June 17, 2019
Over the weekend I received a thoughtful note from a client about renting versus owning.
Our client asked what we thought about the possibility of renting throughout one’s entire life, and taking the money that would be used for a large house down payment (in this case, a 100% down payment) and investing it as we recommend. I wanted to share my reply below:
It’s always great to hear from you!
First, there’s nothing wrong with renting for the rest of your life as long as this is part of your plan, and you do it eyes-wide open. Like anything, it is just a whole lot better if it’s intentional. This is how you’re approaching it, so well done!
In your mail you mention that owning a home means you have to pay taxes on it and maintain it for the rest of your life. This is true, but renting just means you pay someone else to do this for you.
You are correct that you could probably invest the money you’re putting into this house and get enough return to continue renting throughout your life. We can model this with some assumptions if you’d like.
Whether renting forever is scary just depends on your planning. We can share with you that according to Tom Stanley, (author of The Millionaire Next Door and other data-driven books about the wealthy), 95 – 97% of wealthy people choose to own their own home with these type of ratios:
1.) 10% – 25% of their net worth tied up in the house
2.) A mortgage balance between Zero-times and Three-times annual income (not more)
For a family earning $120,000 per year, with a net worth of $350,000 that WANTED to own, these could be reasonable numbers:
- $360,000 purchase price
- $72,000 down (< 25% of total net-worth tied up in the house)
- $288,000 mortgage balance (< 3X annual income)
- All-in monthly / annual payment of $2300 / $27,600
The family in this case should have enough money to build wealth. Even though the bank may be happy to approve their application (!) a $500,000 house is too expensive for this family. As our friend Tom Stanley says, asking the bank how much you should borrow is like asking a fox to count the chickens in your henhouse. On the other hand, a $275,000 house will allow them to become wealthier faster, or to support other goals along the way, such as travel, children’s education, or giving.
For a family in retirement with a net worth of $1.7M, having a paid-for $360,000 house would be totally reasonable; this is less than 25% of their total net worth. For this retired family, a $700,000 house is too much. The home will make it difficult for their other assets to support their lifestyle.
On the positive side, when you own a home, what you get is some protection from long-term inflation for part of your housing budget, and you get a portion of your portfolio returning a very predictable amount once you own it in cash: You save the principal and interest portion of your mortgage payment.
As you can see from the ratios above, we don’t recommend putting 100% or even 50% of your net worth into a house. On the other hand, copying what wealthy people do in terms of habits and ratios is usually a good idea too!
Conceptually, when you rent, this is what you pay:
- Landlord’s Cost of Capital on the home itself
- PLUS Landlord’s Profit
- PLUS Landlord’s Real Estate Taxes & Insurance
- PLUS Landlord’s Maintenance and Repair Costs
- MINUS Tax Benefits that may accrue to the Landlord (deductibility of repair expense, interest expense & depreciation, possibly at a higher tax rate than your own)
When you own, this is what you pay:
Home Ownership Price
- Your cost of capital on the home itself
- PLUS Your Real Estate Taxes & Insurance
- PLUS Your Maintenance and Repair Costs
- MINUS Tax Benefits that may accrue to you (for middle-income tax payers, the TCJA has made this less likely given a much higher standard deduction)
Just looking at that formula lets you know that for an equivalent house, all else equal, by owning you will save the Landlord’s Profit component MINUS any tax benefits that may be greater for the Landlord than they are for you (you may or may not be able to deduct your interest and real estate taxes each year, and you cannot deduct repairs or depreciation as an owner-occupant).
Rather than reinvent the wheel with a bunch of calculations, please check out this excellent article, and then let me know if you want to go deeper on any of this. In a lot of ways, it all comes down to preference and then putting the right plan in place for you.
We wish you all the best!