Renting vs. Buying a home The math of renting vs. buying a home. Challenging the notion that it is always better to buy.
Renting vs. Buying a home
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- Welcome back.
- I'm now going to take a slight tangent and cover a topic
- that, I think, this is probably the single most important video
- that really anyone can watch.
- I go to all of these parties where I go see family.
- And my wife and I right now, we live in Northern California.
- And we're renting.
- And I like to point out, by choice.
- And I have family members, why don't you buy?
- You're at that stage in life,
- that's a major milestone, all of this.
- There's a lot of pressure to buy.
- And when I tell friends,
- I tell them I'm not going to buy.
- Because I think I'm pretty convinced,
- almost 100% convinced,
- that housing prices are going to revert back.
- And I'm going to do a bunch of presentations
- to justify why they will.
- But then my friends,
- they'll just throw out the statement that I hear from them,
- that you hear from real estate agents,
- because obviously they want you to buy.
- Well, isn't buying always better than renting?
- And I think that kind of common wisdom
- comes out of the notion of,
- when you have a mortgage or when you borrow money to live in a house,
- every month that money that you give to the bank
- is kind of going into savings.
- That's the perception.
- While when you rent, that money's just
- disappearing into a vacuum.
- In this video I'm going to work through that assumption,
- and see if that actually is the case.
- So let's say I have a choice.
- Let's say there are two houses.
- This is house number one.
- And this is house number two.
- And let's say that they're identical houses.
- These are three bedroom, two bath, townhouses some place in Silicon Valley,
- which is where I live.
- And I want to live in one of these houses.
- I'm indifferent as to which house I live in,
- because they are identical.
- So living in them is the identical experience.
- I can rent this house for $3,000 a month.
- Or I could buy this house for $1 million.
- And let's say that in my bank account right now,
- let's say I have $250,000 cash.
- So let's see what happens in either scenario.
- Let's see how much money is being burned.
- So in this scenario what happens?
- I'm renting.
- So in a given year,
- let's just see how much money comes out of my pocket.
- So in a given year I pay $3,000.
- $3,000 times 12 months, so I lose $36,000.
- So I'll put a negative there,
- because that's what I spend in rent.
- $36,000 per year in rent.
- And then of course I have that $250,000.
- I'm going to put that into the bank,
- because I have nothing else to do with it.
- I didn't buy a house with it.
- And let's say that I can, in the bank,
- let's say I put it in a CD.
- And I get 4% on that.
- So let's see, 250, that's what? $10,000, I think.
- That's 0.04.
- Right, I get $10,000 in interest a year on that.
- So I get $10,000.
- So plus $10,000 a year in interest.
- So out of my pocket,
- for the privilege of living in this house, in Silicon Valley,
- with beautiful weather,
- out of my pocket every year goes $26,000.
- So that's scenario one.
- So what happens if I give in
- to the peer pressure of family, and realtors, and the mortgage industry,
- and I buy this house for $1 million?
- Well I only have $250,000, which is more, frankly,
- than most people who buy $1 million houses have.
- But I have $250,000 cash.
- So I need to borrow $750,000.
- So I take out a mortgage for $750,000.
- And I'm going to do a slight simplification.
- And maybe in a future presentation,
- I'll do kind of a more complicated one.
- In a lot of mortgages, when you pay your monthly payment,
- most of your monthly payment, at least initially,
- is the interest on the amount that you're borrowing.
- And you pay a little bit extra on that,
- to bring this value down.
- That's called paying off the principal.
- You can also take an interest-only loan,
- but the component of the interest is the same.
- Essentially, when you take a traditional mortgage,
- kind of a 30-year fixed,
- every month you're paying a little bit more than the interest,
- just to take down the balance.
- But for the simplicity of this argument,
- I'm just going to say that we're doing an interest-only mortgage.
- And then maybe with any extra savings,
- I can pay down the principal.
- And that's the same notion.
