Low Inflation Helps Your (Taxable) Portfolio
The U.S. tax code is famously complicated. Congress, over decades, has enacted tax measures (and...
We want to be transparent about how we are compensated. Some links in articles are from our sponsors. Learn more about how we make money.
I was in my late 30s and still renting.
I’d completely bought into the American Dream, so I knew I was throwing away money each month.
I knew I had to do something about it, but somehow just thinking of scraping together a down payment, and worse, committing to paying a mortgage payment on pain of losing the house, seemed overwhelming.
When I shared this with a friend, his response made all the difference.
He simply asked if I really knew I couldn’t come up with the down payment and afford the mortgage payments, or if I was simply assuming it.
Deer in headlights moment…
Ummm, I guess it was really me assuming it…
When I got home, I dug out an email someone had sent me a couple of weeks earlier. I can’t even remember who had sent me that email, but he suggested that if I ever needed a mortgage, I should contact the lender he worked with.
I called that lender, who suggested I take out a first mortgage for 80% loan-to-value (so I wouldn’t have to pay private mortgage insurance) plus a second mortgage of another 10% or 15% (so I could afford the down payment).
Firing up my Quicken, I realized that the monthly payments on those two loans were doable even with my modest income. Also, a 5% down payment plus closing costs on a $175k home would be $10k, which I could scrape together without unacceptable stress.
A couple of months later I bought my first home.
When I sold it after 5 years, it had doubled in value, increasing my then-lamentably low net worth 5-fold.
About 15 years later still, not only do we live in our forever home, we own and lease out our previous home.
Even (or perhaps especially) as a landlord, I’ll tell you that buying your own place generally makes a lot more sense than renting (though if you want to rent my property, I’m happy to take your money :)). However, there are certain situations where renting makes sense:
Over the past week or so, I’ve read several articles where people say that renting is financially better than buying, or that this is so if e.g. you can rent a place for less than 5% of the cost of buying the place, divided by 12 – the so-called 5% Rule as quoted by Ben Le Fort.
These fly in the face of my experience, so I decided to do what my friend told me to do back before I bought my first home – do the actual math so I know, rather than assume.
At best, any data analysis is only as good as the assumptions it’s based on. For example, having your home double in value in 5 years can happen, as it did for me, but you can’t assume that it will. Thus, I used data from Yale’s Case and Shiller for average appreciation rates for residential US real estate, average inflation, and average stock market returns. If you’re interested in my full list of assumptions, I share those below.
Some articles point out that when you buy a home, you shouldn’t count on its value or even on your equity. I’d argue the point, since you can borrow money against your equity by refinancing or opening a home equity line of credit (HELOC).
Once you’re older, you can even take out a reverse mortgage to create an income stream until you die. These should not be your first option when planning your finances, but they clearly show that you can benefit financially from your home equity.
Still, if we ignore the financial value of your equity, here’s how the costs of buying compare to the costs of renting. Note that the blue markers (buying) start at above $100,000 due to the high initial cost of the down payment and closing costs. However, as the years go by, your lower annual costs make the slope of the line low. The gradual downward curve is due to inflation gradually reducing the real cost of your mortgage payments. Past Year 30, you’ve paid off your mortgage, so costs drop dramatically. As the red markers (renting) show, your real annual costs are higher than the real annual costs of owning (except for Year 1), with the markers curving up because rents on average follow real estate values, which appreciate slightly faster than inflation.
Total inflation-adjusted cost of owning a home (blue) vs. renting a similar home (red). The data show that starting in Year 10, cumulative real costs for renting are higher than for owning, even accounting for the high initial cost to buy.
However, even if we don’t want to count the equity while you live in the home, a fair comparison must look at what happens if you want to leave the home, whether you rent or buy. In the latter case, you would sell, getting back your equity minus the closing costs of selling (assumed to be 6% of home value). The second graph shows this comparison, again using blue for buying and red for renting.
Total inflation-adjusted cost of buying a home and then selling it (blue) vs. renting a similar home (red). The data here show that past Year 2, buying and selling wins over renting, with the cumulative savings exceeding the value of the home before Year 20!
The data for renting (red) is unchanged relative to the previous plot. The big change is obviously in the blue, showing the data for buying and selling. Note that each year’s number assumes you sold exactly after that number of years.
The data show that if you sell at the end of Year 1, you recover a significant portion of your down payment, but the combined 7.5% closing costs of buying and selling far outstrip the minimal home appreciation. This results in a significant loss should you buy and then sell after a single year.
However, if you hold off until the end of Year 2, the higher annual cost of renting brings the buy-and-sell scenario slightly ahead of renting.
More importantly, by the end of Year 10 (a typical home ownership period), renting ends up costing you nearly $250,000 more than buying and selling! That’s almost half the assumed $500,000 initial value of the home!
By Year 19, renting costs you nearly $531,000 more than buying and selling. That’s more than the entire inflation- and appreciation-adjusted value of the house!
In short, the data show that buying a home costs a lot (no surprise there!).
They also show that even after 40 years, your total real cost of buying and owning the home are more than the appreciated value of the home. Thus, if you sell 40 years after buying, you’re still in the red. With my assumptions, your average cost of home ownership, adjusted for inflation and appreciation, would be over $8000 a year.
However, you cannot look at this cost in isolation. Unless you’re willing and able to find a housing solution that avoids having to pay rent (couch surfing for 40 years, anyone?), you must compare it to the cost of renting. With my assumptions, over 40 years, rent cost averages over $38,600 after accounting for investing any savings (positive or negative). That’s more than 360% higher than buying and selling!
This comparison shows clearly that if you’re renting, you need to seriously consider buying a home as quickly as possible. Run your own numbers and see how much you’d save in the long run by doing that, even without considering the intangible value of not being answerable to a landlord.
Here’s the full set of assumptions I used in my analysis.
Note that rates of inflation, real estate appreciation, and stock market returns will generally vary widely from the above average values, but assuming average values is a plausible simplification.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.