The Principle Difference

Financial planners often identify ways in which people are wasting money and illustrate how that money would grow if instead it was invested. The most common example is someone who spends $3.50 per day on Starbucks:

If you didn’t spend $3.50 a day on coffee, you’d save $1,277 a year.  If you invested that money over 30 years, you’d have $85,305 (assuming a 5% annual return).

While Starbucks is an easy punching bag, many of us fail to see the elephant in the room. We are penny wise but pound foolish. The biggest expense eating away at our ability to save is your home.

Let’s look at a common scenario:

Your mortgage broker tells you that you can afford a $2,500/mo. payment. You’re approved for a $300,000 mortgage.

What is the financial impact of that choice opposed to buying a more modest home, half its price?

You decide you want the biggest and best possible home, so you borrow $300,000 with a 30 year mortgage at 5% interest. Your property taxes are $10,000 per year and your insurance is $800 per year. You will pay $279,767.35 in interest over the course of the loan.

Your other more modest choice is a smaller house and $150,000 mortgage, $5,000 property taxes per year and $600 insurance per year. At the same monthly payment, you can swing a 7 year amortization. After 7 years, you will have paid $28,087.25 in interest over the course of the loan.

The total interest savings is $251,680.10. But the disparity becomes even greater if, after the loan is paid off in 7 years, you start investing your former mortgage payment of $2,120 at a 5% annual return. In 23 years, that money will grow to $1,053,991.29. After adding the interest savings and subtracting the $150,000 difference in the value of the homes, the total disparity in the two choices over 30 years comes out to $1,155,671.39.

Benefits of Strong Savings

The secret to financial freedom is not earning more, it’s keeping more of what you earn and being content with what you have. Some of the many benefits include giving more money to your church and charity, career flexibility, and being empowered to live in line with your values and not compromise your choices based on money.

Many people moving to town face this question: I’m only going to be in town for a few years. Should I Rent or Buy?

A good rule of thumb in most areas is to rent a place to live instead of buying unless you are certain that you will not move for at least 5 years.  In cities like Peoria where there has been little to no appreciation over the last 20 years, I would recommend renting instead of buying unless you’re going to be around at least 10 years.

In our society there seems to be some inherent nobility in owning real estate and something inherently wrong with renting a home.  The false belief that often permeates is that buying a place is always great idea and renting a place to live is silly because when you own your own home, you are able to build equity while renting means you’re throwing away money.

While it’s true that you can build equity over the long term if you own a home, the reason why you are unable to build up much equity in the early years of your mortgage is due to two things most people don’t fully understand: the amortization schedule and compound interest.

The amortization of your mortgage means that the amount you pay in interest is compounded and dependent on the amount of principal remaining on the balance. Early on, a majority of the money from your payments will go toward paying off the interest. With each subsequent payment, more will go toward paying back the principal.

Why does this happen? It comes down to the fact that the amount you owe when you make your first payment is greater than the amount you owe when you make subsequent payments. So when you apply the compounded interest rate to your initial balance, you come out with a much higher interest payment than for the balance of the last payment.

For example, if you buy a $160,000 house and put 5% down, that leaves a 152,000 mortgage. Figuring a 5% interest rate, 30 year amortization, and average property taxes and insurance, your total monthly payment comes to $1300.

After 5 years and $78,000 of payments, you decide to move. Your balance will be reduced to just $139,580. Figuring a broker commission (7%) $11,200, closing costs (3%) $4,800, and moving expenses $10,000, you would need a sales price of $173,500 just to break even.

The bottom line is: pay attention to the amortization schedule. The moderate buildup of that equity in the early years of a mortgage can be quickly erased by the high transaction costs and moving costs associated with selling. 

Many people have far worse experiences. They not only have not built up much equity, they also get stuck paying maintenance, unforeseen repairs, andtwo mortgages while their house is on the market, which, in a down market, can take many months or years.

Unless you’re settling in for the long term, the prudent choice is to rent. I would set the number at 10 years.

Why is renting a great idea for many people?

We’ve all heard the benefits of home ownership – tax breaks, privacy, and building equity over time through appreciation and paying down your mortgage.  If you know you’re going to be in an area for 10-20 years, owning a home makes perfect sense.  It’s likely your home value will rise and you’ll have a nice nest egg to use at retirement.   

So what are the major benefits of renting vs. buying?  

1. Flexibility – Today’s work environment requires flexibility.  Most people don’t stay at the same job or in the same city for an entire career like they used to.  Careers are likely to take us to different cities.  We’re also likely to change careers a few times.  It is much simpler to move at the end of your Lease than it is to sell your house.  
2.  Predictability – Since owners are required to make most major repairs and maintenance, it’s easier to make a budget and stick to it when you’re renting.  
3.  Time – What is more valuable than our time?  Not having the burden of maintenance and repairs means tenants are able to better budget their time.  Many people enjoy spending their weekends on vacation rather than working on maintaining their property.
4.  Liquidity – Responsible home ownership requires a significant down payment – tens of thousands of dollars – and often a mortgage that won’t be paid off for 15-30 years.  You may be building equity, but you’re as liquid as a brick.  Many seniors choose to sell their homes and rent.  Some do it to downsize, but many choose renting later in life in order to realize the equity they have built up over the years.  If they stayed home owners, they would never be able to enjoy that nest egg they spent decades building up.   

So who are the people that benefit from renting?

• Professionals that are required to move frequently
• Young people that are still saving for a down payment
• Seniors that are downsizing and need liquidity
• Empty nesters that love to travel and not maintain a home
• Recent relocations that are taking their time to buy as they figure out their new community

In Summary

Consider this, an asset is something that puts money in your pocket.  When you own your primary residence, the only time this happens is when you sell it.