If home ownership were a cult, I think half of America’s homeowners would already be gone from kool-aid poisoning.
Call it the American dream. Call it an internal desire for nesting.
Whatever you call it, people attack the home ownership problem with a fire and fury that would make our president proud.
And yet, from where I’m standing, we can solve the entire “buy vs. rent” debate with one simple calculation.
For millennials, buying a home comes down to a question of cash flow.
Nothing more. Nothing less.
Despite all the noise and hoop-la, the buy vs. rent question can be settled with one elementary flow chart:
- If the monthly cost of owning a home is less than the cost of renting, you should buy a house.
- If the monthly cost of owning a home is more than the cost of renting, you should keep renting.
(I should probably add an actual flow chart here, but you get the idea…)
On paper, that looks and sounds like the ‘duh’ statement of the century. But don’t be fooled – this is one of those russian-doll like sentences, where nearly every word leads to yet another question.
Namely, the things we’ll have to figure out include:
- What about all those intangible home ownership benefits you’ve heard so much about!?
- What is the actual cost of owning a home, anyway?
Do NOT Listen to the Crowds (The 2 Massive Mistakes Most People Make)
The question of cash flow should be intuitive, but it’s not. That’s thanks to an army of bankers, real estate agents, and dare I say… baby boomers?… slinging all sorts of distractions our way.
Yes, those baby boomers include your parents…
- They’ll clamor on and on about the magical equity. (Which it appears, almost nobody actually understands)
- They’ll create a sense of urgency with fear-mongering about inflation, a seller’s market, and who knows what else.
As a result, most people stretch The Golden Rule of Home Buying. They end up buying a house that costs them FAR more every month than their previous rental situation, and it cripples their investment abilities for the 30 remaining years on their new mortgage.
In a nutshell, they drink the home ownership kool-aid.
Biggest Mistake #1: The Trap of Home Equity
One of the most common questions I always get is, “Why don’t you include the value of your house in your net worth updates?”
The paper answer is that the house I “own” is technically under Lady Money Wizard’s name. At least until we get married next year. But truthfully, I’m not even sure I’ll add it once it is in my name.
That’s because for the purposes of financial independence, building home equity is a bit of red herring.
Net worth tied up in your house is not the same as true net worth.
Why?
Because you always need a place to live.
Think about it. Once you pay off the mortgage, it’s not like you’re handed a check for the value of your house. You don’t even get a passive income stream.
The only way to profit on a paid off home is to sell your house. And then what?
You’ve got to find another place to live!
This is why increases in your home’s value should be met with a big old shrug.
The only way to capitalize on that increased value is to sell your house, and either downsize to something much smaller, or move entirely to a new town with a noticeably cheaper cost of living.
Almost nobody does this.
Biggest Mistake #2: Not keeping your cash flow as high as possible
The biggest problem with all the rent vs. buy advice is that it typically assumes that if you’re not spending your money “investing” in a mortgage, that you’d otherwise be blowing it on wild nights at the casino.
Reality is much different, especially for people money-savvy enough to be reading this site.
If you’re chasing financial freedom, you want to be pouring as much money as possible into income producing assets that will support your lifestyle after you leave your job.
With this mindset, your living arrangement is nothing more than an expense. No different than groceries, restaurants, or a car payment. And your #1 priority should be to minimize ALL your expenses, as much as possible.
If you can find a place to rent for less than the cost of owning a home, you free up your cash flow. Then, you can use that money to invest in stocks, bonds, businesses ideas, etc. All of which are actually building your nest egg and buying your freedom.
3 Legit Reasons to Buy a House (If it’s cheaper…)
That last multi-section rant might sound like I’m unpacking for an extended stay in Camp Anti Home Ownership. That’s not true at all, and I’ll again reference The Golden Rule.
If you can find a house for cheaper than your cost of rent, then you should absolutely buy it. (Assuming you’re not planning on moving soon, but we’ll get to that…)
Why? Three main reasons:
1. You’re locking in your rent payment forever.
When I first moved to Colorado, my one bedroom apartment was $800 a month. When I left less than three years later, that same apartment had climbed to $1,100 a month!
Closing on a home protects you from this risk. You’ve essentially locked in your “rent costs” with a banker instead of a landlord.
