Home ownership is the American Dream! Of course you should own a home. Plus it’s a great investment!
Right…?
Maybe not.
Buying a home can offer some tremendous benefits. Some of these benefits are financial and some are purely emotional.
It’s difficult to quantify some of the non-financial benefits. These include pride of ownership, having a place to raise your children, having peace of mind knowing that your landlord can’t kick you out, and more.
However, because these benefits differ from person to person, the focus of this article is to quantify some of the financial considerations that we face when deciding whether to rent or buy.
Without knowing your personal financial situation, let’s take a look at three of the most common financial reasons people give for buying homes:
Reason #1 Buying a home is a great investment.
Conventional wisdom tells us that buying a home is a great long-term investment. In fact, some studies show that many Americans think that home ownership is the best investment we can make, beating out investments in stocks, bonds, and gold.
But history would suggest otherwise.
Robert Shiller, a Nobel Laureate and a professor at Yale University, showed this in a recent study that he conducted. He showed that home prices over the past roughly 125 years have barely outpaced inflation.
During this time, stocks and bonds have both significantly outpaced the price increase of homes.
In an interview with US Today Shiller said:
“If you look at the history of the housing market, it hasn’t been a good provider of capital gains. It is a provider of housing services…Capital gains have not even been positive. From 1890 to 1990, real inflation-corrected home prices were virtually unchanged.”
There have been periods of prolonged growth in home values. And home value growth varies greatly in different parts of the country. However, over the long-run there isn’t much evidence to support the claim that owning a home is always a superior long-term investment compared to other investments.
Will things be different moving forward? Only time will tell. But 125 years of history shows us that owning a home doesn’t provide much in terms of investment value in excess of inflation.
Reason #2 I’ll lose out on tax benefits if I don’t own my home.
This is true. You don’t get tax deductions for paying rent. Part of your mortgage payment, on the other hand, is tax deductible.
This is kind of good and kind of bad.
The good – anything you pay the bank in interest (based on a mortgage of up to $750,000 for new buyers) can be deducted on your tax return.
The bad – You only get a deduction for the portion of your payment that doesn’t go towards paying principal. In other words, you’re getting a tax benefit for the portion of your payment that doesn’t increase equity in your home.
Let’s look at an example. Assume your combined federal and state tax bracket is 35%. Let’s also assume that your mortgage payment is $2,000/month, with $500/month going to principal and $1,500 going to interest. (It might seem hard to believe that the numbers are this skewed, but for the first few years of a mortgage don’t be surprised if more than 70% of your payment just goes to paying interest!)
Ok, now back to the example. With that $2,000 payment, you won’t be able to deduct the $500 that went towards principal. You will only be able to deduct the $1,500 that went towards interest.
Now here’s how this impacts your tax bill – you essentially get to deduct your total interest payments for the year multiplied by your tax bracket. So, if your combined tax bracket is 30%, then you would be able to deduct $450 of your $2,000 payment (30% x $1,500 = $450).If your combined tax bracket was 50% then you would be able to deduct $750 of your $2,000 payment (50% x $1,500 = $750).
So even if you are in a tax bracket as high as 50%, keep in mind that to get the $750 benefit shown above you would have to pay the bank $1,500 in interest.
If that’s still appealing to you then I’ll make you a deal – if you give me $1,500 then I would be happy to pay $750 of your tax bill for you 😉
Although the benefit of your mortgage interest deduction becomes more attractive as your tax bracket grows, it will never fully offset the interest expense in purchasing a new home. Tax benefits alone do not justify buying a home when compared to renting.
Reason #3 I’d rather build equity in my own home rather than pay someone else’s rent.
Yes – I know that writing someone a rent check each month is a tough pill to swallow.
And yes – I know that your parents bought a home 30 years ago and since then the price has tripled. Amazing, right? Well, not necessarily.
An asset that triples in value over 30 years means that it has grown about 3.7% per year. Compare that to a stock market index like the S&P 500 over the past 30 years which has grown by about 8% per year, and you see that home value appreciation isn’t as spectacular as we might initially think.
