Renting vs Owning
WHY OWNING YOUR HOME IS BETTER THAN RENTING
HOMEOWNER FACTOR NO. 1
OWNING A HOME IS CHEAPER THAN RENTING
People who say it’s cheaper to rent than to own are simply wrong. Under certain circumstances in certain markets (where real estate values are overheated and rents are low), there may be some short-term advantages to renting. But over the long haul, renting simply is not a good deal.
If you don’t own your own home, you can easily wind up spending more than half a million dollars on rent during the course of a lifetime- probably a lot more. Let’s do the math. Say you rent for $1,500 a month. Over 30 years, that would add up to a total of $540,000 in monthly payments! But that’s only if your rent never goes up – and whose rent stays the same for 30 years? Even with rent control, you’re bound to have cost-of-living increases. And if you ever have to move – well, forget about it!
COMPARING RENTING TO HOMEOWNERSHIP – LOOK AT THE NUMBERS
Let’s try to be at least a little realistic. Assume you’re renting a house for $1,500 a month. Now let’s say you stay put for 30 years, during which the landlord increases the rent by 5 percent a year (which would be conservative). Over those 30 years, you will hand over to the landlord a total of nearly $1.2 million in rent payments – and at the end, you’ll have nothing to show for it except a bunch of cancelled checks. To add insult to injury, you’ll now be paying him $6,174 a month! How’s that for depressing?
Now let’s imagine that instead of continuing to rent, you buy a home for $200,000. Initially, your costs as a homeowner, including mortgage payments, taxes, and maintenance, are likely to total around the same $1,500 a month that you would have paid in rent. But these costs won’t balloon over the years the way rent would. That’s because your regular mortgage payment, which represents the lion’s share of your monthly outlay, is fixed (or, if you have an adjustable-rate mortgage, at least capped).
What will balloon over the years is the value of your house. Say it goes up by 6 percent a year, which is actually slightly lower than the national average. After 30 years, you will own that’s worth just under $1.1 million. How amazing is that?
HOMEOWNER FACTOR NO. 2
HOMEOWNERS GET LEVERAGE
What makes rich people really rich is leverage. Leverage is what you get when you use what is called “OPM”, which stands for “other people’s money.” Buying properties with OPM gives you huge financial advantages, allowing you to multiply your gains. It’s what you will use to buy real estate – the “other person” in this case being your bank or mortgage lender.
Here’s how it works. Let’s say you find a home you can buy for $200,000. Assuming the house is really worth that much, you shouldn’t have too much trouble finding a bank to loan you at least 80 percent – or $160,000 – of the purchase price.
This leaves you with a $40,000 down payment to make. You put up the cash, get a loan, and the house is yours.
Now let’s say the value of the house goes up by 10 percent. So now it’s worth $220,000, or $20,000 more than you originally paid for it.
If you were to sell the house at this point for $220,000, what kind of return do you think you would have just made? If you answer is 10 percent, you’re mistaken.
Remember, you put down only $40,000 in cash. The bank put the rest. But the bank doesn’t share in your profits from a sale. They belong to you. The only thing due the bank is the repayment of the $160,000 you borrowed.
So you take the $220,000 that you got for the house and you repay the bank its $160,000 (minus the payments you’ve made to the principal so far). That leaves you with more than $60,000 – or roughly $20,000 more than the $40,000 you originally put in. To put it another way, you made a $20,000 profit on a $40,000 investment – which amounts to a 50 percent return.
But remember, we were being conservative.
HOW LEVERAGE WORKS
Assumes $40,000 down payment on a $200,000 house
whose value increases by 6% a year
Value of House Total Appreciation Return on $40,000 Down payment
AT START $200,000 0 -
YEAR 1 $212,000 $12,000 30%
YEAR 2 $224,720 $24,720 62%
YEAR 3 $238,204 $38,203 96%
YEAR 4 $252,496 $52,495 131%
YEAR 5 $267,645 $67,645 169%
YEAR 6 $283,704 $83,704 209%
YEAR 7 $300,726 $100,726 252%
YEAR 8 $318,770 $118,770 297%
YEAR 9 $337,896 $137,896 345%
YEAR 10 $358,170 $158,170 395%
As much as I like stocks, bonds and mutual funds, there is little chance any of them will produce anything close to this kind of return. And there is no chance that anyone will lend you or me 80 percent or 90 percent or 100 percent of the purchase price to buy a stock, bond, or mutual fund. The same is true for gold, diamonds, artwork, stamps, limited partnerships – or whatever supposedly “sure thing” investment you can think of. Financial institutions simply won’t lend people that kind of money to make these kinds of investments. When it comes to real estate, however, it’s a different story. And the reason is simple – most people who buy a home will do anything to keep it. In fact, in any given year, banks wind up foreclosing on less than 1.5% of the home mortgages they make.
Home mortgages are such a good investment that many banks will often consider lending you 100 percent of the money you need to buy a home—and some will even make you hybrid loads of as much as 125 percent (25 percent more than the purchase price) if you have decent credit. Please not that I’m NOT recommending that you try to get yourself one these loans. My point now is simply that it’s a lot easier than you may think to buy a house with someone’s money—and then enjoy the benefits of the resulting leverage.
