The Savvy Renter and The Slave Homeowner
25 July 2007
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There seems to be an ongoing debate lately about renting vs. owning a home. Of course, conventional wisdom, as well as my real estate agent brainwashing says that owning a home is the way to go. When you rent, you are throwing away money. Plus, homes appreciate and you’ll get rich by owning your own home. I regretfully say that conventional wisdom no longer applies to many larger cities and expensive areas in the US. If you live in an area where homes are over $500K, and you decide to own one, you’ll be a slave to your house forever and you’ll have far less money to invest and ultimately far less money to retire on. Here’s the story about Bob the slave homeowner, and you, the savvy renter investor. You both live in an expensive area and make the same amount of money.
The Down Payment
Before Bob becomes a slave to his house, Bob has to first work hard, be frugal and save up just for the privilege of becoming a slave. Lets say Bob needs $125,000 (25%) to put as a down payment on a $500K home. $125K is a large chunk of change in itself. Assuming he has to start from $0 and saves up $1000 a month in CDs paying 5.25%, Bob needs to be saving consistently for over eight years. If Bob works hard and live below his means, he can finally have enough money and the privilege to become a slave to a house.
The Mortgage Period (The Dark Age)
OK, so Bob saved up $125,000 to put as a down payment on the $500,000 home. Congratulations, Bob’s a homeowner after he pays the thousands in closing costs. He’s also the owner of $375,000 in debt. His monthly payments at a 6.25% interest rate is $2308.93. Bob’s also responsible for property taxes, which is $6250 a year assuming a 1.25% rate, insurance at $1000 a year, all utilities and any maintenance required on the house. During the duration of the mortgage, Bob’s wants don’t come first anymore, the house comes first. The house payments must be paid before anything else, otherwise Bob loses the house and all he worked for.
You, on the other hand, can rent a place in the same area for $1800, leaving you with about $1200 a month to invest as opposed to Bob. Remember some of the utilities are covered when you rent, and no more maintenance or property taxes will be paid by you. While Bob is paying the monthly payments to the bank, you’re investing in an index fund returning 8% a year. In comes the power of compounding interest. If you put $125,000 into the index fund instead of a down payment on a house, and consistently invest the saved $1200 each month from renting, over these 30 years you will have a whopping $3,155,397. Of course it can be more or less due to taxes and fluctuations in returns, but this number is for the sake of example.
The Paid-Off Period
Ok, so Bob worked hard over the years and he never missed a payment. Over 30 years he will have the $500,000 home plus the appreciation. Even if the home appreciates at a consistent 4% a year, the house will be worth $1,656,749 in 30 years. When The Simple Dollar released an article on renting vs. owning, the author, Trent pointed out that after the mortgage period, owners like Bob would have much more to invest. That is true, without the mortgage, Bob can now invest the entire former house payment of $2300 a month while you, the renter is still investing only $1200. The problem here is that this only happens after the 30 years of mortgage repayment. Even if Bob paid off the house sooner than the full 30 years, we’re still talking at least 20 years. What makes investing and compounding returns powerful is by starting soon to get the ball rolling. Bob is only starting to get the ball rolling after 20 years.
Another significant difference here is opportunity cost. Although Bob has an asset worth $1,656,749.01, he cannot invest that. He never sees that cash unless he sells the house. Even if the house continues to appreciate at 4% a year, Bob never sees that. However if the housing market takes a hit, like how it has now, Bob can lose a large chunk of his net worth since he has so much tied into his house. You, the renter just have to make sure your rent is paid on time, but that should be a piece of cake considering you have over $3.1Million dollars according to our estimate above. That money can be invested in anything you want at any given time because its not stuck in your house. It has the ability to continuously make 8% a year return and you are still adding to it each month. Sure, your rent payments will never stop for the rest of your life, but the interest earned from your large nest egg will easily pay for it.
My Conclusions
Surely you can see the benefits of renting by now. I’m going to say that people living in areas where a house is over $500,000 will do better renting. For instance, if I stayed in the city I was born and raised in, San Francisco, I would rent. There is no doubt about it. I will be a lot richer if I rent if I decided to stay here. However I’m not doing that, I’m moving to an area with cheaper real estate and I will buy a home around $200,000. The determining factor here is where you live and the current home prices. I suggest anyone living in an area with prices ranging from $400K+ to seriously do the numbers. You should find that renting is a better choice and a better path to wealth.
While I agree with you that renting is sometimes a better option. However, I do disagree w/some of your example. First off, you have Bob save up 125K for a down payment, but then compare that to 200K that the renter would have for an index fund. Those numbers don’t match. If you’re wanting to include the closing costs into the expenses, then it would be something more along the lines of 135K. Also, you don’t happen to include the fact that rent typically goes up. In an expensive real estate market, chances are rent is going up a decent amount every year as well, so it would probably only take about 5 MAYBE 10 years until the renter is paying the same, if not MORE in rent than Bob is on his mortgage. That is one beauty of a mortgage…your monthly payments don’t go up (as long as you stay away from variable rate mortgages).
