mortgage expense in the first year of your home ownership.                     The dream-house on the lane. 

For example, the rental market in your city is such that you can rent a place for $1,000 per month, and that's a number you can afford. So, you use a principal and interest mortgage calculator like this one (CLICK HERE), and you figure out that the principal and interest on a $210,000 loan, at 3.95% for 30 years is $997. So, is that the right “rent or buy” comparison for monthly cash flow? The answer is no. If you pay income taxes, say 20% federal and 8% state (28% in aggregate), you can deduct your mortgage interest and the effective monthly mortgage expense on your $210,000 loan is $804.54. That's $195.46 per month less, AND you're building equity. CLICK HERE and enter your numbers to see this. Start with no tax rate and you'll get your standard principal and interest, but oddly enough, the more income taxes you have to pay, the cheaper your mortgage expense.

This calculator (CLICK HERE) will let you enter the monthly amount you can service (MP), interest rate (i), the duration of the loan in months (n), and your personal income tax rate, and it will give you an estimate on the principal amount on a loan that you can afford.

Upping Personal Deductions

If you don’t change your personal deductions, you’ll have to wait for your tax refund to see the savings due to the mortgage interest deductions.  But many people don’t like loaning money to the government, and choose to increase their personal deductions to match their expected tax rate.   This results in fewer tax dollars being deducted from your regular paycheck.  But don’t go spending that money on new stuff, that’s money that goes toward offsetting the bigger mortgage payment.

Down Side

There are, however, other negative things to consider.  The first is that the interest portion of your payment on a fixed rate loan goes down with time as you pay down your principal (see Parts of a Mortgage diagram).  That’s good news and bad news.  The good news is that you’re more rapidly building equity, but the bad news is that you have less interest expense to deduct, and the positive effect on your cash flow is lessened.  If the trends of the past continue, one hopes that inflation, if nothing else, will result in increased wages to compensate.

The other potential down side to buying verses renting is if the market goes down.  This doesn’t affect whether you can make your payments or not, but it does affect the equity one has in the home.  Again, there have been serious short term hits in this regard that have put people “under water” regarding their home’s debt to equity, but with time and inflation, one hopes to overcome this too.  Location seems to be the big factor.  If the local economy has a general upward trend, that seems to help the housing market recover, but if the local economy is reliant on industries that are gone for good, housing prices can stagnate or even decline for long periods of time.    Places like Detroit Michigan and Youngstown Ohio are experiencing this.

None the less, much more wealth has been made in the housing market than lost, and you have to live somewhere.