If your landlord said, “Hey, is it cool if I never raise your rent for the next 30 years?” you would jump all over that deal.
(Just keep in mind that you’re still subject to property tax increases and the inflationary costs of utilities and maintenance.)
2. You’re giving yourself leverage
Despite all the myths surrounding it, home equity isn’t worthless.
As you continue to pay your mortgage, you are diverting some of that money towards building an asset. And in the mean time, you’re also controlling an asset that you otherwise couldn’t afford.
While this does come with some risk, it also allows you options. If your home’s price does appreciate, you could move to a cheaper location or cash out and downsize.
3. Eventual “rent freedom.”
When you pay off the house, a goal most personal finance sites glorify like the pinnacle of money management, you longer have a house payment. Instead, you’re “living for free.” (Sure, you’ll still have to pay property taxes, utilities, and that random sheet rock repair after the dog ate his way through the wall, but we’ll ignore all that for now.)
In any case, pay close attention here… the true benefit you gained in paying off the house is a reduction in your monthly spending. NOT the value of your house.
Again, just like the beginning of this article, home ownership, and its potential benefits, comes down to a question of cash flow.
So, how to actually calculate the cost of owning a home
All that theory is great and all, but how do we actually know if a house is helping our cash flow or dooming us to living paycheck to paycheck?
You calculate your monthly “rent” of home ownership. And you make sure not to overlook so many of the expenses most home owners forget about.
I wrote a whole article about the hidden costs of home ownership, but in general you need to be sure to include:
- Monthly mortgage (Use a good mortgage calculator and make sure to include interest AND principal. Why principle? Scroll up and re-read my thoughts on home equity.)
- Insurance
- Property Taxes
- Maintenance
- Closing Costs
Wait, how the heck do you include closing costs in rent?
When we closed on our house, I was shocked at the price of closing costs. Between expensive inspections, fees paid to the bank, and who knows what else, we paid somewhere around $5,000 to close on our cheap house.
My favorite way to evaluate this expense?
- Estimate how long you will live in the home
- Divide those closings costs by the number of months you expect to live in the home.
- Add those closing costs back to your monthly “rent.”
For example, I think it’s reasonable we will stay in our house for 10 years. In which case, $5,000 of closing costs is $500 per year, or an extra $42 per month of home “rent.”
But… tax deductions! (Or is that a big lie???)
Because math is hard and everyone except masochistic bean counters hates dealing with The Dreaded ‘T’ Word, it’s understandable how many misconceptions there are about taxes and the mortgage interest deduction.
Here’s the first thing you need to know about the tax deduction for mortgage interest: even in it’s glory days, nearly half of homeowners couldn’t take advantage of it.
With the recent tax cuts, 90% of homeowners now get no tax benefits from their mortgage interest.
That’s because in order for the mortgage interest deduction to be worth it, you have to have more taxable deductions than the standard deduction. (Now $12,000 for individuals and $24,000 for married couples.) And 90% of people just don’t.
For reference, Lady Money Wizard’s $180,000 home includes just $5,000 of interest a year. So yeah… like 9 out of 10 fellow homeowners, it’s definitely a better deal for her to just take the $12,000 standard deduction.
Go ahead and crunch the numbers for yourself. But as a general rule of thumb, unless you’re buying a house over $400,000 (or otherwise donate to taxable write offs like an absolute SAINT) you can ignore any sort of mortgage interest deduction from your thought process.
Tying it all together with a real life example
I ran these exact numbers before we bought our house. And I posted the following chart:
Adding back closing costs, we’d be looking at a monthly rent payment of $1,235.
Considering we were spending $1,200 to rent our two bedroom apartment, this was close enough that we considered the extra $34 a month a worthwhile cost to gain an extra bedroom, full backyard for the dog, private walls, etc.
Plus, for $34, we got to take advantage of leverage, protect against inflation, and put down roots.
Final Answer: When should you buy a house?
So, before jumping into one of the largest financial commitments of your life, I encourage you to run the numbers for yourself. Then, follow The Golden Rule of Home Buying and figure out which of the three buckets you fall into:
1. If buying a home costs less than your current rent →
This is a no brainer! Buy the house! (Just make sure you’re not forgetting any expenses!)
2. If buying a home costs a lot more than your current rent →
Keep on, keepin’ on. Nothing wrong with #RentLife.
