Should I Buy A Home? Part 3: Consequences

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Continued from Part 1: Preparation and Part 2: Process



This is about the long term consequences of the decision to buy or not to buy a home, and economic benefits analysis into whether you should want to buy. In order to answer the question of whether it's better to buy or rent and invest the difference, you need to compare the costs and benefits of owning to the costs and benefits of renting over a comparable time frame. If you know you're moving in three years or less, it can be hard to come out ahead, just due to transaction costs. On the other hand, if you've got the wherewithal to turn it into a rental property after any future move you already know you're going to make, that can make the owning calculation move decisively in favor of owning. Be advised, all the headaches of being a landlord are greatly magnified if you're not within easy commuting distance to keep an eye on the property yourself. Also, if you cannot achieve positive cash flow on a rental property, odds are good that you should sell it. This isn't a blanket recommendation, just a rule of thumb.



Now it happens that I've programmed a spreadsheet to answer the "buy or rent" question in a time dependent manner, which is the only way it really can be answered. I'll assume we're talking about a $450,000 home and 90% loan, split into two pieces to avoid PMI. I'm going to pull a few more assumptions out of my hat, but I'm going to do my best to make them reasonable assumptions. 6.5 first trust deed, 10% second for any loan amount over 80 percent of value. Five percent annual property appreciation (perhaps a tad low in the long term), 1.2% yearly property tax (darned close for most California properties), yearly tax increases of two percent (Prop 13's legal maximum in California), non-deductible homeowner's expenses of $120 per month, 4 percent inflation, $1500 in non-housing deductions on Schedule A of your IRS forms, marginal tax rate of twenty-eight percent, and a return net of taxes on any alternative investment with the same money of ten percent. I also assume you're married (That makes a difference on how much your default deduction is).



I'm going to neglect state income taxes, but they make buying more attractive. They would functionally move the equation in favor of home ownership, but the effects are relatively minor in most cases. Furthermore, because investments are only worth your net proceeds after you actually sell them, I'm going to deduct seven percent of the theoretical market price of your home investment in any given year before I compare the net benefit of buying a home to renting and investing the full difference between renting and putative mortgage. This is questionable to be sure, as most people will just spend at least a certain percentage, but I'm in the mood to be generous. You'll see why in a moment.



I'm also going to assume here, very unrealistically, that you never refinance, but that's actually a middle of the road assumption, as far as net benefit goes. The actual spreadsheet also works a couple of other assumptions, and refinancing every five years and making a minimum payment usually comes out better, while refinancing every five years and keeping a thirty year payoff goal usually comes out worse.



Here are the net results:







Year

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

Value

$450,000.00

$472,500.00

$496,125.00

$520,931.25

$546,977.81

$574,326.70

$603,043.04

$633,195.19

$664,854.95

$698,097.70

$733,002.58

$769,652.71

$808,135.35

$848,542.11

$890,969.22

$935,517.68

$982,293.56

$1,031,408.24

$1,082,978.66

$1,137,127.59

$1,193,983.97

$1,253,683.17

$1,316,367.32

$1,382,185.69

$1,451,294.97

$1,523,859.72

$1,600,052.71

$1,680,055.35

$1,764,058.11

$1,852,261.02

Monthly Rent

$2,200.00

$2,288.00

$2,379.52

$2,474.70

$2,573.69

$2,676.64

$2,783.70

$2,895.05

$3,010.85

$3,131.29

$3,256.54

$3,386.80

$3,522.27

$3,663.16

$3,809.69

$3,962.08

$4,120.56

$4,285.38

$4,456.80

$4,635.07

$4,820.47

$5,013.29

$5,213.82

$5,422.37

$5,639.27

$5,864.84

$6,099.43

$6,343.41

$6,597.15

$6,861.03

Equity

45,000.00

71,773.96

99,968.59

129,660.94

160,932.35

193,868.74

228,560.84

265,104.49

303,600.97

344,157.25

386,886.42

431,907.97

479,348.23

529,340.77

582,026.81

637,555.72

696,085.50

757,783.30

822,826.00

891,400.80

963,705.86

1,039,951.00

1,120,358.39

1,205,163.37

1,294,615.27

1,388,978.29

1,488,532.45

1,593,574.63

1,704,419.63

1,821,401.36

Net Benefit

-31,500.00

-16,618.28

-661.53

16,446.32

34,786.83

54,447.35

75,521.53

98,109.78

122,319.72

148,266.79

176,074.78

205,876.51

237,814.46

272,041.55

308,721.90

348,031.70

390,160.13

435,310.37

483,700.67

535,565.49

591,156.83

650,745.50

714,622.67

783,160.06

857,257.09

937,376.62

1,024,021.69

1,117,739.15

1,219,123.64

1,328,821.95







Yes, after 30 years you are 1.3 million dollars better off from having bought a $450,000 home, as opposed to continuing to rent for that whole period. Not to mention that you own it free and clear for the cost of maintenance plus property taxes, as opposed to paying over $6800 per month rent.



