You’ve just graduated from college and landed your first job, and you need a place to live…should you find a place to rent, or should you look for a home to buy? There are tremendous opportunities in wealth generation when you begin your real estate portfolio early; however, there are a number of other factors to consider.
- What are the circumstances surrounding your housing decision? For instance, how long will you be in the area? What are your goals? It’s important as a young person to consider flexibility, as job opportunities and romance may take you to far off lands. If that is a possibility, then you’ll need to add another factor to your purchase decision; in other words, you may consider buying your first home as an investment property – you plan to live in it for a few years, and then when it’s time to move on…rather than selling it, you rent it out and become a landlord.
- Begin with the qualification process. How much mortgage can you afford? How large a monthly payment are you comfortable with? As a general guideline, lenders like to see your house payment not exceed 28% of your adjusted gross income, and your entire monthly debt not exceed 41%. There are many exceptions to this rule, and many extenuating factors that may result in higher %’s, but it’s a good place to start. If your debt is low (let’s say you only have a car payment and a small school loan, and you pay off your credit card monthly, you’ll be able to have a slightly higher ratio on the front end). For the example we’re using today, you would need approximately $33,000 in annual income, and no more than $400 in monthly debt to qualify for a mortgage of $132,000 at a fixed interest rate of 3.75%. Your monthly mortgage payment would be approximately $968, including taxes, homeowners insurance, and the monthly association fee.
Next, look at what that amount will buy, both in the housing and the rental market. The first step in the evaluation is comparing apples to apples. What is available? What is the inventory supply of choices, both in the housing market and in the rental market?
- Assuming that you select a fixed rate mortgage, your house payment will remain the same over the term of your loan, versus a rent payment that will adjust annually to meet inflation.
Let’s compare a $135,000 purchase with a comparable rental. Assuming a minimum down payment, and a 3.75% 30 year fixed mortgage, your house payment would be $613, plus another 30% roughly for taxes and insurance, for a total payment of around $968. Let’s assume a comparable rental will be $900 per month. On the surface, that seems to be a $68 savings per month, or a $816 annual benefit to renting.
- The first adjustment you’ll need to make is to factor in the tax benefits of home ownership. On a $132,000 loan at 3.75% interest for 30 years, for instance, your interest deduction in the first year would be $4,900. So, if you are in a 25% tax bracket, that deduction will save you $1,225 in taxes, or $102 per month. That means that your “effective” mortgage payment after the tax benefit is $866.
- Because of inflation, your rent will escalate annually based on the terms you’ve negotiated in your lease. Commonly, escalation clauses fall somewhere between 3 and 4% per year. So, the $900 rent payment this year will become $1,043 in 5 years based on a 3% escalation…whereas your mortgage payment remains fixed at $968.
Over time, more and more of your mortgage payment will be applied to reducing the principal balance of your loan, which is in and of itself a forced savings program.
Most importantly, and generally considered the most important advantage of home ownership, is the inherent value of appreciation. It’s fairly safe in the current market climate to use a factor of 4-6% appreciation over the next five years. So, as an example, a $135,000 purchase increases in value to $164,250 in just 5 years (based on a conservative appreciation factor of 4%), because as a homeowner, you enjoy the appreciation based on your sales price, not just your investment.
So, if you opt to buy, your initial $4,700 investment grew to $29,250. If you choose to sell your home at this point, you should plan on approximately 8% in selling expenses, so your net proceeds would be $13,140.
Let’s assume that you chose to rent, and so you invested the $5,000 that you saved because you didn’t make a down payment in the stock market. Using a 10% rate of return, your investment grew from $5,000 to $8,050 over those same 5 years, netting you $3,050, compared to the $29,250 in equity you built during the same period as a homeowner (and that does not factor in principal reduction), or $13,140 net proceeds if you choose to sell.
The other important consideration here is that in order to even net $3,050, you have to invest the money you didn’t use as a down payment. Most renters are not that disciplined, which is another argument for why homeownership is a great “forced” savings plan.
- There is one potential downside to the rent vs. buy analysis, and that is market timing. If you’re not in a position to hold your investment long enough to enjoy the benefits of appreciation and equity growth, or worse, if you are forced to liquidate at a down cycle in the market, the equation may not be as favorable.
In order to avoid that, one recommendation is to considering holding on to a property as a rental investment, rather than selling at a low point in the market. If you buy carefully, with an eye toward turning your first purchase into a long term investment, you can create some significant equity over a longer holding period, while the tenant is effectively making your mortgage payment.
Continuing on with our example, the townhome would be worth approximately $200,000 at the end of another 5 years, bringing your total equity to $68,000 not counting principal reduction. Or, after selling expenses, a net of $52,000.
Take away: When you consider renting or buying your first home, think about your long term investment strategy rather than just your short term housing needs. When you add up the tax benefits of home ownership, the “forced savings” of principal loan reduction, and the potential appreciation on the leveraged sales price vs. your cash investment, making smart housing choices can also put you on the path to long term wealth.
Are you looking to start the home buying process? Email us at concierge@lizmoore.com, we'd love to help! Or, click below to download our free Home Buyer's Handbook.
Are you interested in hot real estate topics, tips and trends?
Click below to subscribe to our blog!
