Buying a home can be one of the largest financial decisions people make in their lives. For most, their home offers not only security and stability for their family, but home ownership is often the largest single investment people will make in their lives. For many, property and home ownership represents the American dream offering freedom and independence.
However, when it comes to being a good financial investment, many new home buyers are ignorant to the specific expenses that could make a seemingly good investment downright terrible. In this article, we will look into the pros and cons of home-ownership versus renting and analyze whether purchasing a home is best financial decision. We will discuss the costs of renting the median home or buying the median home in the US.
After looking at the additional costs of home ownership, we’ll determine whether renting and investing the difference in the stock market at the historic return of 10% makes the best choice or if home ownership over time is the better financial decision.
Many potential homebuyers view home ownership as an asset and a savings account that will steadily appreciate in value while they also build equity through their mortgage payments. While homes do generally rise in value over time, constant real gains after considering inflation in a home’s appreciation is not guaranteed. Questions arise as to whether purchasing a home is the best method to build wealth.
After paying for property taxes, insurance, interest, repairs and maintenance that could be avoided by renting, is home ownership really an “investment” or more of a necessary expense?
Certainly, opportunity costs of home ownership are prevalent. Expenses such as a large down payment, paying property taxes, home-owners insurance, repair and maintenance expenses could have instead been passively invested which would have built wealth at a higher rate of return. Aside from the financial aspects of home-ownership, consider the time necessary to work and maintain a home. When the amount of work and upkeep is considered, the financial impacts become even more severe. Unless the plan is to outsource weekly yard work or hire expensive plumbers and electricians, owning a home can result in thousands more in expenses.
For renters, by contrast, the landlord or apartment management company bares responsibility for maintenance and upkeep. The owner also assumes the risk should items inevitably break. Apartment tenants also enjoy the luxury of having maintenance-free pools, gyms, and accessibility to nicer areas where they may not yet be able to afford a home.
Renting allows for flexibility and a low-maintenance lifestyle as well as frees up large sums of money that could otherwise be invested and grow at a faster rate than their personal residence would appreciate. Additionally, renters can avoid the hassle factor of upkeep.
While investing the large down payment and mortgage interest charges may be appealing to many and could result in a higher overall net worth, here’s the secret. Generally, even after investing the expenses saved from renting at a 10% rate of return, the wealth gained on home ownership outweighs renting over a longer period of time. However, this may not be as drastic as people first assume. The benefits of home ownership do not manifest until the mortgage is completely paid off which can be 20+ years away. Additionally, if home owners are not in the financial condition to save for eventual repairs, appliance failures, increasing property taxes, or have the excess cash to contribute to investments outside of their home, renting is the better choice.
Many homeowners who are in a cash crunch turn to high-interest credit cards or home equity lines of credit to finance the repairs they have not saved or cannot afford. If a costly appliance or expensive repair is required early on, these costs drastically reduce the touted benefits of owning the property as these opportunity costs could have otherwise been invested over a longer period of time.
Alternatively, renting offers considerable flexibility and a maintenance-free living experience where a roof leak or window breaking will not cost hundreds or thousands of dollars in unexpected out of pocket expenses. As a renter, there is rarely a worry about scheduling maintenance personnel to come work on your house, yard-keepers to do thousands of dollars in landscaping, shopping for appliances when the dishwasher breaks, or the replacement of large capital items such as putting on a new roof.
However, with renting, payments are not building equity and the eventuality of paying off the mortgage and having no home payment expense at all. Typically, renters must also contend with smaller spaces, close neighbors, and apartment turnover.
In buying a home, many hidden and unforeseen costs arise that are unique to home ownership. The opportunity costs of these expenses must be included when deciding whether buying a home is the appropriate investment to make or if renting would perhaps be a better alternative with the difference invested elsewhere. The information below discusses some of these charges that add up and the opportunity cost and impact of the decision on which is the best financial choice based on median prices in the U.S.
The Psychological Benefits of Homeownership
Perhaps the largest advantage of home ownership does not relate to the financial pros or cons of owning a house but relates to the psychological and emotional stability provided by owning property.
By owning their residence outright, home owners will have the benefit of consistency and a more stable lifestyle. Alternatively, renters are often forced or may desire to move every few years. Coupled with increasing rents, renters often do not have the luxury of consistency in their living situation.
Securing a home in a particular school district allows for parents with children to know their children would not have to move schools should they have to move out of an apartment or rental due to increasing rent costs or a change in management or owner. Especially for those with children, home ownership offers more space as well the emotional benefits of having a more permanent living situation for their family with little fear of being forced to move outside of their own desire. After all, it’s hard to really put a price on the luxury of convenience and stability.
By owning a home, individuals can modify and personalize their space to their own tastes or desires. As an added benefit, if done strategically, modifications, to modernize the layout, upgrade counter tops, bathrooms, or the overall aesthetics will probably increase the value of the property when the time comes to move up in house. As the upgrades would be appealing to potential buyers, the effort, hard work, and additional capital spent on improvements should be reflected in the selling price.