Now, of course, this isn’t the best comparison since you can live in a home, but you’re going to have a tough time figuring out a way to live in the S&P 500. So the counterargument to this would be that it’s better to have an asset that “only” grows at 3.7% per year than to pay rent to someone else and not have any asset to show for it. That’s true. Kind of.
Let’s take a look at a semi-real life example of how owning a home compares to renting when it comes to building equity and investment value.
I live in north county San Diego so I’m going to use median home prices and rent prices here. I know this isn’t indicative of prices countrywide, but the same concepts apply.
Let’s start with some assumptions. I know that these numbers will vary, but here are some generally close numbers.
- You want to purchase a $600,000 home.
- You have $120,000 in cash for a 20% down payment
- You will borrow the remaining $480,000 to complete the purchase.
- Your total mortgage payment will be $3,049/month, broken down as follows:
- Principal & Interest: $2,432/month (assumes 4.5% interest rate on 30-year loan).
- Property Taxes: $550/month (assumes 1.1% property tax rate).
- Homeowners Insurance: $67/month (an assumption based on averages)
- It’s possible you can rent the same home for $2,400/mo.
Those are the assumed facts. Now here’s what we need to do in order to complete an accurate comparison in our analysis – compare the value of home ownership after 30 years with the alternative of renting a home and investing the difference.
In other words, we have $3,049 per month to work with in each scenario. In scenario one, that whole $3,049 is going to be applied toward paying for a home over 30 years. In scenario two, part of that $3,049 is going to be used to pay rent, but the remainder is going to be invested
Let’s start with the investment value of purchasing the home. You invest your $120,000 into the home and you apply $3,049 per month towards the mortgage payment until it is paid off in 30 years.
Let’s assume that the value of your home will grow by 4%. This means that your $600,000 initial investment in your home would have grown to $1,946,039 over 30 years. Not bad! Someday your kids will look back and say “Remember when mom and dad bought a home and it only cost $600,000!”
Now let’s compare that to the investment that you could have made if you chose to rent instead.
In this analysis, you don’t have any home ownership that will appreciate in value over the next 30 years. However, what you do have is that $120,000 that would have been used for your down payment.
Instead of purchasing a home let’s assume that you invested that money. And let’s say that over the next 30 years you earn an average annual return of 8% on that investment. Under those assumptions, your $120,000 investment would have grown to $1,207,519.
But that’s not it. In the home purchase example, the total monthly payment was $3,049, but rent for the same house was only $2,400. That’s a difference of $649/month.
So to give an accurate comparison we need to see what would happen if that $649/month were invested. Still assuming 8% average growth on our investments, investing $649/month over the course of 30 years would grow to $881,918.
Now, when we add $1,207,519 (future value of a $120,000 investment over 30 years) to $881,918, we see that the total “investment value” of renting over owning in this example comes out to $2,089,437 over 30 years.
In other words, until your mortgage is paid off it can potentially be a better investment to rent rather than own a home!
This analysis doesn’t take into account how the investment value changes once your mortgage is paid off. After the mortgage is paid off you would own a paid-for home and you wouldn’t have to pay rent either. So from there on out the investment value of a home tends to increase relative to the investment value of renting.
So let’s back up a step and make one thing clear.
Is this calculation overly simplistic? Yes.
Are there factors involved that are not taken into account here? Absolutely.
Here’s a short list of factors that could change this analysis:
- Changes in home value growth rate
- Changes in stock market growth rate
- Different mortgage interest rates
- Not staying in the same home for 30 years
- Broker fees
- Cost of home repairs
- Different home values in different parts of the country
- Different rental prices in different parts of the country
- Mortgage insurance
- Much, much more
For the sake of brevity, I left these factors out. If you want to see a more comprehensive calculation then let me know and we can nerd out on this together. For everyone else, this analysis should show the basics of the point we’re looking to analyze.
Final Considerations
I know it probably seems like I’m steering you away from home ownership. Please know that’s not the case! I’m simply trying to help you fully consider all the quantifiable aspects of your decision.
There are plenty of reasons to own a home. It can give you a sense of security. It helps you feel more connected to your neighbors and community. It gives you a place to raise your family. In addition to all of this, many people credit owning a home with bringing them a sense of pride and accomplishment.
So go ahead! Own a home! Just know that while home ownership offers many benefits, investment value may not be one of them.