Rent vs. Buy

HAPPY TAX DAY! ย To all you homeowners – congratulations on the mortgage interest write off. ย To all you renters – take a read…

 

The Misleading Math Behind the Rent vs. Buy Calculation

By Jonathan Smoke |

 

Thereโ€™s about $13.1 trillion stashed away in the United States, in plain sight. Where? In our homes!

Do we have your attention yet?

Thatโ€™s the total value of the equity held by over 75 million U.S. homeowners, according to the latest estimates from the Federal Reserve Board. And that works outย to almost $175,000 per owning household.

This is unmistakable evidence that homeownership is a criticalย building block of household wealth.ย Owning a home is a key reason why the median net worth of a homeowner is almost $200,000 while the median net worth of a renting household is just over $5,000.

Sure, part of that is because owners were able to pony up a chunk of money to put down on a house, and to qualify for a mortgage. But the act of paying for a mortgage actually helps produce more wealth, by freezing payment amounts and building equity through forced savings.

A 30-year amortized, fixed-rate mortgage is a beautiful thing. It provides an affordable path to buying a home while locking in todayโ€™s cost of that home for the life of the loan.

The traditionalย rent versus buy argument compares the total monthly costs of buying a home with a mortgage with the corresponding rent. So that comparison is relevant when it comes to representingย the housing choice trade-off in clear cost terms.

Two years ago, that head-to-headย heavily favored buying, thanks to very low mortgage rates and lower prices. Back then, more than three-quarters of the counties in the country saw lower buying costs than renting costs.

With prices and rates higher now, less than half of the counties in the country see math that favors buying.

But those raw numbers hide the fact that unlike a rent check, a percentage of every monthly mortgage paymentโ€”after the lender is paid interestโ€”goes toward the ownerโ€™s home equity. That means itโ€™s really a forced savings plan.

Over time, less of the mortgage payments go toward interest and more go toward equity, so the savings power is enhanced further.

Hereโ€™s how that works out for a median-price home of $250,000 bought in January with 20% down with a monthly payment of $976.

Before their first payment, the proud new homeowners had $50,000 in equity thanks to their down payment. (Actually, 20% down isnโ€™t always typical or necessary, but, hey, it keeps this illustration simple.)

In the first year, an average of 29% of the monthly payments builds equity. After 12 payments, the homeowners have just over $3,400 in added equity.

By year 14, 50% of the monthly $976 payment goes toward equity. Donโ€™t forget that the monthly payment hasnโ€™t changed, because the interest rate was fixed.

At the end of the 14thย year, just shy of $64,000 has been added to the initial $50,000 in equity.

In the final year of the 30-year mortgage, while the monthly payment remains $976, 98% of the monthly payments builds equity until that magic day when the home is owned free and clear.

Think you can beat that with rents? Researchers at Harvard put it this way:

โ€œWhile studies simulating the financial returns to owning and renting find that renting is often more likely to be beneficial, in practice renters rarely accumulate any wealth. In no small part this seems traceable to the difficulties households face in trying to save absent either a clear goal or an automatic savings mechanism.โ€

So, you want a better rent versus buy illustration? First, find a place to rent for no more than $976โ€”the same as our mortgage payment example above. If you can rent for less, great. Will you be able to save that difference amounting to at least $3,400 in the first year? That would imply you can really pay only about $700 in rent to get the same savings effect.

If you canโ€™t save $3,400 yourself by paying less inย rent, ask the landlord if heโ€™llย take a portion of your rent payments and set it aside for your rainy day fund.

Then ask the landlord if heโ€™llย set your rent payment atย todayโ€™s rateย for the next 30 years. And before you close the deal, ask himย to raise the rainy day share each year by 1% to 2% until year 30, when heโ€™llย getย only 2% of the rent payment.

Clearly, this would not be easy to do.

Even if theย house only keeps pace with inflation over 30 years, which is a very conservative assumption, the forced savings inherent in a mortgage guarantees a homeowner isย building wealth. A renter household has to be extremely diligent to amass the same savings that the good olโ€™ 30-year mortgage does automatically.

 

I read this article at: http://www.realtor.com/news/trends/misleading-math-rent-vs-buy/?identityID=9851214&MID=2017_0224_WeeklyNL&RID=353497822&cid=eml-2017-0224-WeeklyNL-blog_1_misleadingmathrentvsbuy-blogs_trends

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