I’m not saying homeownership is correct for everyone (my wife and I made the mistake of buying one, and selling just two years later…we lost ~8K on it after closing costs, plus the upgrades we paid for, etc), but anyone looking at if it makes sense really needs to run ALL of the numbers.
Great Post, and I couldn’t agree more.
I live in an area with reasonable housing values, Pittsburgh PA, and I still haven’t taken the home ownership plunge. Because I’ve rented, same place for 4 years, as my salary has gone up I’ve been able to save more and more of it because outside of a small annual increase the rent has remained stable.
This has allowed me to accumulate a nice nest egg I would no longer need to add to to retire comfortably.
If you are under 30 and your family circumstances don’t dictate the need for the space a house provides it makes no sense to me to buy a house if you have the discipline to save.
Thank you both for your comments. mjmcinto you are absolutely correct. That was actually a mistake because I was initially planning to use a higher priced home as an example and a $200k down payment. I decided to change it since not everyone lives in such high priced areas and I forgot to change the renter’s number back down to $125K. The end numbers don’t change much however.
I do agree with you that rent typically goes up, however even in a high priced area like San Francisco, rent goes up AND goes down as well some times. It’s purely a reflection of demand. The funny thing is when homeownership is up, rental demand is typically low and vise versa. Although I do agree with you that it typically does go up and that should be accounted for. But I still think in the long run, including all the real numbers in the equation, the renter comes out on top.
Anyway, keep those comments coming. Its great to get reader perspectives. Thanks all
Surely mortgage interest of that amount would make a serious impact on your tax burden, which could then be invested? The renter will pay taxes on every cent of his rent. I haven’t done any numbers, and am not sure how big an impact it would have. Should help though.
Although it’s pretty easy to show that home ownership isn’t always the right financial choice, it’s important to remember that home ownership isn’t 100% an investment decision. I was a renter until my mid-30s when I took the plunge into buying a house (in the New York area, right before the run-up, I should add). I did not do this because it was the best financial decision. I did it because I wanted a home that I could own, improve, grow into a neighborhood, etc. I am sure it’s possible to do this as a renter, but my rental experience was to be surrounded by people moving in and out and never really putting any “sweat equity” into the place I lived in. I was living in apartments, so maybe it would be different if you rented a home long-term, I don’t know. But I think this is discounted too often.
Buying a home is not strictly a monetary decision. I wouldn’t buy my home today because the cost/benefit wouldn’t be there. The northeastern US has seen, in my opinion, an irrational increase in prices in the last three years. But I still think that I prefer owning a home from an emotional/psychological point of view. I feel more ‘at home’ in my house than I ever did in my apartments - and again, maybe that’s just a function of where I lived. Good post - always a good debate over this.
Hi Richard,
Yes there are tax benefits to paying a mortgage, however even after the write-offs I believe the renter will still come out far ahead. It just depends on specific numbers and specific situations.
Hi BB,
I do agree with you that homeownership is not purely a monetary decision or necessarily an investment. It does have emotional/psychological impacts to consider, however, I believe there is actually more NEGATIVE emotion/psychological impact. You have the pride of ownership, no doubt about that, however you also have the emotional burden of knowing that large monthly mortgage payment is coming up each and every month. You also dreadfully anticipate that bi-annual property tax bill. I would even go as far as saying the renter also has a lot of emotional and psychological advantages. The renter knows he/she doesn’t have to worry about anything breaking, there is no maintenance required on their part. There is no property tax. All that is on their mind is the rent, which we can see is a lot less than what the owner has on their plate. They even have the benefit of knowing they can pick up and leave if they find a better housing situation of if there is any issues with the neighbors, area etc. Imagine you just bought a home and find out your neighbors are jerks, the crime is higher than you expected and your car got stolen. If you decide to move, you have to pay 4-6% in selling costs plus closing costs, which is tens of thousands.
All in all, it depends on actual numbers and situation, and ultimately personal wants/needs. After writing all this, I’m not even going to rent myself, I’m going to buy next year because I’m moving to a cheaper area and using specific numbers, owning makes more sense for my situation.
Keep those comments coming, I appreciate all your input.
That’s all true (with one exception). I rented for 20 years for that reason - I kept moving around and it was a lot easier to be free of the burden of ownership and the attendant difficulties of selling, costs of selling, etc. I think you and I are arguing the same point - a large part of the renting vs. buying equation IS emotional, it just depends on which your emotions prefer. At one point in your life renting will make sense, and at another buying will. Whether it works out or not after you’ve done it is probably another question.