As long as you’re investing elsewhere, don’t worry about the clueless naysayers claiming you’re “throwing away money.”
3. If buying a home costs a little more (less than 20%) than your current rent →
Then it becomes a matter of personal preference.
- If you’re a free spirit who doesn’t want to do any maintenance, and instead wants to be able to spread your wings and soar at a moment’s notice, definitely do not buy the house.
- If you’re a homebody who’s looking forward to making a place your own or is anxious about putting down roots, then feel free to stretch the budget knowing it’s not the financially optimal choice. Similar to how occasionally going to a nice restaurant might not be the greatest choice for your finances, but does have some real value in making you happier.
Emphasis here on a little more, though. If you’re increasing your monthly home expense by 20% or more, you could be looking at a serious lifestyle change – both in your discretionary spending potential and your ability to save for freedom.
What do you think about The Golden Rule?
Related Articles:
- I Bought a House! Sort of…
- How to Lose Money on Your House (Even After Earning $200,000 on the Sale)
- Home Equity: The Most Misunderstood Term in Personal Finance
I’m surprised you didnt mention the lack of self control people have once they buy a house. “Honey, we need new furniture now.” “Oh wow, now we have room for a pool table.” “Honey, lets remodel the kitchen” *wink wink*.
Haha! So true, buying a house is like pouring gasoline on the compound spending fire. As me and my $15,000 kitchen can attest.
Is 90% of the country really buying homes for under 400k??? I guess being stuck here in a HCOL bubble has made me forget what the average home costs. If you find a single family home for under 400k near me the first question you ask is “What’s wrong with it?”. It’s just unheard of.
Median US home price is $231,000, according to google. I’ve got a piece coming out in a few weeks that shows the median price per state. Should be interesting!
Is this equity question true for an apartment in New York City? In NYC, and perhaps other large cities in U.S., apartment prices seem to always rise.
Tough call… NYC and mega-HCOL sometimes act like another planet. NYC also has strange government imposed rent controls, which I’m admittedly not all that familiar with. So that could change the dynamics a bit.
Often though, the high cost to buy usually tilts the scales towards renting, IMO. Whereas in Minneapolis you can easily find a place to buy for the same or less than the cost of renting, NYC, from what I’ve seen, usually obliterates your cash flow if want to purchase a comparable living arrangement.
I thought this was one of your weaker pieces. To get a more palpable home equity perspective, think about 15 year mortgage, that you paid of and then took out a home equity loan – such that your overall payment remains the same. Then divide the amout of that home equity line by 15 years and that’s essentially your positive cash flow.
Yes, that’s one option. Although if you’re dividing by 15 years, you’d still have to consider the cost of your 15 years of mortgage payments to find the true cash flow, unless I’m missing something with your strategy.
You hit the nail in the head with Biggest Mistake #2. Check out this study that came out in 2017: https://aresjournals.org/doi/abs/10.5555/1052-7001.26.1.1
They basically assumed that instead of spending you are investing the difference between your equivalent rent and the rent you actually pay. Turns out that the renter would be much wealthier than the owner.
You can send the authors and email and I’m sure they will share the PDF.
Very interesting, I’ll have to check it out. Thanks!
Hmm, I think you are right on most of your points here, but I also think you didn’t spend nearly enough time talking about the rent freedom aspect of owning a house.
Simplified scenario: say you buy a house at 25. 30 years later you’ve paid it off at 55. If you continue to live in it until 85, you’ve spent half your time without housing payments (yes, I’m ignoring property taxes, etc.). Your mortgage payments over the first 30 years have paid for the second set of 30 years, effectively making their worth double an equivalent rent value. For what is often the biggest expense for an individual, 50% savings is absolutely massive, especially when those savings come during the retirement period. Add to that the locked in mortgage payment as opposed to inflating rent prices, and you have a real winner.
To me, that is a huge point in favor of buying, assuming you are able to pay off the house and stick to your plan, and live long enough to make it count.
That said, to continue to back up what you have said, I don’t think this makes a house a great investment. You’re probably not making much money on the deal. But I do think, when done properly, it can be a far less terrible long term expense than renting.
I should add to my comment that the older you get, the less true my statement is. If you buy your house at 55 and pay it off at 85 and die at 86, you aren’t reaping any of the rewards. Like most investments, the younger you are when you buy the home, the more you reap the benefits of cheaper living (relative to renting) when you are older.
