Wednesday, May 21, 2014

Own or Rent?

You go to the bank and you notice that advertisement comparing the value of home you could own if instead of rent you were paying a mortgage. It looks like home ownership is the clear cut choice. Don't you want to have your money going toward ownership in a house instead of making the land lord rich? The answer may be no. It doesn't matter how much your apartment complex is making off of your rent. What matters is what is best for you.

Purchase your home when R > A + (L*i) (1-T) + t

What the heck does R > A + (L*i) (1-T) mean? You were probably looking for practical advice and now I'm throwing a formula at you. Don't worry, I'll walk you through it.

R > A + (L*i) (1-T) + t

R = Annual cost of renting                                                       
A = Additional costs of home ownership           
L = Loan amount
i  = Annual mortgage interest rate
T = Tax bracket
t  = Estimated tax savings outside of the mortgage interest deduction

Keep in mind that this formula compares living in a house versus renting for the next year. It makes sense that it is time to switch up your living situation the year that it is less costly to live in a home versus rent.  

As I go through these, keep in mind that you are going to have to make assumptions. However, the closer your assumptions are to reality, the more accurate the formula will be. I recommend putting this into an Excel spreadsheet and so you can play with the numbers and see how it affects your result.

R – Annual cost of renting
Simply multiply your rent payment each month by 12.
E.g. Rent payment = $900
R = 900 * 12 = $10,800

A – Additional costs of home ownership
It is inevitable that you will end up spending more money on your house than your apartment. Remember that home insurance plus property taxes will more than likely be added into your monthly mortgage payment. Also there are just different tools and things you end up needing, even in a brand new house. Lawn care is a drain in particular. Is the move going to add to your commute? Add in those extra fuel costs. Especially if you are buying an older home, plan on a repair budget. Does your price range leave less than what you desire in a house and you plan on some cosmetic uplifts within the first 12 months? Add in those costs. Your utility costs will probably go up to…

I’ll use $400/month ($4,800/yr) for my example.

L – Loan amount
You can estimate how much you expect to borrow by adding the cost of the home minus what you are going to put down. Keep the closing costs in mind; you may not be able to put down as much as you thought. There will be a lot of incidental moving costs around that time frame as well and you’ll be adding a huge liability to your books so my suggestion is to avoid completely depleting your savings for the down payment.

This is the variable that I toyed with the most. I explored this process further in an How Big/Nice of a House to Buy. For the example let’s say you are looking at buying a $150,000 house with $5,000 in closing costs. You have $20,000 to put down. Whether you roll the costs into the loan or not, or the seller eats the closing costs in lieu of a higher sell price, you’ll end up with a $135,000 loan. 

i – Interest rate
There are several factors that determine the interest rate you would pay for a home loan.
         Credit score
         Down payment in comparison to home value
         Term of loan
         Current economy
If at all possible, I highly recommend a 15 year mortgage. You’ll start paying off principal early in the life of the loan plus you get a lower rate. This equals tons of money saved. I ended up with a 3.75% rate, so I’ll use that for example.

T – Tax Bracket
What is your marginal tax bracket? This helps you estimate the tax benefit of all that money going toward your mortgage interest. You should pick the bracket based off the tax bracket that you would otherwise pay taxes on. For instance, if you are single and make $40,000/yr your top bracket is 25%. However, if you plan on $4,000 of charitable tax deductions then your taxable income without the mortgage interest reduction is 15% and that is what you should use.

t – Tax credit effect
Is there a tax credit available to you? If so, your estimated tax savings is the amount of the tax credit times your marginal tax rate as discussed above. Keep in mind the risk that you’ll have to pay the credit back. If that risk is high, you should discount or exclude it in your calculation. Tax credits literally reduce your taxes by the amount of the credit. I will assume there are no applicable tax credits. 

In Conclusion
Plug in the variables (R = 10,800, A = 4,800, L = 135,000 i = 0.0375 T = 0.15 t = 0)
R (10,800) is greater than the right hand side of the formula ($9,103) and therefore according to this calculation, you should buy a house because the expense to rent to greater than the expense to buy. My concept here is to compare the expenses of home ownership versus renting. Expenses are those things you pay for that does not enhance your financial net worth. From a purely economic perspective, your decision should be made on what is best for your net worth. There are numerous considerations in the own vs. rent question that were not captured in this formula but hopefully this helps quantify some of the thoughts swirling around in your head.

As you go through this thought process, keep in mind that what you buy does not have to be a single family detached home. There are so many possibilities, maybe you’d rather buy your share of a duplex or perhaps a condo would fit you. It is just a matter of discovering what is best for you. Have fun and good luck!

Are you thinking of becoming a home owner? What are you doing to help with the decision? Leave a comment below.

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