This is a fascinating study in leverage. Now let's look at a slightly different scenario. Suppose you don't have a down payment, as many folks here locally don't, and suppose the property loses $50,000 in value the day after you buy it, as many here locally are fearing right now.







Year

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

Value

$450,000.00

$420,000.00

$441,000.00

$463,050.00

$486,202.50

$510,512.63

$536,038.26

$562,840.17

$590,982.18

$620,531.29

$651,557.85

$684,135.74

$718,342.53

$754,259.66

$791,972.64

$831,571.27

$873,149.84

$916,807.33

$962,647.69

$1,010,780.08

$1,061,319.08

$1,114,385.04

$1,170,104.29

$1,228,609.50

$1,290,039.98

$1,354,541.98

$1,422,269.08

$1,493,382.53

$1,568,051.66

$1,646,454.24

Monthly Rent

$2,200.00

$2,288.00

$2,379.52

$2,474.70

$2,573.69

$2,676.64

$2,783.70

$2,895.05

$3,010.85

$3,131.29

$3,256.54

$3,386.80

$3,522.27

$3,663.16

$3,809.69

$3,962.08

$4,120.56

$4,285.38

$4,456.80

$4,635.07

$4,820.47

$5,013.29

$5,213.82

$5,422.37

$5,639.27

$5,864.84

$6,099.43

$6,343.41

$6,597.15

$6,861.03

Equity

0.00

-25,475.90

370.07

27,611.45

56,326.04

86,596.22

118,509.18

152,157.26

187,638.25

225,055.77

264,519.58

306,146.05

350,058.52

396,387.81

445,272.65

496,860.26

551,306.84

608,778.25

669,450.57

733,510.87

801,157.89

872,602.86

948,070.38

1,027,799.29

1,112,043.71

1,201,074.09

1,295,178.35

1,394,663.15

1,499,855.20

1,611,102.71

Net Benefit

-31,500.00

-64,345.96

-49,629.60

-33,770.92

-16,683.88

1,724.08

21,552.55

42,908.71

65,907.93

90,674.38

117,341.75

146,054.00

176,966.17

210,245.25

246,071.16

284,637.75

326,153.92

370,844.84

418,953.26

470,740.91

526,490.03

586,505.06

651,114.43

720,672.46

795,561.57

876,895.85

965,264.92

1,061,286.66

1,165,634.91

1,279,044.71





Or you're still almost as much better off by buying as you are in the first set of circumstances - a powerful reason not to wait if buying is appropriate for you. We don't know that prices are going down further. I believe they are likely to, but what if they don't?



I've been playing with this spreadsheet for weeks now. Under the basic assumptions I've listed above, it's kind of hard to be ahead of the game by buying a house instead of investing in the stock market after less than two years under any kind of reasonably average assumptions. On the other hand, it's very difficult not to be ahead after five to seven years, and way ahead after ten.



After thirty years, most sets of even vaguely reasonable assumptions have you so far ahead by buying the home that if you didn't watch over my shoulder as I built the spreadsheet, a reasonable person would be sceptical. Heck, I knew which calculation the numbers favored, but I really never stopped to think how strongly they worked in favor of home ownership. It is difficult to come up with a reasonable set of assumptions and starting numbers where you aren't ahead by significantly more than the original purchase price of the home. Yes, we're all aware of the issues with inflation, and the ratio illustrated here, with a 4 percent rate of inflation, is a little more than three to one (which remembering the rule of 115, seems reasonable, so the first approximation check validates this). So what this means is that by purchasing a $450,000 house that you're going to live in for the rest of your life now, you're adding more than $400,000 in today's dollars to your net worth in thirty years. Actually, it's usually more. That safe, conservative, middle of the road net result after thirty years from the first example converts to about the same number of right now dollars! No flipping, no games, no wild schemes, no re-zoning jackpots and no wealthy benefactors to come along and pay you twice what it's worth. In fact, in this scenario you never talk to another real estate or loan person as long as you live, and you've still effectively "gifted" yourself with almost ninety percent of the property's purchase price immediately upon taking possession.



This should persuade most folks that they should want to buy a home, and that you don't want anyone else to. After all, the more poor schmoes there are, the better this will work for the rest of us. Actually, that last crack about poor schmoes isn't true, because the law of supply and demand is always in effect. But is shows how good for the overall economic health of the nation encouraging home ownership is.



Caveat Emptor.

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About this Entry

This page contains a single entry by Dan Melson published on March 16, 2007 10:00 AM.

Some Perspective on the Sub-Prime Lending Meltdown was the previous entry in this blog.

The California Mortgage Loan Disclosure Statement (MLDS) Part I is the next entry in this blog.

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