Like an automated 401k, your home can act as a vehicle to automate your retirement savings. When you make a monthly mortgage payment, a portion of that payment goes to the principal (the balance on the loan) and a portion goes to interest (the cost of borrowing the money). At the very beginning, only about 1/3 of the payment goes to principal. That may seem like it isn’t very much. But when you are paying rent, none of your rent payment goes toward anything that benefits you. It’s simply lost money. Understanding the financial impacts of renting can help you decide if you should rent or buy a home.
So for a $350,000 home, the principal portion of your payment would be roughly $515/month. By the end of 3 years it would have increased to $575/month. At the end of 7 years, the average time a homeowner stays in a home, you will have paid down $50,000 on your mortgage principal balance. Assuming your property increases in value an average of 2% (a low estimate), your property value will now be worth $400,000. And your loan balance will be around $300,000. If you had been renting, in most cases you would have been paying more per month and none of that would have been earning equity for you.
This is a very simplistic example. If you would like a more complex calculator that can help you assess if homeownership is right for you, The New York Times has a great Rent vs Buy Calculator based on 21 different variables that will help you determine if renting or buying is more financially beneficial in your specific circumstances.
Incidentally, I believe that buying a home and never selling it is a great strategy for financial health. Rather than selling your home when you are ready to move up, wait until you have enough financial cushion to buy a new home without selling the previous one. Then you can rent your first home and someone else will pay your mortgage for you as you continue to gain equity and increasing value. Read here for more information on how to turn your primary residence into an investment property.
In many cases, the interest you pay on your mortgage is tax deductible. However, there are some exclusions to this. For example, you must itemize your deductions and they must be greater than the standard deduction. Also, you can only deduct interest from a home that is your primary residence. Vacation homes and rental properties do not qualify for the interest deduction. And there is a cap on the price of a home that will allow you to deduct interest. In the example above, where your investment earned you $100,000 over the course of 7 years, if you itemized your deductions, your savings would be even greater.
Normally, when you sell an investment and make a profit, you are subject to a capital gains tax. However, when you sell real estate that is your primary residence, there is an exclusion on the capital gains tax. If you have lived in the home for 2 out of 5 of the years preceding the sale of the property and the profit doesn’t exceed $250k for individuals and $500k for couples, you are likely eligible for the capital gains exclusion. For a more complete list of tax deductible expenses associated with home ownership, click here. For information about your particular situation, please refer to an accountant.
Over time, real estate prices rise. That is as true for a professional investor as it is for an individual homeowner. And while, like all investments, those increases in value do fluctuate, homeowners and renters are affected differently by the fluctuations. When you own a home, if property values move up and down your mortgage payment will stay the same in most cases.*
But when you are renting a home, the demand for rental properties will likely increases. Property owners will raise rents in response to that increased demand. And salaries often don’t keep up with rising costs of living. Purchasing a home can help equalize your budget in response to the up and down nature of the market.
For quite some time, low home prices and interest rates have made it cheaper to buy a home than to rent one. According to Time Magazine:
…owning remains at least a bit cheaper than renting in all 100 of the major cities on Trulia’s list. On average, U.S. homeowners can expect to pay 33% less than renters in 2017 for an equivalent dwelling, even after you factor in costs such as payments on a 30-year mortgage, home maintenance, and taxes.
However, that gap is narrowing as some major cities. Cities primarily on the west coast, have seen the difference in cost between renting and owning a home dwindle to as low as 3.5%. Here in the Triangle, it would be challenging to find a scenario in which renting is the most cost effective choice. Again, the Times rent vs buy calculator is a terrific tool.
Life is often unpredictable. There are many things out of our control and owning your home removes one of those variables.
I recently had a client who asked me to help sell her investment property. The property was occupied at the time of sale. The renter was very upset that they were selling the property. Showing the home and potentially moving (once her lease expired) were very inconvenient at that phase in her life. But the property owners were a young couple with a new baby of their own and they badly needed the money out of the property to help with some household expenses. The renter was frustrated because she felt that she had been a good renter and always paid her bills on time, so she shouldn’t be subjected to the sale process.
But the whole process had nothing to do with whether she was a good tenant or not. The owners needed the money to pay for their expenses. When you rent a home, the financial needs of the property owner add another layer to your own needs. Unfortunately, you have less control than you would if you were the home owner. Owning your own home takes some of this unpredictability out of the equation.
I don’t know about you, but I don’t feel like my home is really mine until I have made some changes to it that make it feel like mine. Changing the paint color, planting some trees or flowers or replacing those cabinet knobs or light fixtures with something that appeals to your personal tastes begin to create a space that is truly, uniquely yours. Sometimes this is possible in a rental property, with the owners permission. But in many cases, landlords don’t want changes made to the property. The landlord may allow you to make changes. And your improvements may increase the value of the property. But those increases would go to the landlord, not to the tenant.
For more information on buying a home, see:
How to Save for a Downpayment by Kyle Hiscock
10 Biggest Mortgage Mistakes of First Time Buyers by Xavier De Buck
*Some buyers may choose an adjustable rate mortgage when purchasing a home. In this case, your mortgage payment would change as the rate changes over time. However, your mortgage payment would not be directly affected by the increase or decrease in home values.
Ellen is the founder of Harmony Realty, a socially conscious realty company. Ellen believes in empowering her clients through education and open communication. Ellen is a number-cruncher at heart and takes great pleasure in following and analyzing the trends of the housing industry. She loves communicating the big picture to her clients and helping them to understand how the market affects their sale or purchase. Her honest and down-to-earth approach allows her clients to make informed and intelligent decisions to get the most out of their offers and negotiations.