Myths On Money

The Word on the Street:

I still struggle to convince people that paying rent is not a purely wasteful practice. I have already done several posts on this topic.

The Truth:

Paying rent can be cheaper than getting a mortgage, and the difference in the cost can be invested to your ultimate gain. While I support the idea that most people would benefit from buying a home, I want to emphasize that no one should rush to buy simply because they don’t want to “waste” their money paying rent.

• A Quick Distinction
• A Waste?
• A New Perspective
• Real Estate As An Investment

A Quick Distinction

First off, I want to make a quick point of clarification. Renting an apartment can be much cheaper than taking out a mortgage, but renting a full house may or may not be cheaper. Personally, I think renting a home is not a very good decision, and should only be approached under special circumstances or at necessity. Because of the square footage you are renting, the cost to you to rent a home cannot be much less than paying a mortgage, so if you are going to be paying that much, you may as well get some equity out of it.

That said, if your rent is less than what you would pay for a mortgage, then renting is a viable option that ought to be considered.

A Waste?

So, is paying rent a waste? People often ask, “I paid all this rent, and what did I get out of it? Nothing!” But is that really true? Do renters truly get nothing from their rent payments? To answer, let’s look at a similar situation.

Suppose your family pays $200/month for groceries. At the end of the grocery run, is your net worth increased? Nope. Your net worth has decreased because you now have less money in your checking account. So buying groceries is a waste, right? Please say no. For your money, you got food, and food is necessary to life, so you could argue that buying groceries is a fantastic investment ($200 invested and you get back a month of life for your family, how can you measure THAT return?)

So it is with rent. You may not be getting any DOLLARS back, but the need for shelter is as vital as the need for food. So, for your rent, you are purchasing shelter. So it’s not a complete waste, just as buying groceries is not a complete waste. It is simply a necessary purchase.

A New Perspective

In a very real way, you can think of your mortgage payment as consisting of two parts: one part covers the cost of providing shelter, the second part is an investment in real estate. The interest that you pay every month is exactly like paying rent, with only one significant difference (to be discussed later). The principal portion of your payment is exactly like depositing money into an investment, again with only one significant difference (also discussed later). So, if your interest is just like rent, and your principal is just like an investment, then why not pay rent and make an investment? In the end, the result would be very close to the same.

Examine the chart below for an illustration of what I mean:

Notice the amount of interest paid versus the amount of rent paid. In the earler months of the mortgage, the interest is higher, leaving less to invest. But, over time, the interest expense decreases, thus freeing up more of your money to be invested in your home as equity. This is the fundamental difference between rent expense and interest expense. notice that it takes almost 7 years (83 months) for the interest expense to become less than the rent expense. So, for 7 years, you are “wasting” more money on interest than you would have on rent. After that point, the situation reverses. This is one reason why it is so important to keep a mortgage long-term; you need the late years to make up for the high expense of the early years.

So, if a portion of your mortgage is going towards an investment, what investment is it? It is your home. You are putting money into your home as equity. Simply put, you are investing in real estate.

Real Estate As An Investment

From EzineArticles.com:

Have the historical returns on Real Estate Investment measured up to the confidence it has received?

The answer is a cautious yes. Between 1926 and 1996, the annual average rate of return on Real Estate was 11.1%. During the same period the rate of inflation was around 3%. So, it was obviously a better investment to buy Real Estate than to bury cash in jars in your backyard. However, the rate of return for small stocks checked in a bit higher at around 12% while the Dow Jones Industrial Average was a bit lower at 10%. These figures would suggest that Real Estate investments were right there at a par with Stock Market Investments.

So, you can see that real estate investments enjoy similar returns to the stock market, so either investment would be a good choice. However, there are some differences between them. Perhaps most important is that real estate investments are not as easily converted into cash; this convertability is calledliquidity. If you have a large store of home equity, the only ways to access that is to sell the house or to take out a home equity loan (which would cost interest and thus reduce your net gain on the home). On the other hand, stocks (and bonds for that matter) are generally quite easy to convert into cash. The downside with stocks is that they experience a much higher degree of volatility in the short term. So they may be temporarily low in value when you have to cash them in. Both investments carry risk. The type risk each carries varies. Both investment types carry expenses. Again, the type and magnitude of these expenses can vary.

The important point to carry away is that both renting and home ownership present the opportunity to provide shelter, and that they both have room in them for you to save your investment in some kind of investment vehicle. Bear in mind also that the rent vs buy decision is not a decision that you make only once. At some point, renting may be better for you, but that may change next year or the year after. The key factor in the rent or buy decision is your time frame. If you are going to live in a place short-term, then renting is likely the better choice. If you are settling in for many years of living, then home ownership is likely the better choice.

P.S. Thanks to my Facebook Group for the inspiration for this post! Anyone is welcome to join.

