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Buy vs Rent and Invest: Planning for Financial Independence



ttl townhouse pay mortgage or invest

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I’d like to help you understand how to analyze the decision of buying a home vs renting and investing your downpayment. Living arrangements are an important part of your plan for financial independence. What are the costs of owning a home and how does that affect your plan for financial independence? What’s better: buy vs rent and invest your downpayment?

The final answer is almost certainly going to come with a dash of “it depends”, but I can at least teach you how to figure out how to create your own unique calculation.

Is the Best Investment You Can Make Buying a Home?

The townhouse we lived during my high school years pictured from behind. Jenni spent many after school afternoons tutoring me in chemistry here (no, really!).

The townhouse we lived during my high school years pictured from behind. Jenni spent many after school afternoons tutoring me in chemistry here (no, really!).The townhouse we lived during my high school years pictured from behind. Jenni spent many after school afternoons tutoring me in chemistry here (no, really!).

My parents moved into their current house in 2002. This month, they’re finishing up a significant bathroom renovation and intend to put their house on the market for sale relatively soon.

And, don’t worry—I haven’t tried to convince them to use one of my recommended websites to sell your stuff to facilitate that transaction. My dad happens to have a realtor license.

My parents worked hard to pay down their 30-year-mortgage early in the last 18 years and they’ve nearly done it. As I described recently, they answered the “pay off mortgage or invest” question by making lots of extra payments toward their debt over the years.

My dad is often flabbergasted at the value of the house and how it’s risen since they moved in all those years ago. They keep the place spotless and maintain it well.

He’ll often flippantly mention:

“This house is the best investment we’ve ever made!”

My dad

But I wanted to know: is that true? Is a house really an investment?

More importantly, how can you ask yourself the same question and figure out if buying or renting and investing makes better sense for you?

Buying vs Renting and Investing

At the end of this analysis I want to answer the question: were my parents better off buying their house with a 20% downpayment or renting the same home and investing the downpayment. I’d like to calculate the total cost of ownership and compare that to renting and investing.

Comparing the rate of return

Let’s start off with the easier, initial question. Is residential real estate or the stock market a better investment? We’ll take a look at my parents’ anecdotal experience and then bring in historical context.

My parents purchased their house in 2002 for just shy of $350K. Today it’s worth just under $666K. Just glancing at the numbers it’s easy to see how that $316K increase in value, or potential profit, would seem like an incredible investment.

Over the 18 year timeframe we’re analyzing, the compound annual growth rate (CAGR) is 3.64% for this house.

We’ll use the S&P 500 index to represent “stocks”—I like investing in index funds vs individual stocks. If we took the same ~$350K and invested in the S&P 500 when they purchased the home in 2002, would the resulting value today be more or less than $666K?

Make your own guess before we calculate this!

On the date of their mortgage opening, the S&P 500 was at 1,153 points.

The S&P 500 was at 3,363 points on the date of their most recent property value estimate in 2020.

If they purchased an S&P 500 index fund with $350K in March of 2002 and left the dividends reinvested it’d be worth about $1.37M today. That’s near 4x more! The CAGR for the S&P 500 investment is 7.88%!

I don’t think it’ll be a surprise to most people that the S&P 500 beat my parents’ house in terms of appreciation, but we needed to calculate this in order to set up the rest of our analysis.

Historical residential real estate return rate

How has my parents’ property compared to the average residential real estate CAGR in the US? The St. Louis Fed exposes the data for the S&P/Case-Shiller U.S. National Home Price Index to calculate CAGR easily.

For the same 18 year period, the average home earned a 3.51% CAGR which was just behind my parents’ house 3.64% return rate.

The CAGR for the same home price index (HPI) going back several decades suggests this is pretty close to average which is about 3.9%.

HPI varies around the country. Since they purchased their home, the US went through a massive housing crunch in 2008-2009.

This timeline video will give you a sense of house HPI varies around the country. Housing Price Index Source: CaseLogic & New York Fed.

You can easily calculate your own CAGR via Moneychimp’s CAGR calculator.