Yep, good point. And I’m admittedly biased, since I’m more concerned with hitting financial freedom before age 40. This post is skewed in that direction, rather than a true apples-to-apples wealth comparison at age 85.
Your follow up is a good counter-point though. Small differences in cash flow when you’re young, if invested, can compound into massive portfolios by the time you’re 85. So the increased benefit of the rent is discounted by the increased size of your investments.
Fun post once again, Money Wizard.
Although I find your comparison of renting vs buying very interesting, and an excellent thought exercise, I think Jack’s argument wins the day. The whole idea of index fund investing is to win the long term, not the short term. You made the critical mistake of saying, “Once you pay off the mortgage, it’s not like you’re handed a check for the value of your house. You don’t even get a passive income stream.” As Jack points out, you do indeed receive a financial benefit in the form of no rent (property taxes and maintenance excepted). If one were to prioritize their mortgage with the same fervor as they do other savings, you could maximize this savings over the long term.
Furthermore, if paired with the frugal zeal that you so enthusiastically endorse on your site, in the form of modest home sizes and less affluent zip codes, and avoiding the material trappings of filling a large home, then one could definitely imagine a situation of essentially negating the largest cost in most people’s budget. That’s never going to happen if you rent.
Fair enough, but at what point is an increase in living cost too much? If you bought a house that dropped your savings rate down to 0% and put you into financial worry, that’s obviously a problem.
The “one day I’ll live rent free” trap is probably the biggest reason people overbuy on homes. Especially when “rent free” means you’re still paying over half of your usual living costs with taxes, maintenance, utilities, etc.
IMO, the “less than your current rental payment” rule, give or take 20%, is a good compromise for this.
I agree 100% with your second point about frugality in home buying. Then again, if you’re buying a massive house in the most expensive zip code, you’re probably breaking the rule anyway.
I’m interested in seeing the breakdown over a lifetime when you consider “locking in” your rent cost when you purchase a home. This seems like a bigger deal on savings than you detailed. Thoughts?
See my comment to Jack – this post is tilted towards a strategy to reach financial freedom ASAP, rather than total, old-age wealth accumulation. I’ll have to do a long-term comparison at some point, although I suspect it’s still closer than a lot of people think!
One other intangible (from a Boomer perspective, lol). When you rent, your building, condo or house can be sold, and you may have to move. Or, your rent could increase to the point where you wish you had bought a few years ago. In a landlord’s market like Southern California, someone renting who happens to have kids or a pet may find themselves SOL if they get 30 or 60 days notice they have to find a new place. May have to give up the pet, or go live in a completely different school district, both huge problems. Moving from state to state while raising children, we always preferred to buy for that reason. But we made sure we bought one of the lesser priced homes in a great neighborhood. We never came out on the bad end when selling to relocate.
All good points Lisa, thanks for sharing!
Hello Money Wizard. Love your articles! Question: Should the cost of the downpayment be divided up over the 10 years you are estimating that you will be living in the house & included in the monthly house expenses, or am I wrong? And thanks again for all your great posts!
You could if you want to. I chose not to since I’m approaching this from a question of cash flow. While there’s obviously an opportunity cost to a downpayment, diverting money you’ve already saved to real estate doesn’t by itself impact your ability to save for financial freedom in the future. And like I mentioned in the article, for all the misrepresentations of home equity, it’s not worthless… the down payment goes towards building equity that can be realized later.
I realize it’s a little inconsistent to ignore the cost of the downpayment while counting the cost of principal reduction. I consider this my compromise for equity being overrated, yet still holding some value.
To answer this question you have to solve for two problems:
1) The opportunity cost of $40,000 ($35,000 Down, $5,000 Closing Costs)
2) The delta between the cost of home ownership and the cost of renting (for savings reasons)
For argument’s sake let’s just say the intangible benefits/costs of owning and renting cancel out one another. In other words, you are indifferent between owning and renting. (On one hand I can have the TV loud without worrying about my neighbor complaining, but on the other hand I have to mow my lawn).
I disagree with the premise that you should NOT include home equity in your net worth.
“The only way to profit on a paid off home is to sell your house. And then what? You’ve got to find another place to live! This is why increases in your home’s value should be met with a big old shrug.”