The only thing I disagree on is the property tax. If you’re a renter, you’re paying property tax. It’s just buried in your rent, but your landlord is very definitely not just absorbing those costs himself. The advantage there is that if the city/county suddenly hikes the tax rate, your landlord can only pass on those costs when the next lease renewal comes around, so you have a choice to accept it or not.
BTW, too, the tax write off advantage depends a lot on your situation. If you are in a low tax bracket or low tax state, it may not help as much. In my case I’ve got a high income (compared to the national average but average at best for the NYC area) and very high state/fed/city/property taxes, so the mortgage interest tax deduction is VERY significant to me. If I ever trigger AMT and lost that mortgage interest deduction I’ll have to flee the country, practically…
Hi BB, agreed. There are a lot of factors involved and perhaps it comes down to personal choice, preference, risk tolerance, financial situation, zip code, etc. The answer remains “it depends”.
As always, thanks for your insight.
[...] The Savvy Renter and the Slave Homeowner - Some people insist you need to own a home to achieve wealth, others say renting is the way to go. Who’s right? There is no right or wrong answer, but the Money Socket illustrates the situation nicely. [...]
Note that San Francisco has rent control for all units.
The rent you pay will go up slower than inflation.
The longer you rent, the less you pay (after inflation).
John that is an excellent point. Thats another plus for the renter in high priced areas. I can safely conclude one thing with this analysis; a San Francisco renter will likely build more wealth in a lifetime than an owner if all other variables remain the same.
Other factors:
1) Reverse mortgages.
After all, if the house is worth $1.6M, Bob could take out a reverse mortgage, which should more than cover the utilities, taxes, and insurance on the house. So his housing expenses are effectively paid for as well.
And incidentally, a housing increase of only 4% is rather low-balled. Every area is different, but we have only gone down to 7%/yr, after 6 previous years of 10% appreciation in our house (newly built house purchased in 2000).
2) Family (i.e. children) … it’s not always a good thing to move around every couple of years.
3) Tax write-off of mortgage interest. So, the 6.25% interest rate for the mortgage can easily come down to 4% or less, by lowering Bob’s effective tax rate. Ours is an example of such a thing: Our upper tax bracket is easily into the 25% rate, but our effective tax rate (due to child-tax credits, mortgage interest, and property taxes), was 2.49% this past year - for the federal taxes of course.
Like you said, you have to examine every single item in order to make a complete assessment.
Thanks for the reply Chris, for a few days your comment got sent to the comment spam box, I just recovered it. Sorry about that. You make excellent points. Although I truly don’t believe that 4% a year is low-balled. That is about the average home appreciation over the past 30 years nationwide. However, like you said as of late in hot areas we’ve seen appreciation of up to 10%, you probably live in one of those areas, as do I but that is why there is a correction happening right now. I just can’t see how homes can continue to appreciate beyond 4-5% just based on inflation. Salaries aren’t increasing at the same pace, sooner or later people just won’t be able to afford the mortgage let alone that higher property taxes which never end. Anyway, great points, many to put into consideration. Thanks again for commenting
Thanks for the response Danny.
As for housing not being able to appreciate at a higher rate than 4-5% based on inflation, is almost a moot point. That is, after you take into account that those who make minimum wage are supposed to get a 38% pay raise over the next 2 years. I arrived at this figure by taking the current $5.15/hr rate for minimum wage, and the fact that it’s supposed to go up to $7.15/hr within the next 2 years (I believe).
I wholeheartedly agree that salaries aren’t necessarily keeping up with inflation (in general). I’ve only received 1.75% increase last year, and I was really lucky that I received a 2.5% increase this year. However, both years were more than enough to offset my additional expenses (i.e. increase property taxes, etc.), since I have a pretty high gross income (higher than twice the nationwide average). But we live in NJ (a very high property tax state).
People won’t be able to afford the mortgage, if they were foolish enough to get an ARM with one or more the following true:
1) prospect of the rate not going up too much
2) not paying the mortgage down aggressively while the rate was so low
3) dependency upon 2 incomes to make the minimum monthly PITI
4) not assessing the possible increase in utilities if they bought a larger house
I truly feel sorry for the folks that are in these 2 categories:
5) possible layoff of one or more jobs
6) medical issues coming up
“It just depends on specific numbers and specific situations.”
That’s the key. Living in San Francisco, we are in vast minority to the rest of the nation. Things are HUGELY skewed towards the renter here. However, one can imagine a place where the rent is $3,500 for the equivalent of a $500K home. In such a scenario, it probably is best to buy.
In the New York area now it’s either rent a one-bedroom for $3000 a month or buy a studio apartment for $1 million. Fun choices. I’ll end up like Danny and move somewhere cheaper… time to hit monster or indeed.com and find a job in Florida…
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