Updated: Feb 4, 2020
This is part 1 of a 3 part series on the cash impact of buying vs renting. Barring unusually wild escapades from small children, part 2 will be posted tomorrow. Enjoy! Drew and I are on our second home we have owned, and both experiences have been quite different in the impact on our wallets. Up until recently, I was convinced that as a whole, buying a home is better than renting; renting is just “pouring money down the drain." However, conversations over the last few years with very fiscally conscious friends of mine who have a different point of view has caused me to explore my position further.
To help me think through this, I went to my two power-house realtors, Cynthia Ilewicz with Nest Realty in Blacksburg Virginia, and Katie Beam Galloway Real Estate in Walpole, New Hampshire. I posed the question, “From a net cash-gain perspective, when is it worth buying a home?” There were two overlapping themes that emerged from their responses:
1. When your monthly payment on the home is about the same that you would be paying in rent anyway.
From Katie, “Rent has zero return whereas a home can provide a return on investment if done right and it also provides one of human's basic needs....a roof over their head/shelter.” Katie also emphasized that you have to take into consideration if the home will require a lot of ongoing repairs, as that impacts your cash flow.
2. When you own the home long enough for the initial cash investment to be worth it.
Cynthia recommended at least 2 years. **I also want to add here from a tax perspective, if you live in a home 2 out of 5 years, it is considered your primary residence and up to a certain threshold, you do not have to pay tax on the gain when you sell. That is one of the ONLY ways I know to make money tax-free.
In addition to these two themes, Cynthia highlighted the importance of negotiating for the seller to pay your closing costs. I think that makes a lot of sense when analyzing the cash impact. Let’s say you could rent a home that meets your needs for 1,200/mo, but you qualify for a mortgage in which you would be paying 1,100/mo. Obviously, your monthly payment is better in the second scenario, but if you are coughing up 6,000 for closing costs, and you average out that cost over the course of a 2 year period, that adds $250/mo, which then puts you above what you would be paying in rent.
Katie brought up the effect of interest rates. This is particularly important, as it can be a very nebulous concept to home-buyers. Whereas on a day-to-day basis we are counting pennies & dollars (should I really buy this coffee on my way to work?), with home ownership your mind does this crazy thing where you skip to thinking in thousands and tens of thousands (oh, it’s only another 5,000). The impact of interest rates can be even more difficult to pin down. To help you understand, here is an example of the breakdown between principal and interest in a 2 year period, using a basic amortization schedule template that anyone could find via google:
Scenario 1 Purchase price: 180,000 Interest rate: 5.0% Loan term: 30 years Monthly payment: 966.28
Monthly payment breakdown: Month #1: Interest 750, Principal 216.28 Month #24: Interest 728.30, Principal 237.98
Scenario 2 Same as the above, except with 4.0% interest rate Monthly payment: 859.35
Month #1: Interest 600, Principal 259.35 Month #24: Interest 579.37, Principal 279.98
Not only are you paying less overall per month, but how wild is it that with paying 1% less in interest, you are paying more proportionately of the principal balance in month #1 than it took you to pay in two years with the first scenario?! Interest rates matter.
You may say about either scenario, “But I’m paying the same per month no matter what, why does it matter how much of that is principal and how much is interest?” Because it directly impacts your gain when you sell. So in scenario 1 at 5% interest, you paid down the principal balance to 174,552.82 after 2 years. In scenario 2 at 4% interest, you paid the principal down to 173,531.12 after 2 years. Upon selling, that is a little over $1,000 back in your pocket.
In part 2 of our series, we will look at what features of a home are most important in order to guarantee the best cash outcome.