Yes, but now I’m finding a place to live with a (hopefully large) chunk of change in my bank account. When you “cash-out” your home’s equity by either selling or refinancing, that cash can be invested to pay for “rent” or you can use those savings and cash is no longer coming out of your “pocket”. Cash is fungible, so not really sure where he is going here.
Despite this disagreement, the Wizard comes to a sound conclusion with the +/- 20% rule. It is true that if you can save +/-20% by renting and investing those savings every month, the returns on those contributions when compounded may outperform your investment in real estate in the long run.
It really depends on your assumption of three things:
1) How the stock market will perform
2) How your home’s value will perform
3) Over what period of time you are analyzing the following
So, rather than beat this to death through words – drop your email and I’ll share an easy to use Excel template that you can tailor to your own situation and your own assumptions effortlessly and see for yourself!
Rock on,
Hank
Rock on, indeed. I fully expected my view on home equity to be the most controversial view in the post. For the record I don’t think primary residence equity is worthless, just a slippery slope that’s often used as justification for buying too much house.
Here I’m living in a college town in rural South, the rent for my one bedroom apt. altogether increased $25 per month in the last 8years and the landlord does everything such as mowing and maintenance. Houses are also very cheap here. For half a million you can own a castle. The prices change little over the years either. Yet as a single person I prefer to rent because I don’t know a thing about maintenance and I’m always out of town for summer and winter breaks, so it would be good to let other people do the work. In the long run I might end up paying a bit more by renting instead of buying, but by renting I have freedom and ease of mind. I think it is important to invest, but it doesn’t have to be in the form of a house, even if buying is cheaper than renting. I might buy a house in a place where the housing prices rise fast, but not here (only 1~2% at best without considering taxes, insurance, closing cost, interest, and maintenance)
Sounds like the perfect setup for somebody who enjoys their flexibility. Enjoy!
This is a very well written post MoneyWizard! I couldn’t agree more with your conclusions! Although I might add the following….
Growth is also major factors that need to be considered also. For example, I live in a high growth area and the demand for housing has been increasing faster faster than the number of homes being built. This has jacked up the cost of real estate incredibly. Rents have gone up like crazy and it’s tough for young people.
Meanwhile homeowners have done OK because of that fixed “rent” you mentioned.
The cost of materials to repair to a home has gone up with inflation, but you know what’s gone up even more? Labor! The cost of hiring someone to perform those repairs has grown incredibly.
These factors rarely get any attention, because they’re not predictable. Growth is pretty much unpredictable.
Good point. As a new homeowner, I’m surprised at the cost of repairs, and more specifically, the hourly rates a lot of handymen charge. Interesting to hear your take on it.
This is the most honest article ever written on home ownership. When you eliminate the emotional aspect of home-buying, it really becomes an easy decision as you’ve illustrated. Superb post, one of my favorites so far!
Awesome to hear! Thanks, Andrew.
so if you were thinking of buying a 750,000 house cash, what would the investment losses of buying vs renting be if rent was say 2500 per month
How does this apply to someone living in an expensive real estate market, like New York, or San Francisco, or Toronto? Property is so expensive that it is unlikely monthly housing payments would ever be lower than monthly rent, unless one goes for an unreasonably nice rental. Would this mean no one should ever buy in those markets (at least until the price bubble bursts – if there is one – or rent prices catch up)?
IMO if you can rent the same quality place for cheaper than it costs to own, then why would you want to spend more to own?
Others will disagree with me on this, and they’ll say it’s worth it to lock in your rent costs. I still think that gives you too little flexibility and can wreck a young person’s ability to save for freedom. But to be fair, I’m also more debt averse than most. Other bloggers like Sam from FinancialSamurai had good luck taking massive risk with San Francisco real estate and swinging for the fences. They also had $200,000+ salaries to offset the cost though.
It’s good to know that buying a home can help you build a financial asset. My sister has been telling me about how she came into some extra money recently, and she’d like to use it to invest. I’ll share this information with her so that she can look into her options for getting a home.
It made sense when you said that millennials should rent a home if the monthly cost of owning a home would be higher. My son needs to move for his work later this year and is trying to decide between renting or buying a home. I’m glad I read your article so I can let him know why renting a home would be a better option for him!