There are many times when conventional wisdom is wrong, especially in personal finance. Many of us were sold on the American Dream of a house with a white picket fence, two cars, and a dog. Many people have discovered, the hard way, that if those dreams were heavily financed with debt the American dream can quickly become a nightmare. The dream isn’t necessarily the problem. There is nothing wrong with having a goal to purchase a home, cars and/or pets; the challenge, however, is putting oneself in a financial situation to truly be able to afford it.
The definition of what one can afford has dramatically changed over the years and our parents have a strong influence on how we define that. The past 40 years have seen dramatic changes in consumer financial products allowing the middle class to participate heavily in the consumer economy. With credit cards, 0% financing, adjustable-rate mortgages and the like, the ‘buy now, pay later’ phenomenon took off and those who save cash for major purchases were marginalized as either unsophisticated or old-fashioned. Like with most fads, many of these financial marketing ploys later displayed disastrous consequences for people over time.
Fast forward to one of the most common themes, “Why are you still renting, don’t you know that you’re just throwing away money every month?” If you’re getting your finances together to eliminate consumer debt, build an emergency fund, save for a down payment or you’re just not ready to commit to an expense that large, renting is exactly what you should do! We are not suggesting that homeownership is a mistake, only that if you’re a renter and feeling social pressure to buy, there are very legitimate financial reasons to rent. Let’s chat about a few of the common myths out there and bust them one by one.
It’s Cheaper To Buy
In some areas of the country (typically in the South and Western states not named California) it may be relatively inexpensive to purchase a home as compared to renting. However, if you live in or near the 20 most populous metropolitan cities of the US, it’s likely not the case. When people say it is cheaper to buy, they are often comparing monthly rent to the monthly mortgage. Unfortunately, that’s a short-sided view comparing apples to oranges. The additional costs of maintaining a home can costs thousands of dollars each year that renters do not pay. Here are just a few items people typically leave out of the cost of purchasing and maintaining a home:
- Purchasing: Down Payment, Closing Costs, Home Inspection, Land Survey, Appraisal, Attorney Fees, Title Search, Mortgage Processing Fees
- Ongoing Costs: Private Mortgage Insurance (PMI), Homeowners insurance, Association fees, Home Repairs, Lawn Maintenance/Snow Removal, Property Taxes, Utilities
You’re Not Building Any Equity
While it is true that you do not build equity renting, the cost of that equity is important to understand. Also, the additional ongoing costs of homeownership mentioned above like maintenance, property taxes and association fees (not paid by renters) don’t add equity. Those additional costs not paid by renters can be saved and increases a renters’ net worth.
We’ll use an example for this one: Let’s say you’re diligent and save $20K for a down payment on a $220K home. You get a 30-year mortgage at 4.5% for the $200K balance.
After five years, you’ve paid a total $68,800 to your lender ($1,013 monthly mortgage payment + $120 monthly PMI X 60 months), but $43,118 of the $69Kwent straight toward mortgage interest and $7,200 went toward PMI. So after 5 years, you’ve only gained $17,684 in additional equity. In other words, it cost nearly $70K to get $18K in additional equity.So the question is whether all the additional homeowner expenses during both the purchasing process as well as five years of maintenance and taxes (not paid by renters) are more than the $18K of equity built. We all know the answer to that.
You Can Save On Taxes
The mortgage interest deduction is commonly misunderstood and while we’re not going to go into tax policy, there are a few things of note to be informed of when confronting this myth. First, only about half of homeowners receive the mortgage interest tax break. In order to qualify for the mortgage interest tax deduction, youmust itemize your deductions. For many homeowners, the standard deduction outweighs their itemized deduction and therefore, they fail to qualify.Even if one does itemize and qualify for the mortgage interest deduction, note that it is adeduction and not a credit. Some mistakenly believe that it’s a $1 for $1 reduction of taxes, so if you spend $10K on mortgage interest, you’ll save $10K on your taxes, which is false. If you spend $10K on mortgage interest and itemize, you would save $10K multiplied by the income tax rate (i.e. 25%) or $2500. So you would be paying $10K mortgage interest directly to a bank to save $2500 in tax liability. This is not a reason to purchase a home.
It’s The Best Way To Build Wealth
We imagine there are hundreds of thousands of homeowners who faced the 2008 Great Recession that no longer agree with that statement. The reality is that the housing market is unpredictable. One has to be financially prepared for market swings.
In the earlier example of the $200K 30-year mortgage at 4.5%, at the end of that loan, the homeowner would have paid nearly $165K in mortgage interest.
Let’s make that clear, a $200K loan at 4.5% costs $365K, not including PMI.
So we do not believe paying $365K (plus the additional purchase and annual maintenance costs) to buy a $220K home is the absolute best way to build wealth.Note: for more information on the costs of a mortgage, check out the amortization calculator in our Wine Cellar.
If you are a renter and/or feeling social pressure to purchase, we hopefully have busted some myths about renting. Everyone’s finances are different, so run your own race. Decide on your own terms if or when homeownership is right for you. If homeownership is in your future, be well prepared financially as it may be the most expensive purchase in your lifetime.