Of course, this is a very simplified comparison between index funds and a primary residence. We’ve ignored multiple key factors:

  1. Real estate often uses leverage
  2. Housing has additional expenses

Before diving into how additional housing expenses affect the primary residence vs stocks equation, let’s look at using debt—leverage.

Leverage in real estate investments

Simply put, a mortgage is by far the most common form of debt the average person will use to amplify an investment. This amplification through debt is leverage.

If you put $70K down on a $350K house, you’ve only invested 20% to obtain the underlying asset and its growth. If the home value goes up 10% to $385K, your investment is worth $35K more whether you paid in full or not.

It’s the increase relative to your initial investment that matters.

You stand to have a 50% gain over your initial transaction cost in the leveraged scenario!

Of course, the risky part is that if the house were to lose just 10% in value, you’d stand to lose 50% of your initial investment!

Debt can increase rate of return

Let’s reanalyze our initial rate of return calculation for the house which suggested that it earned a $316K profit off of a $350K investment over 18 years.

If we only put $70K down but still earn the same $316K profit after paying the remaining $280K debt balance from our $666K sale, our CAGR rises to a whopping 8.73%!

That beats long term CAGR for the S&P 500 stocks.

Again, this is a simplified explanation with 0% debt interest.

While it’s not something I’d do, you can use leverage (margin) to invest in stocks as well.

Mortgage interest rates’ impact on rate of return

As you near paying off your mortgage, your rate of return will decrease as you have more of your money tied up in the asset but still earn the same growth on the asset.

Let’s make this quantified comparison of primary residence vs stocks a little more realistic by including the effects of leverage and the related interest on the debt. Let’s assume a 20% downpayment ($70K). In March of 2002, the average 30-year fixed-rate mortgage had an interest rate of about 7% which we’ll use.

Year Debt ($) Interest Paid ($)
Mar 2002 280,000 0
2003 277,893 14,651
2020 183,890 300,496
Sep 2020 176,618 309,983

We can see from the table above that while the home value nearly doubled over 18 years or so, almost $310K of interest would be paid with a 7% mortgage.

Meanwhile, just a bit over $100K of the original debt would be paid down.

Extra costs of real estate

So far, we’ve ignored these additional housing costs:

  • Realtor fees
  • Transaction fees (transfer taxes, title, etc.)
  • HOA fees
  • Maintenance, improvement
  • Property taxes
  • Insurance

These expenses can really add up as we’ve revealed in our own annual FIRE budget, making the actual principal and interest payment look small.

Not to mention the fact that interest rates these days are near historic lows. My parents have refinanced since their initial mortgage at 7%.

Let’s try to account for some of these larger expense factors and also add refinancing into the equation.

Refinancing to increase real estate returns

Let’s assume a refinance occurred about midway through the payoff period with a newly refreshed 30 year fixed rate mortgage at 4% in early 2012. The fee for the refinance itself would have been around $5,500 which we’ll include in the total interest paid column at the refinancing point.

Let’s take a look at our mortgage table again.

Year Debt ($) 7% Loan ($) 4% Refi Loan ($)
Mar 2002 280,000 0
2003 277,893 14,651
2013 237,890 179,637 14,301
2020 202,959 179,637 76,305
Sep 2020 198,604 179,637 82,338

Our initial 7% mortgage sits at a total cost of $180K from the start of 2012 onward.

Getting rid of the higher interest loan at 7% really juices returns. The mortgage refinancing would cut their total interest paid so far from $310K to $262K.

Ongoing costs of real estate

But what about some of those housing expenses? Property taxes are probably the element most folks would like to see included.

Here’s the tax history for their property:

Year Property Taxes ($) Tax Assessment ($)
2020 6,098 589,140
2019 6,034 577,450
2018 5,709 526,150
2017 5,783 514,030
2016 5,887 518,080
2015 5,882 512,420
2014 5,842 505,760
2013 5,947 493,550
2012 5,602 453,600
2011 5,872 457,000
2010 5,798 451,300
2009 5,736 441,900
2008 5,774 457,500
2007 5,458 527,300
2006 6,337 612,200
2005 5,522 533,500
2004 5,308 512,800
2003 4,520 436,700
2002 3,891 375,900
Total 107,000

That’s $107K worth of property taxes they’ve paid so far on their place!