A Shocking Discovery

I was recently watching a financial self-help video from a very popular finance guru, and I was shocked to hear this person say that buying a home was a great investment because it would yield a very high return in the first year that it was owned, and that it would continue to give high investment returns throughout the life of the home. This is surprising, because any one well grounded in finance would be able to tell you that a home is a very very bad investment for the first 3-5 years. It is not until after that time range that the home’s appreciation will begin to actually give a positive investment return.

How Could They Miss?

If the point of the high cost of a mortgage and the need for longevity in a mortgage are such a fundamental principles, then how could the guru have possibly missed it? The answer lies in the cash flows the guru used for the analysis. See, from a certain perspective, the guru was right. But it’s not the whole story. It’s kind of like in Star Wars, when Luke accuses Obi-wan of lying about his father’s death. Obi-wan tells Luke that what Obi-wan’s statement that Luke’s father had died was true, from a certain point of view. And it was. But did Luke realize that he was not hearing what he thought he was hearing? No. He thought that his father was physically dead, while Obi-wan meant that he was dead in a less literal sense. So, while what Obi-wan had said was true from a certain perspective, it certainly succeeded in deceiving Luke. Such is often the case in finance. What you hear may be true from a certain perspective, but it is still deceptive and does not tell the whole story of what is happening to your wealth.

So What Is Happening?

Before I can answer the question of what is really happening and what return you are getting from your investment in your home that first year, I first need to explain a financial tool called a cash-flow diagram. The diagram is fairly simple: it consists of a horizontal line with vertical hash marks all along it. Each hash mark corresponds to a specific time period (ie a month, a year, etc). The diagram must be consistent in that each hash mark must represent the exact same amount of time that each other hash mark represents. On each hash mark, the relative cash flows for that period of time are listed. A cash-flow diagram helps us visualize where the money is flowing, when it is flowing, and which way it is flowing (in to your pocketbook or out of your pocketbook).

With that brief introduction, let’s take a look at the two cash-flow diagrams below. Here’s the scenario: you make a $10,000 down payment on a $160,000 house, meaning that you must borrow the remaining $150,000. Closing costs (typically ranging from 3-5 percent of the balance of the loan) come out to $6,000, a conservative 3% of the loan amount. The home appreciates 4% the first year that it is owned. The top diagram shows the full, actual reality of what the calculation of mortgage returns would look like; the bottom one illustrates a diagram like the one the guru was using for their analysis.

The areas highlighted in yellow are cash-flows which the guru neglected to account for. Notice that in the top analysis, we have taken into consideration EVERY expense and EVERY income associated with the mortgage. In both cases, the final amount of equity in the home that you get when you sell the home is the same, but the amount of the expense is different. The difference in the “investment return” is 138%!

Okay, time to break out the ol’ thinking cap. A negative investment return means that you are losing money at that particular rate. In order to get an idea of the implications of this loan, think of the cash-flows above as a savings account. If you put $16,000 (the $10,000 down payment plus the closing costs) in a savings account today, and deposited $997.95 into that account every month and you only had $17,923.71 in that bank account at the end of the year, what would you think? You deposited almost $38,000 between the initial deposit and the monthly deposits. And at the end of a year, you have less than half of what you deposited in the first place. Wouldn’t that make you mad? I know I would be calling the bank and giving them an earful if my savings account exhibited such behavior!

This is why it is so very very important to consider all cash-flows associated with a purchase/investment. I am not trying to say that buying a home is a bad thing to do. I am only trying to show the importance of understanding and applying the effects of all relevant cash-flows when considering an investment. Suppose you had gone in to the bank and your mortgage officer had told you that you could earn a 79% return on your home in one year. Before you read this post, you would probably have believed him, wouldn’t you? But that fact remains that, while the equity growth from $10,000 to $18,000 is indeed 79%, it does not really tell the whole truth. What about the expense of closing costs? What about the interest expense? Shouldn’t that be considered? Isn’t that important? Doesn’t that strongly affect the investment returns your home is providing? Absolutely. So before you jump into a financial decision, stop and ask yourself the following questions: (1) What will it cost me, both now and in the future? and (2) What will I get (income) from it, both now and in the future? If you do that, you will find yourself making much better financial decisions. And if you can’t figure it out, or what a specific calculation in regards to your decision, then ask a (unbiased!) financial professional for help.

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.

The Truth:

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.

Equity:

1. The monetary value of a property or business beyond any amounts owed on it in mortgages, claims, liens, etc.
2. The interest of the owner of common stock in a corporation.
3. The excess of the market value of the securities over any indebtedness.

Websters.com

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.

Mortgages Cost

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.

Mortgage:

• Interest Paid: $58,000
• Equity (no appreciation applied): $14,000
• Total Change in Net Worth: -$44,000 + appreciation on the property

Renting:

• 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.