Myth: You Must Never Pay Rent
The Word on the Street
People often buy homes or other properties because they feel that rent is wasted money. They want to build equity in their homes as soon as possible, and that by paying rent they are “falling behind” in equity.
While it cannot be denied that money paid out in rent is in fact lost and will not yield any future benefit (besides providing shelter), there are reasons to pay rent. In fact, depending on how long you stay in a home, it can actually be MORE wasteful to buy a home.
Doubt me? Let’s take a look at some factors that weigh in on this subject and see what we find.
What is Equity?
One of my biggest grievances against the “rent is waste” argument is that the people who generally espouse and propagate this myth are real estate agents and mortgage brokers. One of their prime arguments is that buying a home builds equity and renting does not. While this is true, it doesn’t tell the whole story. There ways to build equity other than buying property. In order to how to build equity, let’s consider what equity is.
- The monetary value of a property or business beyond any amounts owed on it in mortgages, claims, liens, etc.
- The interest of the owner of common stock in a corporation.
- The excess of the market value of the securities over any indebtedness.
Simply put, equity is the positive cash value that belongs to you, whether it be contained within the inherent value of a property or whether it be in the stock market, savings account, etc. So you can build positive value and increase your net worth in other ways than in accruing equity in a property.
Disadvantages of home equity Property equity is an asset much like a fine painting, a vintage automobile, or a rare Mickey Mantle baseball card; IT ONLY HAS MONETARY VALUE IF SOMEONE IS WILLING TO PAY FOR IT!! The only way to access your home equity is to sell the house or take out a home equity loan (which has its own dangers in addition to costing you interest). And when you sell the home, how much equity will you get? You don’t know. An appraiser can estimate the amount of equity that your home has, but until the deal closes and you get a check in your hand, you don’t know how much equity your home truly will give you.
Another problem with home equity is that it is much like any other equity asset; its value can go up or down. While most profitable equity vehicles also have this feature, sometimes it is forgotten that property values can go down. With the 2007 housing slump, this is a point that many Americans have learned the hard way. If the housing market turns sour (or the city build a dump next to your house!), there is not much you can do about your home equity unless you leave your home before the market hits its bottom. Other accounts can be moved or adjusted to try to protect your cash value.
Don’t get me wrong, I think buying a home is a great way to accumulate equity, and it does have some advantages over other equity vehicles. For starters, while it can go down, property value usually increases much more consistently than other accounts. There are always exceptions, of course.
Have you ever looked carefully at a mortgage bill or an amortization table? No? Well, I have an amortization table right here. Let’s take a look and see what we find:
This is for a $200,000 30 year fixed-rate mortgage at a 6% interest rate, analyzed over the first year of the loan. Notice how much is paid in interest. The cumulative interest for the year is almost $12,000!! That’s about $1,000 a month that is lost as surely as rent is lost when it is paid. You only have about $2400 worth of equity in the home, plus any appreciation that the property experienced that year. If you pay a higher interest rate than 6%, then you pay even more in interest and have a higher monthly payment as well.
Compare the mortgage above with the following situation. You rent an apartment for $600/month. You could afford to pay the mortgage payment, but are not sure whether it is a good time to move into a home. Instead, you invest the difference between your $600 rent and the $1200 mortgage payment.
So, after 5 years, where would you stand on the rent vs. buy scenario above? Let’s see.
- Interest Paid: $58,000
- Equity (no appreciation applied): $14,000
- Total Change in Net Worth: -$44,000 + appreciation on the property
- Rent paid: $36,000
- Savings Account Balance (no interest applied): $36,000
- Total Change in Net Worth: $0 + interest on the account
As you can see, the net benefit of renting exceeds the benefit of homeowner ship, at least from a purely mathematical perspective. With renting, you would have received interest on your invested dollars, and with the mortgage, you would have received appreciation on the property.
Many first-time home buyers neglect to account for some of the other costs of homeownership. Things like state property tax and higher utility bills make homeownership just that much more costly without providing any equitable benefit. Think also about the cost of maintaining the property (not to mention the annoyance of having to fix everything that breaks!). These costs can be quite substantial, just ask anyone who has owned a home for a significant period of time. When you own your own home, there is no landlord to come fix the broken water lines, or to replace the furnace, etc. Paying to maintain the house does not generally increase the value of the home, unless improvements are made while repairs are going on.
The Last Word
I know it may sound like I am opposed to mortgages and homeownership. The fact is, homeownership can be one of the best ways to increase your wealth, not to mention the perks of having your own private home. But when considering whether or not to continue renting, don’t just discount renting as an option because it provides no property equity. Take a look at your situation. Crunch some numbers (or find someone who knows how to do it for you), think things through, try to find the hidden costs, and make an informed decision. Homeownership will benefit you greatly in the long run, but in the short term can leave much to be desired.
Posted on 8 Dec 2007