finance

Some thoughts on Home Ownership

A friend is thinking about buying a house in Maryland, so I decided to think about how the cost of ownership compares to renting.  There was a Washington Post article that I believe looked at this comparison between renting and owning for a townhouse in Arlington and concluded that they were basically the same.  Unfortunately, from what I recall, they neglected taxes, maintenance, etc.

Suppose you bought a new $300,000 townhouse in Maryland.   Let’s think about how much it may cost you (I use the calculators from bankrate.com).

 

Maintenance expenses:

These are usually estimated to be anywhere from 1-4% of the homes value per year.  So, let’s go with 1.5%.   That’s $4000/yr. 

Property tax:

State: 0.1%  $300

Montgomery County 1%  $3000

Waste disposal, Waste connection, etc: $500

Home Owner’s Insurance:  $650

Mortgage:

Let’s imagine that you put 20% down and you opt for a 30 year mortgage.   At 4.5%, that would correspond to about $1215/month, so that’s $14,580/year.

Let’s pause for a moment a tally what we have so far:

$23030/yr, or about $1920/month.

 

Now, usually people attempt to add in the fact that you can deduct the interest/property taxes on your income taxes.  Let’s see how much that saves you. The median income in Montgomery county is ~ $92,000/yr, so let’s round to $100000/yr to make the numbers easier.  Let’s further imagine that you are putting in enough payments to your 401K that you fall in the 25% tax bracket (Montgomery county would seem to charge 3.2% and the state 4.75%, so let’s assume that state tax is 8%).   Then you get to deduct ~$4100 the first year.  So at the end of the day, that puts you at about $18930/yr, or about $1580/month that you’re paying to own.  

 

So far, I have not included closing costs.  These are estimated at 2-5% of the home’s cost.   So, let’s assume you pay 3%, that’s $9000.  I checked with Bank of America website and the they estimate $11000, so let’s go with $10000.   I’m not sure what the best way is to add this to the calculation.   But, let’s say that you’re normal and hold on to the place for 7 years (it’s a bit complicated to predict this:  http://www.nahb.org/generic.aspx?genericContentID=110770&channelID=311).   So, you have to figure in the cost to sell your house after this of ~6% of the homes value.  Let’s neglect inflation (the value that I think a house should rise at in a sane market) $18,000,  So let’s add this to the closing costs and divide by 7 years to see what you paid per month.   This corresponds to about $333/month!!!   So, This put’s you back up to $1913/month to own.  Finally, throw in $100/month for Home Owner’s association fees and you’re at ~$2000/month to own.

Now, let’s look at rental prices.  If you want to rent a townhouse in the same county, you’re probably paying a comparable rate—perhaps even slightly more.   

So, the long and short of it is that unless I’m missing something terribly obvious, at the end of the day, it would seem that renting and buying are about the same in Md.   So, what are the pros and cons of one over the other?

Some people might argue that homes appreciate in value with time.  This doesn’t seem sane to me.   Over time, it seems like it should index to inflation.   A more detailed  analysis can be found on http://michaelbluejay.com/house/appreciation.html), but the basic idea is that if appreciation is greater than inflation, eventually nobody can buy a house.   This is in the best case scenario where salaries are indexed to inflation and even that doesn’t necessarily hold true...  

The other reason that a number of people give to suggest that home ownership is better than renting is the idea that you build equity in your house as you pay your mortgage, but with renting, you gain nothing.   However, this argument is a bit simple minded.   Your mortgage is front loaded, so initially, more of your payments go towards interest than towards the principal.   Also, that $70,000 (20% + closing costs) that you paid initially could have been invested instead.   Depending on your assumptions on the rate of returns, this could beat your accumulation of equity in your house (assume that you just get a boring index fund with low fees).

The downside of owning a home is that you simply aren’t flexible if you have to move for work.  Also, if you find yourself with a lowered income, it’s a fixed expense—a number of states, like Maryland, are “Recourse states", where if you are foreclosed upon, you’re still liable for the difference between the loan amount that you took out and what your lender was able to sell the house for.   Another danger of owning a home is the equity risk.  On the one hand, you could win the lottery and sell your home during a time where appreciation has favorably decoupled from inflation.  However, you could also have to sell during a housing bust when the value of the home is far less than what you initially paid for it (even without accounting for inflation), in which case, even if you’ve put equity into the home, if you sell it, you’ll lose money on the sale.  For example, suppose your home’s value drops to $250K.   You will have lost $50K when you sell, even if you’ve put equity in (of course, there are risks to investing as well).    The other risk  to home ownership comes from the fact that a number of states and municipalities have used creative accounting to balance their budgets.   However, at some point, to pay for expenses that they are obligated to (for example pensions) and to continue to provide services, they will have to increase their tax rates.  I would imagine that property taxes will have to go up as well.   

 

After thinking about this, I found:

http://www.nytimes.com/interactive/2014/upshot/buy-rent-calculator.html?_r=0

 

Which depending on assumptions, might be a a bit more optimistic about owning.  For them, using similar numbers would suggest that the cross over point is at around $1600/month.   This depends on your assumptions about the rate of returns on the down payment/closing costs money that you could have invested instead of using it to build equity in your home (along with assumptions on inflation/appreciation, rent increases, etc.).

 

So, the TL; DR is that the question of owning vs renting depends on your assumptions about the relative rates of return on investments and guesses about how appreciation and rent index to inflation.   It also depends on how long you are likely to be in the home and your tolerance to risk.   There are of course intangibles such as whether you want someone else to deal with maintenance or if you want more freedom to decorate.  For the scenario I described, it would seem to be owning by a nose, but it does carry the risks that I mentioned earlier.   So, on pure financial grounds, this doesn’t seem like it’s an obvious risk-adjusted choice to buy instead of renting.  

 

*This is for informational purposes only.  It is not investment advice and you should consult a professional if you want such advice.  I am also not a lawyer.  All opinions expressed are my own and not my employer’s.

 

Posted by william in finance