When we were searching for a house a few years back, I used to refer to a lot of online tools around this topic. These tools typically ask you what is the house value, mortgage amount, rate of interest, your tax bracket & current rent you are paying. I realized that all these tools gave me skewed results towards buying the house then. Today, after the housing debacle, I referred to a couple of them and they now tell me to rent instead of buy! Well things have really changed.
Being a little skeptical then (and a lot now), I thought of listing all the factors that make or break this decision. The most important factor is of course “emotional”. If you have decided one way or the other firmly, you don’t need to read this article, however, if you are a little undecided emotionally, do consider the following factors.
Tax Deduction
This is the most advertised reason for buying a house. Of course, you can avail deduction on your mortgage interest, mortgage insurance (PMI), property taxes etc, which is a definite plus. Bear in mind, though, that to avail this deduction, you MUST itemize, thereby foregoing the “standard deduction”. Very few realtors will actually discuss this aspect with you. The tax advantage is on the amount you paid towards your house on top of the standard deduction.
For a couple filing jointly, the standard deduction amount for 2009 is $11400. That means your tax advantage is based on the following simple mathematical formula.
(Mortgage Interest + PMI, if any + Property Taxes – 11400) * your tax bracket.
And not simply the following (as portrayed by many realtors/tools)!
(Mortgage Interest + PMI, if any + Property Taxes) * your tax bracket
Assume that you are paying 5% interest on a $400,000 mortgage, no PMI and your house value is $450,000. Positive equity! Your tax bracket is 30% and Property taxes are calculated as 1.35% of your house value. Your tax advantage is
(400000 * 0.05 + 450000 * 0.0135 - 11400) * 0.3 = $4402.5 instead of $7822.5 without taking standard deduction into account.
To make this picture a little rosier, because you are itemizing, you can also deduct local income or sales taxes paid and also charitable donations. With the plain old standard deduction, you don’t get this advantage. A simple math will tell you whether you are in red or black and what the real tax advantage towards owning a house is.
Increase in rent & increase in house prices
Well, increase in rent is definitely a reality, increase in house prices is not, in fact in this market, you should consider decrease in house prices. Realtors always tell you, oh, you invest only 10% of your money (towards down payment) in your house and if the house price increases even by 2% per year, you are actually getting 20% return on investment. Now consider the same house price drops by 2%, instead of increasing by 2%; your return on investment is -20%, which means you have lost 20% on your investment (down payment).
Lost Interest on investment
The down payment towards your house is locked in your house. If you would have continued to rent, you would have gotten interest on this investment, anywhere from 2% (bank CDs) to 5-7% or more in stocks depending on your portfolio. This should be considered as opportunity cost of owning the house. Of course, the net benefit from this investment income is again based on your tax bracket.
Net benefit = Investment income * (1 – your tax bracket)
If you pay the bank an additional principal every month or year, yes, in the long run, you will end up in paying a LOT less. But this additional principal again is locked into your house, thereby not generating any positive cash flow for yourself.
Additional Principal Repayment
Looking at the previous point in the other way, if you are paying $1000 per month towards principal instead of investing the same amount every month in a bank CD which fetches 2% annual interest, your actual payment towards principal over the long run (say 15 years) will be
1000 * ((1 + (monthly mortgage interest - bank interest)) * (1-tax bracket)) compounded over 180 pay periods (15 years & 12 months each)
1000 * (1.03 * 0.7) ^ 180 = $1399.
This means, for every $1000 you overpay, you are actually saving $400 over the lifetime of the loan.
Maintenance costs, HOA fees
A lot of costs which you can pass on to the landlord while renting, are to be borne by you while owning a house. All these costs are non tax deductible and depending upon the age of your house, facilities provided by your HOA and a bunch of other factors, these costs can vary. If you are moving to a single family home from an apartment complex having a fitness facility &/or swimming pool (which you actually use), you may have to enroll into a fitness club nearby or buy a treadmill or dig a swimming pool! Consider these monthly or one time costs in your calculations.
Increased commute
Typically, to fulfill the American dream of owning a house, you may need to sacrifice on the distance from work. You may need to commute more distance because the house in the area where you were renting may be extremely costly (unless of course you are a millionaire, but then why would you be reading this article!). Many people move to suburban locations in order to own their piece of land.
If you need to drive 5 days a week, and your commute is increased by say 20 miles (and you are not using the recalled Prius), you may be looking at excessive costs related to your commute. Additional commute miles can be calculated based on the formula.
Increased miles one way * 2 * number of days/week * 52 weeks/year
OR
20 * 2 * 5 * 52 = 10400
At a cost of 21c/mile (to account for fuel, maintenance & insurance charges), you are looking at spending $2200 in additional commute related costs every year. Well, these costs are already tax adjusted, because they are coming right out of your pocket. Uncle Sam is not giving you any tax benefit on this one!
Isn't it time to think of carpooling?
Summary
Based on above simple calculations, you can prepare cash outflows towards owning as compared to renting. Assuming all things happen as expected, i.e. rents go up steadily and so do the house prices (Yessss!), you may eventually break even after a few years. A good timeline for break even is about 6-7 years. That means, if your cumulative net cost for owning is equal to the net cost of renting over that period is the same, you would be better off owning, otherwise, well go back to your emotional frame of mind and decide which way to go!
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