Buy vs Rent (when interest rates are high)
f you are a renter who would like to get into homeownership yet fear how you will be able to afford one with today’s interest rates… then Trust Us, The Loan Nerd has created this page just for YOU! And if you are not a renter but know of one… please feel free to share this page!!
You are interested in purchasing a home that is listed for $400,000 and decide to put in a full purchase price offer of $400,000 with a loan amount of $360,000 and an interest rate of 6.5%.
In case you believe I am biased in favor of buying, I will make this home purchase example as ugly as possible.
Let’s begin with the assumptions on the ‘buy’ side:
- You stay in the home for 9 years (the average length of time today’s homeowner remains in their home)
- Rates never drop and you do not refinance at a lower interest rate
- Property taxes increase at a rate of 2% per year
- Homeowners insurance increases at a rate of 2% per year
- Estimated repair expenses are $2000 per year and increase x% per year
- Your home does not continue to appreciate at the current record-setting pace. Instead, we will assume that your home will appreciate at the historical appreciation rate of 4.75% per year
- When you sell your home at the end of the 9 years, you will pay an agent commission of 6% of the sales price
- You paid $8000 in closing costs when you purchased your home. These are fees paid to the lender and other service providers who assisted in obtaining your home loan and property deed.
If you were to rent a comparable $400,000 house:
- A typical monthly rent payment on a $400,000 home would be $3,000 per month or more. However, you are a really good negotiator and bargained for a rent of $2,900 per month.
- Historically, rents increase approximately 5% per year. In the spirit of keeping this conservative… you negotiated a maximum rate increase of 4% a year.
- You also negotiated a killer deal on your renter’s insurance at $40 per month, increasing 4% per year
Now, let’s look at the math.
There are 3 components: total cashflow, appreciation gain, and amortization gain
Total Cashflow
When we look at the monthly expense in year 1, you pay $3,386 per month to buy your home and $2,940 per month to rent your home. This is an additional $446 per month to buy your home. Because you purchased your home with a fixed rate mortgage, the principal and interest portion of your payment will never go up. Looking at the graph above, your rent payment dramatically outpaces your mortgage payment. At the end of the 9 years, you will have paid a total of $371, 984 to buy your home and $372,601 to rent a comparable home. The cashflow difference is a mere $617 at the end of 9 years. You can see that, by staying in your home longer, the cashflow savings of buying vs. renting would weigh heavily in favor of buying.
Amortization Gain
Amortization gain is like a savings plan. You borrowed money from the lender to purchase your home. Every time you make a payment on your mortgage loan, it is like you are transferring money from your checking account into home equity/ownership.
As I mentioned, every time you make a loan payment a portion of your payment goes to principal and interest. The principal payment reduces the amount of money you owe (principal or loan amount) and the interest payment is the cost of borrowing the money from the lender. Overtime, a larger part of your payment goes toward principal repayment and a smaller part of your payment goes toward interest. This is called amortization. In this example, it is called positive amortization and results in a gain for you.
In our example, your original loan amount was $360,000. At the end of 9 years, instead of owing $360,000, you only owe $312,405. This amortization gain is like a cash savings of $47,595! It is drastically different than making a rent payment to your landlord.
Appreciation Gain
Appreciation is the change in property value over the 9 year period. We can add this to your wallet in favor of buying your home – and it is a BIG deal!
Let’s remember that I forecast the annual increase in value (appreciation) very conservatively. I chose to use 4.75% per year because this is the historical average appreciation per year over the last 63 years. In recent years, we know that increases in home values have far outpaced the historical average, presenting a challenging position for the homebuyer.
Generally, appreciation and interest rates are related so that when home values increase dramatically, so do interest rates. Conversely, when home values slow, interest rates decline. This means that, if the housing prices slow you may have the opportunity to refinance your mortgage at a lower rate. Either way, this is a winning situation for a homeowner!
In our example, your initial purchase price was $400,000. With an annual appreciation of 4.75%, your home will be worth a whopping $607,360 at the end of 9 years – a gain of $207,360!
Let’s keep in mind that you will need to sell your house to realize the appreciation gain and you will need to pay the an agent commission, estimated at 6% of the sales price. 6% of a $607,360 sales price is $36,442. This reduces your appreciation gain to $170,918, which is still a very respectable gain.
Bonus - Tax Benefit
You will want to check with a tax professional on this one… mortgage interest on your residence is tax deductible! Based on a 22% tax bracket, this would save you $5,142 over the standard deduction after 9 years.
Let’s put it all together…
The above graph includes all the costs we talked about. It shows homeownership can generate personal wealth over a period of time.
Remember that when we looked at the cashflow, we only saved $617 over the course of 9 years. When we add in the amortization and appreciation gains and subtract out initial closing costs and cost to sell, we save $216,272 over the same 9 years!
You may be thinking, ‘Of course I want to buy a home! Where do I sign up?’
Let’s slow the horses. It might not be the right time for homeownership for you, right now.
According to the above graph, if you sold your house at the end of year 1, you would lose $14,624. This is because the cost to buy and sell overwhelmed the benefit of homeownership in the short term. By the end of year 2, you would have been ahead $5,037. Given this scenario, if you planned to stay in your home less than 2 years, I would recommend that you continue to rent at this time.
The bottom line is that making a decision about when and if to purchase a home can be tricky. Your experienced Loan Nerd is here to discuss your personal and financial goals with you and help you navigate the path to homeownership. We can tailor a scenario specific to your needs.
It is generally best to meet with a Loan Nerd first, before hunting for houses. Your Loan Nerd can help define your budget – including purchase price, tax and special tax districting, homeowner’s and flood insurance, and even homeowners’ association fees. We can outfit you with a pre-approval letter to share with your real estate agent so they have the information to help you find your perfect ‘right now’ home and the ammunition to make sure your offer is accepted.