Perhaps the greatest benefit of home-ownership is the fact that after the mortgage is completely paid off, your living expenses drop drastically. With no house payment, thousands of dollars that would have once been used on a rent payment or principle and interest for a mortgage can be redirected in investments to build wealth or used on an increased lifestyle. Having a paid for house greatly reduces risk as there is little chance of eviction even if a job is lost or another financial tragedy strikes unexpectedly.
The Financial Benefits of Homeownership
Aside from the psychological and emotional benefits of home ownership, there are also significant financial benefits to owning a personal residence. Owning a house or condo helps protect and buffer individuals from inflation which would affect their housing payment should they choose to rent.
By taking out a mortgage, the monthly payment is locked in over 15, 20, or 30 years while rents would be appreciating with inflation or at the rate of supply and demand for rentals in a particular area. For instance, according to CNBC, rents increased nearly 3% in 2018. While a 3% rise in rent may equate to hundreds of dollars in extra rent every year, after considering inflation and hopefully, salary increases, the effect is somewhat mitigated.
However, individuals or couples who own their home, would not have to worry about their payment increasing with inflation unless they have an adjustable mortgage rate because their monthly mortgage payments will remain the same assuming a 20-year, fixed-rate mortgage. In fact, in this scenario, the real value of their mortgage payment would have dropped by the 3% of inflation.
Home ownership is like a forced savings account
Paying down the mortgage over a 15 to 30-year period of time essentially works as a forced savings account as a certain percentage of every dollar put in is going towards principal repayment and building equity in the property.
Unlike paying down a mortgage, rent payments offer no equity build up over time. While this seems appealing to many people who do not wish to “throw money away on rent,” consider the fact that paying interest on the mortgage is equivalent to “throwing away money in rent” since the financing charges represent the means by which banks profit on the mortgage and do not bring any value to the homeowner.
Let’s look at an example
Consider, a scenario in which an individual or couple purchases the median price home in the US of $225,300 and puts a 20% down payment on a 20-year mortgage, fixed-rate interest rate at 4.25%. Roughly 57% of the first year’s payment or nearly $7,700 would be going strictly to interest. In fact, the home owner does not begin paying back more principle than interest until the 4th or 5th year of making payments. Over the course of 20 years, the home owner will pay over $90,000 in interest or nearly 40% of the home’s value in interest. If just the annual interest payments were invested in the stock market at a 10% rate of return, instead of being out $90,000, that person would have nearly $355,000 in investments.
Additionally, the portion of the mortgage payment that went to principle as well as 20% down payment of $45,000 could have theoretically been invested and grown in value as well. Instead of making principle repayments to the bank, if the money had been invested in the market, the account would have a nearly $500,000 balance. The down payment would be worth around $303,000 assuming a market rate of return over 20 years.
Opportunity Cost from Mortgage Interest Payments: ($355,000)
Opportunity Cost from Mortgage Principle Repayments: ($500,000)
Opportunity Cost from Down Payment: ($303,000)
Total Opportunity Cost: ($1,158,000)
While there are certainly benefits to paying back a mortgage and building a forced savings account through principle repayment, in the beginning of the mortgage, these benefits tend to be muted as a larger amount of the payment goes to interest. A forced, illiquid savings account is not the best place to store money that could be making a higher rate of return generated elsewhere. However, aside from the loan repayments, homeowners do have the benefit of owning an appreciating asset over the long-term which will be analyzed further in our example.
Each year, homeowners should realize equity appreciation in their home value as the values typically rise from 3% – 10% per year depending on the local economic supply and demand of housing. As homes are typically levered assets due to the mortgage, any gains in appreciation are accentuated due to the use of mortgage debt. This is because the homeowner is able to realize the full appreciation in value while the bank is not entitled to anything other than the principal repayment and included interest.
For instance, suppose an individual purchases a $200,000 home by putting down 20% or $40,000 as a down payment. Let’s suppose the value of property in his or her particular market increases at 7% the next year. Therefore, the house that was purchased for $200,000 is now worth $214,000 or $14,000 more than when the property was initially purchased just one year prior. Therefore, in the first year, the home owner could technically realize a 35% return on their invested money ($14,000 gain in equity value / $40,000 down payment) should they decide to sell and ignoring interest and commissions.
The ability to have 100% control over such a large asset with relatively little equity interest in the property allows for the return on equity to be much greater due to the added leverage.
Over the 20-year period in which the home is paid off, if home prices continue to rise at an average of 6% per year, the median home of $225,300 would have more than tripled to nearly $682,000.
Net Gain in Home Appreciation: $456,700
Opportunity Cost from Down Payment, Mortgage, and Interest: ($1,158,000)
New Net Opportunity Cost from Home Ownership: ($701,300)
While the values of homes generally rise over time, certain expenses end up negating a lot of the gains from the equity appreciation and further decrease the financial prospects of home ownership.
Property Tax Expense
One of the hidden expenses many do not factor in that affects the return of home ownership relates to property taxes. As property taxes in the US average around 1.15% of the property value per year, and the median home price in the US is over $225,300, this equates to nearly $2,600 per year in additional expense that renters do not typically pay. However, the property taxes on the apartment are generally captured in the price of rent payments which results in bill being split among various tenants.
