4 Reasons Why Renting is Not 'Throwing Away Money'
Time and time again I hear people mention to me that they hate renting and want to buy a house because they are simply tired of throwing away their money.
I understand the sentiment, as no one likes the thought of such a large portion of their money going out the door to someone else (housing costs are roughly 33% of household expenditures per the Bureau of Labor Statistics). However, we must keep in mind that owning a primary residence also comes with its fair share of costs, and the adage of renting is throwing money away is not nearly as cut and dry of an analysis as it might sound or feel.
That being said, here are four financial advantages of (or arguments for) renting that one should keep in mind before jumping to negative conclusions about leasing their primary home.
1. Renting avoids dead equity
When you buy a home, the actual portion of the home's value that you own is called equity (as opposed to the portion of debt you still owe). This equity is tied up in the property and subject to opportunity cost, meaning that this equity could potentially be used for other investments if it weren't locked up in the property. Equity embedded in a primary residence earns nothing, something that can be referred to as dead equity.
When buying a home, it is customary that a buyer has to make a down payment of roughly 20% of the purchase price of the property. For a $200k home, this would be $40k (in addition to closing costs) of money embedded in the property that can no longer be invested elsewhere earning a return. Assuming a potential 10% return, this would translate to $4k/year of missed investment and/or cash flow opportunity. And as the loan is paid down over time, equity (missed opportunity) continues to build.
When renting, you are commonly obligated to make a deposit of 1-month's rent, which is held in escrow by the landlord throughout the lease. That deposit is peanuts compared to the larger down payment required for the purchase of a property, freeing up much more of your equity to be invested elsewhere.
2. Owning (a mortgage) also 'throws away money'
This is an important point that many people miss, so please listen close. When you mortgage a property, not all the money you pay to the bank each month is going towards paying off your loan. In fact, a very small percentage of that required payment (especially in the early years) goes towards the balance of the loan!
Let's run through an example to better explain how this works:
Home purchase price: $200k
Down payment: 20% ($40k)
Interest rate: 4.5%
Loan term: 30 years
Property taxes: $4k/year
In this example, the first monthly mortgage payment would be $1,144.03, which consists of $600.00 in interest, $333.33 in taxes, and $210.70 in principal/loan pay down. This means that only 18.4% of that payment is helping to pay off your loan. The rest is still being 'thrown away' to the bank and local governing bodies.
Banks front-load the interest on a mortgage, which is why the interest on your payment through the first half of a mortgage term will outweigh the principal (that $600 of interest versus only $210.70 in principal). Due to this lending structure, it ordinarily takes about 20 years to pay down half of the mortgage balance on a 30 year loan. Unfair, right?
Lenders do this because it is smart business for them, not you.
Banks know that the medium home-ownership for families is 6-9 years. By front-loading the interest payments, they are always of the winning side of the profit margin spectrum. On average, mortgages terminate and/or turnover before the consumer sees any real advantage.
3. The new tax bill provides less incentive to own a primary home
As we introduce ourselves to 2018, we will also be introducing ourselves to a new federal tax code. Some changes that are taking place could lessen the tax benefits to owning your primary home. In fact, a prominent policy analyst (Ed Mills of Raymond James & Associates) recently stated, "There's really no difference between owning and renting in the tax code anymore for most Americans."
What's the rationale behind this statement? Most importantly, the new tax code will double the standard deduction for both individual and joint filers, meaning that significantly fewer people will be able to itemize and take advantage of the mortgage interest deduction. Also, state/local income, sales and property taxes will now be capped at $10k per year combined, which will basically penalize home-ownership in high tax states.
In fact, this tax bill has caused the National Association of Realtors to express concern about it's impact on the health of the broader housing market. Less incentives to own could very well translate to a downward pressure on housing prices. At the very least, it helps even the playing field (from a tax perspective) between primary home buyers and renters. Any way you look at it, this new tax bill is a feather in the cap for renters.
4. Maintenance costs are someone else's problem when renting
In addition to mortgage interest expenses and real estate taxes already referenced above, home ownership comes with a number of other rather hidden costs. Homeowner's insurance, routine maintenance, structural repairs, and potential HOA fees have to also be considered.
According to the Hidden Home Fees calculator by Angie's List, a homeowner should expect to dish out roughly 1.5%-2% of a home's total value each year for insurance, maintenance and repairs. On a $200k home, this would equate to $3-$4k per year. HOA fees (if applicable) could add significantly/additionally to these expenses. A thorough list of expenses one should take into consideration is laid out here by the folks at My Modern Home.
Painting walls, replacing flooring, repairing roofs and HVAC units, maintaining insurance, etc. are all a part of home ownership costs that can add up in value. By renting, one deflects these costs as long as maintenance required is due to normal wear and tear, and not due to that 30th birthday party that got a little out of hand.
The purpose of this article is not to try and deter a person from buying their primary home, as home ownership has many advantages in the right situation. Instead, I simply want to put to bed the notion that renting your residence is a fools errand. In fact, renting can often times be the smarter financial move.
But as is always the case, every individual's financial situation, goals and local economy will vary. So even though you can follow some general guidelines on buying or renting your home, each person/household has to approach this decision differently.
If you are having trouble in the decision to rent or buy your primary home, and want help evaluating the best move for you, feel free to reach out and schedule an appointment where we can discuss just that. I am more than happy to help!