I was reminded again this week by how red hot the residential rental market is in the San Francisco Bay Area. Over lunch with a few friends, discussions quickly turned from the quick “what are you doing now” updates to rants like “I am spending so much on rent…and my landlord is going to increase it again this year!” This statement is quite common for renters across the Bay Area and the nation.
Finding a decent place to live has always been a challenge, but it seems over the past 2-3 years the search has become even more formidable. However, with rents so high, the BIG $1M QUESTION now is does it make sense to continue paying high rent or is it better buy a house (or condo) and put the money towards a mortgage? Interest rates are so low now that monthly mortgage payments could actually be lower than paying rent! Yikes. The barrier to explore this option, however, lies in finding the cash for a down payment. No matter your income level, obtaining that amount of cash is not easy and requires discipline. Don’t buy that BMW M series with your savings or stock options. Buy the house first!
I have been asked this “should I rent or should I buy” question several times recently. I am fan of buying a home as a longer term, 5-7 year play. I reached out to a mortgage broker friend to help build the business case for home ownership taking into consideration economic factors including home appreciation, tax benefits, etc. Of course, the analysis is positioned within the context that anyone considering buying a home should consult a CPA or financial planner to understand the implications for their specific circumstances. Come on guys, you know I had to say that!!!
Following is a rough analysis that focuses on the tax advantages of home ownership. The numbers used are for illustrative purposes only to explain the concepts. Feel free to manipulate the equations as needed. Or run a few calculations yourself using a “rent vs buy” calculator like the one on Bankrate.
OK, let’s get to it! For example, let’s assume someone lives in California, makes $120,000/year and is in a combined state and federal 30% tax bracket and will pay $36,000 in taxes.
Now, let’s assume a $800,000 home is purchased with a 20% down payment of $160,000 and with a $640,000 loan at 4%. The monthly payment breaks down as:
Monthly payment: $3,055.46
Property taxes: $833 (based on CA property tax rates)
Total Monthly Payment: $3,968
The same home could be rented for $3,000 per month, BUT don’t forget that the mortgage interest and property taxes are tax deductible. This benefit is potentially HUGE. The annual interest paid on the loan in this example is about $25,000 and annual taxes are $10,000. As a result, taxable income has been reduced by $35,000. The buyer will pay $10,500 less in taxes, or $875 less per month, or the equivalent of $3,093/mo ($3,968 – $875). Hey, we can all use a little extra money each month, right!?
But wait, there’s more to this. Now hear me out. Let’s assume the property value increases by a modest 5% per year. Over a 5-year term, the $800,000 property will be worth $1.021 million. Not bad, right?
Let’s assume rent increases by a modest 5% per year when in reality it has increased by much more!! Given the $3,000/mo rent in this example, rent will increase to $3,828 per month by year 5. Keep in mind that any renter (tenant) is at the mercy of a landlord and the laws that govern the local rental market as well. A renter could be asked to leave if, for example, the landlord wanted to sell the property.
Again, this scenario is designed to introduce the basic concepts to understand the benefits of buying a home vs renting. There are a ton of other factors to consider beyond the quantifiable including emotional benefits. We all have our hot buttons for what makes us happy.
Personally, I find happiness in home ownership from the remodeling and interior design perspective. I love that stuff. My mom spent many years as an interior designer and it rubbed off. Many family meals include conversation around what projects we are working on or what great home interiors we’ve seen. However, I have friends who are SCARED TO DEATH of any home project and prefer to just rent and let a landlord take care of it. To each his own.
My goal is to share with others the great opportunities, benefits and risks of home ownership to empower them to make their own decisions for what works best.
Please feel free to Tweet me with questions about this post @ericdunstan .