Choosing between renting vs buying a home is one of the biggest financial decisions many adults make. In fact, one could argue that this choice not only has the greatest impact on monthly budgeting, but also on shaping long term wealth. Let me show you how buying a home and owning real estate is one of the most powerful wealth building tools and can contribute over 300,000 to your pocket over 5 years.
Let’s assume you are deciding between renting or buying a 2 bedroom home in the Sunnyside/Highlands area. I found 2 homes to use for the sake of comparison (I am not publishing the actual street number): Zuni St is a beautiful Victorian home for sale with hardwood floors, 2 bed 1 bath and 1048 square feet at $340,000. w Clyde Pl is a 2 bed 1 bath home around 1000 square feet for rent at $1945/mo.
Through your wonderful, talented, attractive friends at Swan Realtor Group, you’ve been connected with an awesome lender! He/she reviews your financials and comes up with a number of loan options to choose from. You have some money saved up or a generous family member is willing to gift money towards a down payment, but you don’t feel comfortable putting it all down. There are many loan options available that have down payments as low as 3.5%! Not to mention grant money and down payment assistance is available, as described in my post up to 5% of the purchase price. That’s $17,000 on a 340k house Heres how it works.
For the sake of simplicity and being conservative, one of the options the lender offers is a fixed rate FHA loan at 4.25% and 10% down. Since you are putting less than 20% down, Mortgage Insurance Premium (MIP) as well as home insurance and annual taxes will be included in the payments: I entered numbers from last years’ information from the county website and figured a .4% for home insurance. Below is a loan calculator that shows the monthly breakdown. Using something like a bridging loan calculator is usually necessary in this kind of situation so that you cannot be accused of committing loan fraud.
From a monthly expense standpoint you are paying almost exactly the same amount to rent the house on Meade as you are to OWN the house on Zuni St! Numbers aside, wouldn’t you like the benefit of never having to deal with a landlords and compete in the rental market every year? Besides these intangible benefits, there is lots of MONEY! Let’s look at the effects this wise investment has on your wealth over a period of 5 years.
When you pay rent, the check you write goes straight out of your pocket and into the landlords account-never to be seen again. However, when you pay your mortgage, a portion of that check goes straight back into YOUR pocket in the form of equity. Equity is a concept I had a hard time understanding in college, but I eventually developed a visual that helps me comprehend. Think of it this way: Imagine a pie. When you purchase a house with 10% down and 90% financed, your slice is 10% of the pie and the banks slice is the other 90% of the pie. As you pay your monthly note, a portion of that money goes to interest (the amount the bank keeps for providing you with the money) and a portion goes towards paying back the principal (the amount you still owe). When you pay down the principle, you are essentially purchasing a portion of the pie back from the bank. When you sell the house, you now own a larger piece of the pie than when you started. Plus, with appreciation, it has grown to a much bigger pie! Let’s look at a real life simulation.
Assume you bought the house on Zuni street with the loan described above in 2015. Its 5 years later and time to get something else. Maybe you have kids now and want a larger home or wish to move to a different location, so we put the home on the market and sell. According to some sources, the average appreciation for Colorado since 1975 is 5.3%. More recently, the Denver market is hot and we have seen appreciation above 10 percent in the last few years. Since I can’t predict the future, let’s be very conservative again: split the difference and round down to 7% appreciation per year. (Related: see my post 5 reasons its not a bubble) Entering a starting value of $340,000 and calculating the interest gain per year gives us a new value of……………..wait for it……………$476,867!!!!!
That is a 40% return over 5 years! Behold the power of leverage: homeowners get to gain appreciation on the full $340,000 by only putting down a portion of it in down payment. You have gained over $100,000 in equity from appreciation. But wait, what about that equity we discussed earlier that we gained from paying down the principle? Let’s look at an amortization schedule for a loan similar to yours and see how much “pie” you bought back from the bank.
The table shows how the portion of the years payments went towards paying down the principle (Column A), the amount you paid to the bank in interest (Column C) and the total of all your monthly payments. The year 2020 shows a balance of $275,282.94 on the loan at the end of the year. The difference between the beginning balance ($311,355) and the end of 2020 balance (275.282) shows you have gained $36,072 dollars in equity from paying the mortgage. Now, to figure out how much you made on this investment. Go back and subtract the ending loan balance (275.282) from the new sales price ($476,867) and you get a net capital gain of $201,585!!!! Take our your original down payment (34k) and we get $167,585. Not to mention, tax advantages: homeowners are shielded from paying any taxes on net capital gains from the sale of their primary residences (up to 250k for single and 500k for married couples if you have lived there for 2 of the last 5 years). Also, when you own a home, mortgage interest can be deducted from your yearly taxes so figure that you are deducting column C from your net taxable income every year! If you are in the 20% tax bracket, 20% of $13,000 is $2600 less you have to pay Uncle Sam.
Now, not adding insult to injury, but here’s what your financial situation would look like if you rented that house for those 5 years. Again let’s be crazy and assume that the rent doesn’t increase a penny during those 5 years and you get all of your security deposit back (which we all know is very unlikely). $1945/mo x 12 months x 5 years = $116,700. That is over One Hundred Thousand dollars no longer in your pocket. Oh, and just in case you were wondering, the financial difference between the two (the $201,585 you gained in owning/selling your home vs the $116,700 you lost in paying rent) is $318,285!!!! Now can you see how purchasing real estate is such a powerful wealth building tool?
The above example is an illustration of how purchasing a home can be a wise investment. The numbers, data, calculations and assumptions were deduced using rational logic and should be verified- I am not a certified mortgage specialist, accountant or economist. There are no sure things in life, and real estate involves risks just like any other form of investing. I am, however, a real estate agent that can and will gladly help you navigate the risks and pitfalls that go along with this type of investment. I can tell you that investments like these are realistic and have personally invested in numerous properties with fantastic returns. At Swan Realtor Group we can help you purchase your home and make a wise investment in your future.
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