What about HOA fees? Their current HOA fee is $119 per month. Over the course of their ownership, it has averaged $101 per month. That’s another $22,422.

Over the course of 18 years, their home insurance has run an average of $1,140 per year. Total cost: $20,520.

Real estate transaction costs

Transaction costs when selling a home will vary from person to person. I’m going to give our scenario the benefit of the doubt in the calculation.

We’ll assume my dad, with his realtor license, will sell the home himself to cut the 3% fee that is typical for a listing agent. They’ll still need to pay the buyer’s agent 3%.

If they were to sell around $666K, that’s another $19,998.

Transfer taxes vary as well, but we’ll lump them in with title insurance, escrow fees, attorney fees, and prorated property taxes. 1% is a common rule of thumb, which is $6,659.

Ongoing home maintenance and improvement costs

Consider that the average maintenance and improvement cost for a home is 2% per year. You can cut some maintenance and improvement costs by not being fearful of DIY projects. Nonetheless, home maintenance and improvement costs are estimated at $126K in this scenario!

I know they’re working on a bathroom renovation right now I suspect will ring in at $20-30K!

Homeownership tax deductions

Back in 2002 the standard income deduction every married couple gets on their federal taxes was $7,850. People without itemized deductions would claim this standard deduction. In that year, they were certainly paying more on their property taxes, mortgage interest, and state income tax so they would have itemized their taxes. These state and local taxes (SALT) would have been deducted from their income to reduce their tax liability.

The value of tax deductions for owning a home are highest in the beginning of ownership because you’re paying the most interest at the start of the mortgage. For example, we know that by 2003 my parents paid about $15K in interest on their loan. This along with the property taxes for the year ($3,891) would have resulted in an itemized deduction of about $19K. That’s about $11K more than the standard deduction.

If we assume their federal and state tax rate combined was about 32%, the tax deduction was worth about $3.5K in year one!

However, this number would have shrunk when they refinanced since they were paying less interest and the standard deduction has kept increasing.

Let’s use 2013 as another snapshot to test the tax deduction value. With the newly refinanced loan at 4%, they would have paid $9,435 in interest. Their property taxes were $5,947. The standard deduction in 2013 for them was $12,200. Without any other deductions, their itemized deduction would be $3,182 over the standard deduction. If we assume the same ~32% effective tax rate, the tax deduction on their house was worth $1,018.

With the Tax Cuts and Jobs Act of 2017, the standard deduction is now $24K for married couples. SALT deductions are also limited to $10K! Like many couples who own a single home and don’t have many itemized deductions, they’ve taken the standard deduction since at least 2018.

Overall, I’ve estimated their tax deduction for owning their home as worth $36K.

Downpayment opportunity cost

Lastly, we need to account for the opportunity cost of the original downpayment. The 20% they put down on the loan to secure it would otherwise be invested over their 18 years of ownership.

We know from our earlier discussion about this home’s price appreciation vs the stock market that an S&P 500 index fund would have increased more than four fold. In fact $70K invested then would be worth $274K today with dividends reinvested!

The growth, $204K, is the opportunity cost of the downpayment being locked away in this house for 18 years.

Adding opportunity cost into their homeownership cost calculation treats the analysis like it happens in a vacuum—as if alternatively, they could have lived at some other place free of charge.

True Cost of Homeownership

What has been the true total cost of home ownership in my parents’ scenario?

Description Value ($)
Home Sale 665,941
Income tax deduction 36,144
Debt (280,000)
7% Loan Interest (179,637)
4% Refi Interest + Fee (82,338)
Property Taxes (107,000)
HOA Fees (22,422)
Home Insurance (20,520)
Buyer’s Agent (19,998)
Closing Costs (6,659)
Maintenance & Improvement (126,000)
Initial Downpayment (20%) (70,000)
Downpayment Opportunity Cost (203,727)
Total homeownership cost (416,216)

It’s incredible to look at this real estate investment that has increased in value from $350K to nearly double at $666K yet because of all the expenses associated with owning your own home, it can be a pretty bad investment.

