The conversation of renting vs buying comes up at least once a week in the real estate business. I have seen not just younger renters who became first time home owners, but also people with kids out of high school who had never bought a home and weren’t sure how they felt about home ownership.
I had a couple just like this recently that I had spoken to who did finally have an interest in stepping into the world of home ownership. It was almost a “point of pride” that they noted they were only paying $650/mo in rent for the past decade or so as proof they were getting a great deal on their housing costs, yet they made it very clear during their first conversation with me by phone that they were doing a USDA 100% loan (nothing down) and that the seller “must agree to paying our closing costs.” So the first question to come to mind would be, even with every intention towards saving money, what got in the way of helping these folks who had the benefit of such a ridiculously low monthly rent to save money over these past years? The answer is pretty much the same for everybody. It’s called “life.” Without a forced savings, life always has a habit of getting in the way.
What’s interesting is that the reason so many who are renting right now tell me they are or have been leasing instead of buying a home is because of “saving” money. What about growing your net worth though? Why is that part always forgotten about?
Forbes magazine had a post last fall entitled, “Why Real Estate Builds Wealth More Consistently Than Other Asset Classes.” In it, they provide some startling statistics. The gist of the article was that, “Appreciation, or the rising of home prices over time, is how the majority of wealth is built in real estate. This is the “home run” you hear of when people make a large windfall of money. While prices fluctuate, over the long run real estate values have always gone up, always, and there is no reason to think that is going to change.
One thing to consider when it comes to real estate appreciation affecting your ROI is the fact that appreciation combined with leverage offers huge returns. If you buy a property for $200,000 and it appreciates to $220,000, your property had made you a 10% return. However, you likely didn’t pay cash for the property and instead used the bank’s money. If you consider that you may have put 10% down ($20,000), you actually have doubled your investment, a 100% return.”
They also touch on a couple of points that I thought were useful to the conversation, loan pay down and forced equity.
Regarding loan pay down, “When you take out a loan to buy real estate, you pay it back,” as there is a component of each monthly payment that is principal repayment. One of the best parts of buying real estate is the fact that not only do you own your own home, but you’re also slowly paying down your loan balance with each payment to the bank. It’s forced savings that renters can’t experience!
The Forbes article continues, “In the beginning of these loans, the majority of the payment is going towards the interest of the loan, not the principle. This means you aren’t making much of a dent in the loan balance until you’ve had the loan for a significant period of time. With each new payment, a larger portion goes towards the principle instead of the interest. After enough time passes, a good chunk of every payment comes off the loan balance, and wealth is created in addition to the monthly cash flow.”
Paying off your loan is another way real estate works to grow your wealth passively, with each payment taking you one step closer towards financial independence.
“Forced equity is a term used to refer to the wealth that is created when an investor (or a home owner on their primary residence) does work to a property to make it worth more.” Unlike appreciation, where you are at the mercy and fluctuations of the market along with other factors you cannot control, forced equity allows homeowners an option where they can have a hand in increasing their properties value.
“The most common form of forced equity is to buy a fixer-upper type property and improve its condition. Paying below market value for a property that needs upgrades, then adding appliances, new flooring, paint, etc. can be a great way to create wealth through real estate without much risk. While this is the most common method, it’s not the only one,” according to Forbes.
You want to look at a really big benefit of homeownership?
What happens when a homeowner turns around and one day decides to sell? As a primary residence they can sell and take the gains tax free up to $250,000 or $500,000 per couple! The CPAjournal.com notes, “Several conditions must be met in order to earn the $250,000 or $500,000 tax exclusion. The exclusions apply only to sales of a primary residence, that is, the main home where the seller has lived. Selling a vacation home or investment property does not qualify. A primary residence can be any dwelling, however, including a condo, a co-op, a mobile home, a recreational vehicle, or even a boat. As long as it has sleeping, cooking, and toilet facilities, the place where the seller has spent the most time can qualify for these exclusions on a profitable sale.
The seller must have owned the home and used it as a primary residence for at least two of the five years before the sale. The two years can be interrupted.”
Another real life example
An agent friend of mine was renting about five years ago due to “the Great Recession” and what it had done to her financially. In 2014 however, she was able to buy a new home. Looking back, and I know that hindsight is 20-20 as they say, she has a mortgage payment of right under $2,000/mo, bought the home with an FHA loan, and the home today would be worth roughly $125,000 more than she paid for it. What’s interesting about this is that rent in the county she lives in for a comparable home was going for $2,000-$2,350/mo. She actually “saved” money off her monthly rent payment to purchase the home and now once she sells, she has a $125,000 tax free gain on the home! That home helped rebuild her net worth from the low’s the housing market had come through. With her $10,780 down payment on an FHA loan back just five years ago, that equity has grown to six figures.
So to me, this conversation is more than about saving money on rent. It’s about how you build net worth. In this context, it can only be done on a primary residence however. Better than a 401k or IRA, this builds substantial wealth because of the exclusion to capital gains. So says Forbes, and I have to agree.
** For any tax related advice and guidance, please see an accountant or CPA to know how current tax law applies to you and your situation!