Investing Myth: Buying a Home is Always a Good Investment
Blog post
03/20/24In a previous blog, we deconstructed a common investment myth about market returns. We will continue with that theme by going through another common investment myth about home buying. No matter if it is your first time or tenth, buying a home is an important life event. One myth that is common to hear is the fact that ‘buying a home is almost always a great investment’ and should be part of a good wealth-building strategy. Here are two common quotes you have likely heard some variation of before.
“Paying rent is just throwing money down the drain”
“Buying a home will allow you to save money while you pay down your mortgage”
While these quotes can be true at times, I would argue that they are not always true. I would also argue that in most cases, renting is the cheaper option than buying a home.
Opportunity Costs
First, start by trying to guess what percentage of your monthly payment is going towards interest and what percentage is going towards principal. When you think about the difference between renting and paying interest on a mortgage, they are theoretically the same. In the renter’s case, you are paying a landlord while in the homeowner’s case, you are paying interest and principal to a bank. This generally would favor a homeowner assuming most of your mortgage payment was going towards principal, but that isn’t the case for new homeowners.
For a new homeowner with a 30-year, $500,000 mortgage with an 8% interest rate, your monthly principal and interest (P&I) payment equates to $3,668.82. The real problem isn’t the amount of the payment, it’s the fact that approximately 91% or $3,333.33 of that total payment is going towards interest only. That leaves just 9% or $335.49 being “saved” by lowering your mortgage principal. Can you rent for less than the interest portion of that payment? My guess would be a resounding ‘yes’ in most cases.
Second, renters don’t have to worry about ongoing maintenance as well as the potential risk of large one-off expenses. You pay rent each month and there isn’t anything else to worry about. The average annual maintenance cost of home ownership is between 1-3% of the home value per year. If we use 2% for the annual maintenance cost on a $500,000 house, that equates to $10,000 per year or $833 per month. That cost can add up for homeowners, whereas renters could save/invest that amount instead.
Third, homeowners are required to pay property tax each year. Depending on where you live, this also can be quite expensive. If you take Ohio as an example, the effective tax rate for property tax is 1.59%. Applying that to a $500,000 home purchase, you are paying $7,950 per year or $662.50 per month. This is another area of cost savings for a renter.
Fourth, homeowners are required to pay home insurance to protect against a catastrophic event. The average cost of a homeowners policy for a $500,000 home is $3,878 per year. Someone who is renting might have to purchase a renter’s policy, but in comparison to home insurance, that is very small.
Comparison: Renting vs. Buying
If you add up the additional expenses, which really are opportunity costs, home ownership can be expensive. Between maintenance ($833/month), property tax ($662.50/month), and homeowners’ insurance ($323/month), that’s an additional $1,818.50 per month which is on top of your P&I payment. Assuming you can rent for $2,500 per month, the marginal cost to own is $833/month ($3,333.33 interest only – $2,500). This equates to a grand total of $2,651.50 extra you are paying each month.
If you take the opportunity costs and invest that money instead of buying for 5 years, assuming you can earn 8% per year, you will accumulate savings of $159,143. To calculate the “breakeven”, your house value would need to increase by that same amount. The same $500,000 home needs to appreciate in value to $669,143 which is an increase of 31.83% or 5.68% annualized. To give you a reference point, the national average for home appreciation over the last 25 years is 3.9%.
Lastly, we can calculate the cost of owning vs renting. Assuming your house did grow at the national long-term average for 5 years, your house value would be $605,407. If you take the difference between the national average and the value of your savings plus growth over 5 years, the opportunity cost of buying a home vs. renting is $63,736 ($669,143 minus $605,407) which is $5,311.33 annually.
Conclusion
All of this is not to say that owning a home shouldn’t be a priority OR that it can’t be financially rewarding. I am saying that there is a common misconception about renting, and in many cases, it might be the better option. Additionally, you could argue that for a house to be considered a wealth-building asset, you need to buy the right house, at the right price, at the right time. If you don’t do all three of those, you really aren’t any better off financially (emphasis on financially – there are other benefits that aren’t financial) than renting. If you find a house in the right area for the right price, you could very well be better off buying, but just be aware that is surely not always true.
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