A Formula to Understand the “Cost of Homeownership”
Looking at these figures might give you a better clue of whether you should be renting or buying
It’s a mortgage, you’re told. It builds equity, society says. The money doesn’t get wasted going to rent, you think.
Deep down, there is a foundational mismatch between what we believe we are getting ourselves into and the reality of our new situation. On the surface, a mortgage is simply a monthly, fixed payment you’re giving the mortgagor for the amount of months that you’ve agreed.
Adjacent to that number, however, is a “cost” that we don’t talk about. This cost involves the usual suspects:
- Property taxes
- Maintenance costs
- Interest rate
- House value
- Federal income tax rate
Outside of your income tax rate, these are elements that you aren’t thinking about when you’re renting.
Using this formula, where:
We can conclude that the cost of a home is as follows:
For example, the cost for a $250,000 home at 6% interest over 30 years, 1% property tax, .75% maintenance costs, and a 30% federal income tax rate is approximately $1,361 a month. If you are looking at a rental cost for an equivalent home in that area for less, then you should consider that, with all factors considered, a better choice.
It’s important to understand a crucial nuance to this cost formula. Namely, adding a down payment to it may significantly lower the monthly cost of ownership. However, that works both ways; by lowering that cost of ownership, the income stream that could have been rendered from that downpayment is now forgone. The opportunity cost of reducing the cost of homeownership is the income that downpayment could have generated in an equity or investment alternative.
There are a few very important takeaways from this comparison:
- Disposable income amount matters. This means that the more disposable income you have, the less the cost figures matter. Obviously, if you have money to spare all the time, then renting will always be a bad choice because you have the ease to take on a mortgage and weather a bad market whilst continuing to make payments.
- There is an actual cost to homeownership. Banks are not working out of love for charity. They want to make money, and they understand how. Most people don’t understand that no matter how low interest rates get, if the house prices continue to skyrocket, then you’re still paying a significant amount in interest for the first 10 years of that mortgage.
- The downpayment is an important number to work with. The more you put down, the lower that cost gets. This means that planning to buy a home is oftentimes more important than actually going through the process and buying it right away. Having that down payment saved might make or break your ability to weather an economic setback. Regardless of how most people feel, equities and assets, and even homes, don’t appreciate in price at every point in time indefinitely. See 2008 for reference.
- There are great times to be renting instead of buying. If you don’t need the space and can forgo the luxuries of the room in a house, then you’re actually saving money by subtracting the property tax, maintenance, repairs, and using that future downpayment for investment purposes instead.
Nothing in life is free. Especially when it comes to homes. Making sure you’re financially literate is a blessing; mostly because it’s a nightmare for realtors and brokers constantly hungry to transact on anything they can.
Always double-check the numbers before you get serious.