Over time, property values generally increase and when reassessed, a higher value will result in continually higher tax bills. Assuming a reassessment each year on the increased value in the property, the total amount paid in property taxes over a 20-year period is $95,300. Had the property taxes paid been invested instead, the account would have nearly $250,800.
Opportunity Cost from Property Taxes: ($250,800)
New Net Opportunity Cost from Home Ownership: ($701,300) + ($250,800) = ($952,100)
Repairs and Maintenance
Aside from property taxes, the most obvious expense homeowners will endure that hurts the economic prospects of home ownership relates to repairs and maintenance.
Whether the repairs add value such as putting on a new roof every 20 or 30 years or they are as simple as buying and replacing light bulbs periodically or mowing the lawn, owning a home and property requires upkeep that those who rent rarely need to bother sweating over these expenses. Typically, home repairs and maintenance cost can vary depending on particular areas of the country, the age of the home, and how well the property has been maintained historically.
However, estimates peg repairs and maintenance from 1% – 3% of the home’s value as a good basis to determine costs. Therefore, the analysis used takes the average of 2% of a home’s value to determine costs.
In the ongoing example of the median home price in the US of $225,300, this equates to roughly $4,500 per year or $375 per month in maintenance, repairs, and upkeep that could otherwise have been avoided through renting. This does not consider particular years where homeowners may be hit was tens of thousands of dollars in costs for major repairs or replacements of appliances.
As the value of the home rises, this analysis assumes ever higher costs to repair and maintain as the overall cost of goods and services increases with inflation. Additionally, as home value rises and salaries increase with promotions over a 20-year span, people will generally want to upgrade to higher-end appliances and nicer, updated finishes and remodels.
Total Opportunity Cost of Repairs and Maintenance: ($436,200)
New Net Opportunity Cost of Home Ownership: ($1,388,300)
Home Owners Insurance
Another monthly cost, albeit small, that homeowners must contend with is home owner’s insurance. Should a disaster such as a fire or storm strike your home, instead of being left out in the cold, your home owners policy would cover the cost to replace the most value asset that you own. This insurance also covers individuals should someone get injured on the property and elect to sue the homeowner.
Typically, home owner’s insurance is a relatively small monthly payment. This analysis assumes roughly $35 per month per $100,000 in home value or .04% of the home’s value.
Total Opportunity Cost of Insurance: ($92,000)
Final Net Opportunity Cost of Home Ownership over 20 years: ($1,480,300)
In total, the opportunity cost for buying a home with a 20% down payment that appreciates around 6% per year in value is nearly $1.5 million.
This means that if an individual could somehow avoid any housing expenses, they would have a net worth of nearly $1.5 million more in investments over the 20-year period as compared to sinking their money into their primary residence.
However, unless the plan is to continue living with parents or house hacking until age 50, this is probably not feasible to accomplish or a realistic expectation. Instead the most obvious choice to compare is the opportunity cost of renting.
Let’s look at the economics of renting
With renting, we will assume the landlord is 100% responsible for repair and maintenance and the other costs associated with living in the property. Since the median rent in the U.S. is around $1,405 per month or $16,860 per year, we will use this as the starting point and assume a 3% rise in rents due to inflation each year to calculate the total opportunity cost over the same 20-year period. Since the rent payment theoretically encompasses all of the housing costs, this will be the only number in the opportunity cost calculation.
Total Opportunity Cost of Renting over 20 years: ($1,304,000)
Buying versus renting
In total, over a 20-year period, buying a home will have an opportunity cost of nearly $176,300 more compared to renting. While $176,300 is by most standards a lot of money, any large capital expenses such as putting on a new roof early on in the journey of home ownership would make renting that much of a better financial choice in this analysis.
Net Benefit to renting over 20 years: $176,300
What about after 20 years when the home is paid for?
While this analysis was only performed over a 20-year period, the benefits of home ownership is really derived when the mortgage is finally paid off and that freed up money can be invested or spent elsewhere.
Renters, by contrast, can never eliminate their monthly payment and will be stuck with an ever-rising payment in perpetuity. However, should individuals be content with splitting the rent costs with roommates for a number of years or living in a much cheaper house or condo than the median rent, renting could come out much more favorably compared to owning a home outright after paying all of the expenses discussed.
More than likely, the expenses and opportunity cost associated with owning a home do not make it a great investment as there will inevitably be high cost repairs and other unforeseen expenses that were not captured in this analysis that will offset many of the benefits. However, since everyone needs a place to live, owning the property and eventually paying off the mortgage makes the best financial decision in the long-term.
In fact, the breakeven on home ownership beats rent around the 4th or 5th year that the mortgage has been completely paid off. At this point, the homeowner would not only own the full value of the appreciated asset but would also have an entire housing payment that would be free and clear to invest and build immense wealth.
While the prospects to be in this situation took nearly 25 years, completely paid for living with only maintenance expenses and the psychological benefits of owning property outright make property ownership worth the investment for individuals who value this lifestyle.