- And right now, if I do 25% down,
- and I'm buying a $1 million house,
- I'll have to take a $750,000 mortgage.
- I don't know what a good rate is, 6%?
- So let's say at 6% interest.
- So to live in this house,
- how much am I paying just in interest?
- Well I'm paying $750,000 times 6% a year.
- So $750,000 times 0.06 is equal to $45,000 in interest.
- That's coming out of my pocket.
- And of course, on a monthly basis,
- that means in interest per month, I'm paying,
- just to get an idea.
- I'm paying about $3,700, $3,800 in interest a month.
- My mortgage actually might be something like $4,000 a month.
- So I pay the interest.
- And then I pay a little bit
- to chip away at the whole value of the loan.
- It takes 30 years to chip away at the whole thing.
- And over time, the interest component becomes less,
- and the principal becomes more.
- But for simplicity, this is the interest that I'm paying.
- $45,000 a year.
- And then of course at a party, when I start to explain this,
- it's like, ah-ha.
- But interest on a mortgage is tax deductible.
- And what tax deductible means, is that this amount of money
- that I spend on interest on my mortgage,
- I can deduct from my taxes.
- I can tell the IRS that
- I make $45,000 less than I actually did.
- So if I'm getting taxed at, let's say 30%,
- what is the actual cash savings?
- Well I'll save 30% of this.
- I'll have to pay $15,000 less in taxes.
- How does that work?
- Well, think about it.
- Let's say I earned $100,000 in a year.
- And I normally have to pay 30%.
- So I normally pay $30,000 in taxes.
- This is, if I didn't have this
- great tax shelter with this house.
- Now I have this interest deduction.
- So now I tell the IRS that I'm actually
- making $55,000 a year.
- And let's say my tax rate is still 30%.
- it actually will probably go down since I'm
- -- but let's, just for simplicity,
- assume my tax rate is still $30,000.
- So now I'm going to pay $16,500 in taxes to the IRS.
- So how much did I save in taxes?
- So I saved $13,500 from taxes,
- from being able to deduct this $45,000 from my income.
- So let's say tax savings, plus $13,500.
- Now what else goes into this equation?
- Do I get any interest on my $250,000?
- Well, no.
- I had to use that as part of the down payment on my house.
- So I'm not getting interest there.
- But what I do have to do is,
- I have to pay taxes on my property.
- In California, out here we have to pay 1.25% in taxes,
- of the value of the house.
- So what's 1.25%?
- So, taxes, this is property tax.
- And that's actually tax deductible too,
- so it actually becomes more like 0.75% or 1%.
- So let's just say 1% just for simplicity.
- Property taxes.
- So 1% times $1 million.
- That equals what?
- 1% of $1 million is another $10,000 a year
- in property taxes.
- And notice, I'm not talking about
- what percent of my mortgage goes to pay principal.
- I'm just talking about money that's being burned
- by owning this house.
- So what is the net effect?
- I have a $13,500 tax savings.
- I have to pay $10,000
- --actually I have to pay a little bit more than that,
- but we're getting a little bit of income tax savings
- on the deduction on the property taxes.
- And then I actually have to pay the $45,000 of interest
- that just goes out the door.
- So I'm paying $41,500.
- Notice, none of this $41,500 is building equity.
- None of it is getting saved.
- This is money that is just being burned.
- So this is a completely comparable value
- to this $26,000.
- So in this example
- -- this example is not that far off from real values.
- Out here in the Bay area,
- I can rent a $1 million house for about $3,000.
- But in this situation I am burning, every year $41,500,
- where I could just rent the same house for $26,000 out of my pocket,
- when I adjust for everything.
- And then people a couple of years ago said,
- oh, but houses appreciate.
- And that's what would make it up.
- But now you know, very recently
- -- we know that that's not the case.
- And in the next video, I'll delve into this,
- and a little bit more.
- I'll see you soon.
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