Is Renting Throwing Money Away?
Sep 21, 2013 | COLUMNS > Jon C. Ylinen
The classic argument of “rent vs. buy.”
Conventional wisdom states that renting is just throwing your money down the drain and paying someone else’s mortgage. Well, this is not always true.
If you are going to buy a home or condo, but do not plan to live there for more than four to five years — maybe during medical school, a residency, a fellowship, or just testing an area or new practice — it may well be in your financial interest to rent instead of buy.
Here are some factors to consider:
1. Pure transaction costs
Cost of entry: Closing costs. These are said to be 2% to 5% of your purchase price, usually. A list of closing costs and deeper explanation can be found at Zillow.
Cost of exit: Realtor fees. Technically, these are negotiable and could be paid by the buyer or seller, but traditionally by the seller. The commonly accepted number here is 6% of the purchase price, which then is split in some way between the two agents involved.
2. Principal vs. interest
At first, you’re mostly paying the bank in the form of interest, not yourself. The monthly ratio of principal vs. interest is defined in the amortization schedule. Earlier in the payment terms, you pay more interest and as you get closer to the end of the loan terms your payment is more principal than interest.
I recently saw a sample of an amortization schedule for a client whose mortgage was $400,000. Monthly payments on principal and interest were $2,087 a month. In the first month, $503 went to principal, or about 24%. It took 15-and-a-half years for the payment to be 50/50 between the principal and interest.
So in this case, if you only held this property for four years you would have only paid down and gained about $26,500 of equity, or 15%. However, the one positive is that you can deduct your mortgage interest off of your taxes if you are itemizing and your total mortgage is not over $1 million — so this does help slightly offset this argument. Maybe you get 25% or 33% back on your interest; it still doesn’t balance the scale.
3. Additional expenses
When owning a home, you have property taxes to pay, which are also tax deductible, so you should only count a portion against your argument to rent (but the majority of your taxes end up being a bottom line extra cost), and as well as home owners association fees (which are not tax deductible) if you’re in a condo.
Clearly, this isn’t something you can pin down, but it is a variable. Potential costs are appliances going out, furnaces/AC needing replacement, a new roof needed, etc.
5. Value of property
A lot of expenses can be offset by the valuation of the real estate. Of course, in some areas the market could go up the same as it could go down. This is very area specific and can have a lot to do with the economic environment. It’s certainly a relevant factor, though.
There are many factors in play that may not always meet the eye when weighing the pros/cons of renting vs. buying. The longer you plan to hold the real estate, the more favorable it can become for buying to make sense. Rarely does buying make financial sense if you are planning to sell in the short term.
Jon C. Ylinen is a financial advisor with North Star Resource Group. This should not be considered as tax, specific loan repayment for an individual, real estate, or legal advice. You should consult a tax/loan/real estate or legal professional for advice regarding your specific situation. 731935IR/ DOFU 9-2013.