Now that I wrote quite a bit about stocks and bounds and made some conclusions about the asset allocation between the two, it’s time to write a bit about real estate. But why just a bit? Let’s dedicate a whole series to it! Real estate is interesting, it’s complex and no matter you are renting or you’re a home owner, your living costs will make up a huge part of your monthly expenses. So let’s get to the bottom of this!
Everybody wants to live somewhere and everyone will raise the question eventually: Shall I buy or rent? First of all let me recommend two articles to read from fellow financial bloggers and whose opinion I value a lot: FIRECracker from Millennial Revolution suggests that the best way to achieve early retirement in the shortest time is to rent. Financial Samurai recommends you to buy real estate as young as you possibly can. Got confused? I did. Then I’ve spent quite some time with thinking about this topic and I have found the answer on this question: It depends!
There are a lot of factors that has effect on whether buying and renting is the most beneficial. In my view these factors are:
- Property price vs. rental fee (let’s call it price to rent ratio)
- Mortgage interest rate
- Length of the mortgage
- Amount of down-payment
- Home ownership costs
In this, and the next couple of articles I’m going to demonstrate how these factors have effect on your pocket. Let’s take a basic example that is close to the current nest of Mr. & Mrs. Roadrunner (of course you can, and you should adjust the numbers in order to meet your own personal situation).
Let’s say your dream house is on the market for EUR 380k. Looking at the buy to rent ratio in the neighborhood you see that it is around 18 (380,000 / 18 / 12 = EUR 1,759 per month). You want to get a mortgage for 30 years, fix the interest for 10 years with 2.4% and you can put 10% as a down-payment.
What are the costs of home ownership? It will hugely depend both on your personal situation and the local tax system. For example if you have property tax, that can be a big expense. In the Netherlands there is a property tax that you pay to your local government, but it is only around 0.08-0.1% (depending on which city you live in) of the property value per year. Otherwise we have a kind of wealth tax system here; if you have a property that values 400k or you have 400k in shares, it doesn’t matter, you’re being taxed based on a fictitious 4% return on that value. Because of it I’m gonna exclude it from your comparison. If you live under a different tax system, amend the home ownership costs accordingly. Like we need to pay a relatively high amount of taxes for the maintenance of dams, canals etc., in order to not find ourselves under the water in one morning. You might not have such tax where you live. The point is that you must make sure that you are aware of all kinds of home ownership costs before you buy a property.
Another important expense in relation to home ownership costs are maintenance fees. If you own a house and the boiler breaks, the roof starts to leak etc. you need to pay it yourself. If you rent, it is the responsibility of the landlord. I will calculate with a 1% maintenance fee based on the property value. This might work well for most of the people, but if you live in a small but super expensive condo, things might be different.
In my own personal situation these expenses are adding up around 20.4k per year. I will use it for the calculation.
Inflation: now I will calculate with a 2% annual inflation, which is the mid-term aim of the European Central Bank. Once you will get to the end of this series, you will realize how important inflation is in the calculation. On average all your expenses (if you buy, then home ownership fees, if you rent your rental fee) will get increased by the rate of inflation. Even though property prices can increase rapidly or quickly lose several percent of their value (yes, this is a cyclical thing, just like most of the economy), on a long term they also increase by the rate of inflation (as a comparison share prices have historically risen 6.8% above inflation; this is why you shouldn’t consider your own home as an investment). There is one expense that surely will not get increased: your mortgage payment during the fixed interest period. And this is something that you should really appreciate; we will talk about it later.
So how do I do this by to rent comparison calculation? First of all, you have some cash in your pocket. You need it for two things: the down-payment (now I calculate with 10%, so EUR 380,000 * 10% = EUR 38,000) plus the associated costs around the purchase (notary fees, mortgage adviser, valuation costs, some renovation like painting etc.) We bought our house last year and I have calculated all these fees adding up around EUR 10,000. This is a nice round number, so let’s say you have EUR 48,000 (38k+10k) in your pocket in year zero.
If you buy, in year 1 you use all this EUR 48k to buy the house. You will have 16.3k costs, adding up from the followings: EUR 380 property tax to the local government, EUR 237 water tax, EUR 3,800 maintenance fee, EUR 11.9k mortgage payment (EUR 16k mortgage minus EUR 4,060 interest tax deduction). At the same time you will have the benefit from not renting. The rental fee would’ve been 21.1k in year 1, therefore EUR 4.8k would be your benefit that next year you can invest (I will always calculate with 6.8% return above inflation, which is the historical average stock market return). At the end of year 1 you will have EUR 4.7k.
If you rent, you will still have your EUR 48k that you can invest, and which will return 6.8% above inflation. At the same time you need to pay 21.1k rent, while saving 16.3k on home ownership costs. At the end of year 1 you will have 47.4k.
How your finances will change during a 20 year period, the below chart demonstrates. Of course when it goes negative, it doesn’t need that you’re bankrupt, it’s just you need extra money to fund it.
|Year start||Total cost||Year end||Year Start||Rent||Year end|
|16||177,743.47||19,592.67||202,205.00||– 7,655.08||28,412.78||– 17,148.83|
|17||202,205.00||19,848.58||229,131.49||– 17,148.83||28,981.03||– 27,790.38|
|18||229,131.49||20,110.19||258,745.53||– 27,790.38||29,560.65||– 39,686.40|
|19||258,745.53||20,377.63||291,289.37||– 39,686.40||30,151.87||– 52,953.04|
|20||291,289.37||20,651.03||327,026.70||– 52,953.04||30,754.90||– 67,716.78|
The same figures in a chart:
Hmm, let’s interpret what we see here. At the beginning renting is the more beneficial, even though the monthly rental fee is much higher than the mortgage minus interest tax refund (in year 1 it is EUR 1,759 vs EUR 995). From year 2 the gap is getting narrower, while from year 7 onward buying seem to be more worthwhile. In this year you already pay EUR 1,981 per month as a rental fee (based on 2% increase per year), while your net mortgage payment only slightly rises to EUR 1,046 due to the decrease of interest tax refund. The increasing expenses that come with home ownership also do not change this fact.
We can already make an important conclusion: you should only buy a property where you are willing to stay for quite a few years. (If you want to keep it as an investment property, that’s a different story.) Buying a house only for a few years and then sell it is a dumb idea, unless you’re lucky to have a rapid property price increase over those years. The actual turning point in case of selling is even a few years later, due to the costs you will need to pay during the sale.
So this is our starting point based on a real example. In the following part of this series we are going to see how each of the factors we listed at the beginning of this article can change these numbers and possibly change the result whether buying or renting is the more beneficial option for you. Stay with us!
Are you a dedicated renter? Or you can’t imagine living at any other place than your own house? You consider other aspects before you decide between buying or renting? Share your thoughts at the comments!
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