But the truth is, my parents didn’t buy their primary residence with an eye for it to be strictly an investment.

Assuming the sale goes through at the price they expect and without any last-minute repair needs, it’s cost them $416K to live there for 18 years. Over 222 months, that’s $1,875 per month on average.

Really, I don’t think that’s a bad deal! But, is it an investment? No. Their asset has cost them money, it’s not something they were able to rent out to produce cash flow and the appreciation wasn’t enough to overtake the expenses.

Someone looking to retire early through real estate investing would analyze the situation from a perspective of rental rates, my parents just wanted a place to live that would increase in value, too.

Rent and invest or buy?

Let’s come back to my original question: would they have been better off, financially, to rent and invest their downpayment or to have purchased their home as they did? We’ll analyze that opportunity cost of the downpayment as an actual second scenario.

The estimated rent for their home currently is $2,900 per month. There happens to be a very similar house available nearby that this rate so we’ll assume it’s accurate. Rental history for homes in the area back in 2002 shows monthly rent rates around $1,950 per month. We’ll estimate that as an average of $2,425/month over the same 222 month period.

We know that had they invested $70K in the S&P 500 (or even better, a total US stock market fund like VTSAX or VTI), they would have earned $203,727 over the initial $70K. Typically, renting a home requires 1-month of rent as a security deposit, so we’ll subtract that from our $70K investment. $68,050 invested would be worth $266,102 (earnings of $198,052).

Rent & Invest Buy
Initial cost ($) (1,950) (70,000)
222-month cost ($) (538,350) (537,917)
Investment earnings, stocks 198,052 0
Investment earnings, home1 0 395,428
Security deposit return 1,950 0
Net (340,298) (212,489)

1) Investment value, home = sale price + tax deduction value – debt – buyer’s agent – closing costs

Strictly financially speaking, given rental rates for similar homes, buying was the smart move for them.

The decision to buy their home instead of rent and invest their downpayment put them ahead by about $128K over their 18 years of homeownership.

Buy vs Rent Pros and Cons

As an investment, your primary residence is very unlikely to produce a positive return once figuring in all the expenses related to homeownership. On top of that, unless you rent out a portion of your primary residence, you can only rely on appreciation (which tends to be 3-4%/year in the US) to increase your total investment value.

The story is much less clear when you begin to analyze buying property to rent out versus investing in the stock market, but that’s an analysis for another time.

Your primary residence is almost certainly a liability. Nonetheless, as the old saying goes, you need to live somewhere. Even with all the expenses associated with homeownership, it may be smart to include it in your plan for financial independence. That’s extremely dependent on the myriad variables involved with your decision between renting or buying. If you’re quantitatively analyzing that decision, NYT has an excellent comparative rent vs buy calculator.

In tighter housing markets, rental rates should reflect the underlying costs of homeownership pretty well. In that case, consider the pros of renting vs the pros of owning. Perhaps that’s more relevant to your decision that the strict financial costs.

Renting pros:

  • Housing flexibility
  • Less responsibility for maintenance
  • More liquid assets

Owning pros:

  • Housing security
  • Easier to mold your home to your liking
  • Asset appreciation possibility

There are many more detailed differences between the two approaches.

I think that for most people, much of the decision simply comes down to housing availability within a particular location. Many want to live in a particular place or neighborhood and the availability of rental units or purchasable units may be limited in that location.

Ultimately, the most important thing you can do to help yourself to achieve financial independence is to run your own analysis and create a plan. For your own specific criteria, renting may be the smarter choice. For others, buying could be the ticket. It’s not a one size fits all question. Use the buy vs rent and invest criteria outlined in this post to help make your own smart decision on the path to financial independence.

What do you think drives people to decide to rent or buy? Which is healthier for those on a path to financial independence?
Let us know in the comments!

This post was originally published on this site

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