HOMEOWNER FACTOR NO. 3:
HOMEOWNERS GET TAX BREAKS—
RENTERS DON’T
The best way to stay poor is to pay more than you have to in taxes. As a renter, that’s just what you’re doing. When you rent, you get absolutely zero tax breaks on your housing costs. As a homeowner or real estate investor, you get a ton of them.
By far, the best—and best-known—tax break that homeowners enjoy is the mortgage interest deduction. Very simply, when you own a home, the IRS allows you to deduct from your taxable income the interest charges you pay on the first $1 million of your home mortgage—which means that if your mortgage is $1 million or less, you get to deduct all your interest payments. (The limit rises to $1.1 million if you borrow $100,000 of it from a home equity line.) And since for the first ten years of a standard 30-year mortgage, nearly 80 percent of your monthly payment goes to pay off interest charges (as opposed to paying down the principal), in the early years at least, you can write off more than three-quarters of what you make in mortgage payments. (If you happen to have an interest-only mortgage—you get to write off 100 percent of your monthly mortgage payment.)
Let’s say you’ve got a $200,000 mortgage. If mortgage rates are around 6 percent, which means your monthly payment on a standard 30-year mortgage would be roughly $1,200. Since in the first year 83 percent of that $1,200 represents interest, you’d be able to write off just about $1,000—meaning that over the course of your first year of homeownership, you’d be able to take deduction of nearly $12,000.
Assuming you’re a typical taxpayer in the 28 percent bracket, that $12,000 deduction would reduce your tax bill by around $3,360. But a better way to think about it is that, at the beginning at least, your $1,200 monthly mortgage payment really costs you only about $900. In effect, the government is giving you a $300-a-month subsidy.
Years Rent Payment Mortgage Payment Monthly
Difference After Tax Savings/mt Yearly Difference After Tax Savings/yr
1 1000 1500 -500
2 1050 1500 -450
3 1103 1500 -397
4 1158 1500 -342
5 1216 1500 -284
6 1277 1500 -223
7 1341 1500 -159
8 1408 1500 -92
9 1478 1500 -22
10 1552 1500 +2 +24
If you’re a long-time renter and you have an accountant who hasn’t explained this to you, you should find yourself a new accountant.
The point is that those tax deductions you get to take for mortgage interest are a GIFT from the government. Take that gift!
HOMEOWNER FACTOR NO. 4:
HOMEOWNERS CAN EARN TAX-FREE PROFITS
Another way to stay poor (or least middle-class) is to keep letting the government take part of the profits you make from your investments. Buy shares in Google at $300 and sell them at $600, and you’ve made a bunch of money, but not as much as you think. This kind of profit is called a capital gain, and as with virtually all income, the IRS insists on taking its cut. If your profit comes from the sale of a stock you held for 12 months or less, it’s considered a short-term capital gain and you will pay ordinary income taxes on it. For most people, this means 30 percent of your profit will go to Uncle Sam. If you held the stock for more than 12 months, it’s a long-term gain, and you get taxed at a lower but still hefty rate (from 5 percent to 15 percent, depending on your tax bracket).
There is one asset, however, that you can sell at a profit without having to pay capital gains taxes to the government. You guessed it—it’s your home.
Here’s why. Under current tax law, if you sell your primary residence (which the government defines as a place where you lived for at least two years out of the last five), you don’t have to pay any capital gains taxes on the first $250,000 in profits—the first $500,000 if you’re married.
For example, if you’re married, you can buy a home for $200,000 and sell it for $600,000 and earn $400,000 in tax-free income. Not only that, but you can then turn around and buy another home for $700,000, sell it later for $1.2 million, and pocket $500,000 in completely tax-free gains. And you can keep doing this, buying and selling and pocketing the profits tax-free, as many times as you like for as long as you want—or at least as long as the tax code stays the way it is.
If you happen to make more than $500,000 in profits on a sale (or more than $250,000 if you’re single), it’s no biggie. You simply pay capital-gains taxes on the amount by which you exceeded the cut-off.
DOWNSIZE TO THE RIGHT SIZE
A great way to take advantage of this terrific tax break is to do what’s called “trading down.” For example, you sold your house for $600,000 with a nice $400,000 gain. You now want to buy a house for $350,000. You can use $70,000 of your $400,000 tax-free profit to make the 20 percent down payment. You then use the remaining $330,000 to buy two more homes to rent out. You can put a larger down payment on these homes if you want, meaning you will be generating positive cash flow from the very start.
HOMEHOWNERS FACTOR NO. 5:
HOMEOWNERS BECOME SAVERS
One of the most important features of homeownership—and the thing about it most responsible for making homeowners rich—is that owning a home turns you into a saver. Why is this important? It’s simple. People who have money have it because they saved it. People who don’t didn’t.
Homeownership creates savers. Each time you make a mortgage payment, you’re saving money. That’s because with each payment you’re reducing your loan balance a little—and that in turn is building you equity. (This assumes you don’t have and interest-only loan.) The longer you own your home, the more equity you build, the more you save—and the richer you get.
