Another look at renting versus buying

There are those that worry that a new bubble is forming. Rents are a good yardstick: house prices that appreciate in line with rents make sense, since both are a sign of demand. But when one outstrips the other, it is time to review whether to buy or rent. In most Texas metros, rents have been outstripping home and real estate appreciation. Renters should worry. Obviously with rents increasing over 50% in all Texas metros over the last ten years, now is the time to buy.

Deciding when the right time to buy a house or investment real estate is hard. Homes and real estate investments are a costly investment. The slightest up or down tick in the market can cost or save huge sums. In most of the US, those deciding on a purchase are hearing particularly confusing signals. Prices have soared for the past couple of years, suggesting that those who wait will suffer. But slowing price appreciation, weak construction data, and jitters about a possible interest-rate rise (among other worries) suggest that values might drop, as they did after the bubble of five years ago.

Those looking to buy a home or real estate investment have reason to be nervous: during the ‘bubble’ years values in some areas of the country were appreciating by over 40% annually. California and the sand states (Nevada, Arizona and Florida) come to mind.. Texas was never in that category. Texas was 50th in appreciation for a number of years. Looking back, that is not necessarily a bad thing.

The common wisdom for decades was to buy a house as soon as you can, because it’s a great investment. That “wisdom” hurt many in the past decade as the market tanked. But was it because real estate cooled, or because they were using their home as a personal ATM, constantly refinancing to the max as appreciation was so strong? Let’s take a cold, hard look at the economics of owning a home.

In the past, the own-or-rent decision was largely about whether to live in a house or apartment. The own-rent decision should be apples-to-apples with comparable properties. If you are thinking about moving from a small apartment and buying a medium sized house, you’ll find that it’s more expensive simply because you’re getting more square footage and a yard.

Also the ability to find a steady flow of cheap “distressed” housing is pretty much over. Between 2008 and 2011, over a third of all sales nationally were in this category: either foreclosed homes or those being sold at a loss, often by banks. This wasn’t happening in Texas. Less than .015 of all homes went into foreclosure in the Texas region. And presently it is almost nonexistent.

Because of the lending ‘bust’ the pipeline of new houses is a trickle of new construction. Comparatively the supply is less than half of what it was pre-recession. Even here in the country’s strongest markets, home starts are still under 50% of pre-recession numbers. During the financial crisis many builders went away. Up to last year both public and private builders were reluctant or found it hard to obtain loans to build more homes. This helps explain why supply has not responded to perky prices: the pace of building is still far below its pre-crisis average across America. The larger builders, who have easier access to equity, have been able to increase market share.

Even if supply does improve, new homes will not be cheap ones. Construction costs have risen by 18% in the past two years. Median prices of new and existing homes have always had about a 20 to 25% value difference weighted towards new. With labor and materials increasing so quickly, that value difference is increasing, causing some to question new home values against existing. The builders cannot build for free and most are not seeing near the profit margins that were there before the bust. And realize that with the rest of the nation recovering, we have not seen demand for materials and labor really challenged.

One opportunity in today’s market is low interest rates. Recent data also make a rate rise even less likely. Falling household debt and a rising number of cash-funded sales will ease concerns at the Federal Reserve. In addition, predictions of a future rise have already made buying tougher: for every 1% rise in lending rates, the consumer looses 12% buying power. Although as of this week, rates will remain low. Realize that the near future of higher rates, lower leverage, and evidence that high prices will reflect supply constraints more than speculative demand means that the central bank has little reason to make homeowners’ lives any harder. At least, not yet.

Since 1975, housing has appreciated by an average of 4.5 percent per year. Housing seems to be a great investment in good times because it is usually leveraged to a great degree. With a 20 percent down payment, a price increase of just three percent turns into a 15 percent increase in the homeowner’s equity. Do some arithmetic with a hypothetical $100,000 home to verify that result. Real estate proponents call this the “cash-on-cash” return. However, leverage applies to the downside as well. With 20 percent down, a 20 percent price decline wipes out all of the buyer’s equity. That’s not an outlandish scenario as we’ve learned from the price declines of the recent housing bust.

Interest on home mortgages is deductible, but the deductibility doesn’t offset the fact that you are paying someone interest. It’s an expense, and you are worse off because of it. If you want a big tax deduction, you could make a contribution to charity. You’ll end up with less money than before your contribution despite the deduction. The same is true for interest expense. It may be worthwhile, all things considered, but it’s still an expense. Talk to your accountant first, because the actual benefit from a deduction varies from family to family.

When you rent, the landlord picks up the taxes, insurance, maintenance, and sometimes utilities. If you buy, plan on replacing the water heater some years, the back fence other years, the roof occasionally. Hope that you don’t need to replace all of them the same year. If you are going to hire out all of the maintenance, you’ll probably pay more than your landlord does. The landlord is in the business of maintaining properties and is probably very efficient. However, if you can do some of it yourself, your cash outlays will be much less than the landlord’s. And you can do it yourself if you’re willing to learn. Try Googling “leaky faucet” and you’ll find plenty of advice. Personally I find a professional to help maintain properties, because the ‘self learn’ cost is prohibitive (I have a history of my “DIY” attempts landing me in the emergency room).

Most people thinking about buying compare monthly payments to rent, which is a good starting point. However, some of that monthly payment goes to principal. It’s like saving. To put buying on a level playing field with renting, look at just the part of the monthly payment that will go to interest.

Example: you borrow $200,000 for a house with a 30-year mortgage at 4.25 percent. Your monthly payment would be $993, but $285 of that would be going to principal. Your parents will be surprised that you’re paying so much to principal. When they got their first mortgage, rates were much higher and only a small portion of their payments went to principal.

Transaction costs are large in housing. Real estate agents charge six to seven percent commission on sales, which will make moving expensive. You can sell the house yourself, but keep in mind, you are not a professional and that it’s a lot of work and your house may not be exposed to as many buyers, reducing the price you can get for it and taking a lot of personal time and labor. This argues against buying unless you are confident you want to stay in the house for several years, preferably even longer.

Renters should keep in mind that they do not control their housing destiny. If the landlord decides to sell the property, you’ll be looking for a new home. The landlord can also raise the rent at the end of the lease. The landlord can also decide not to rent to you, though that’s rare for people who are well behaved.

One of the benefits of owning a house is the ability to do with it what you want (subject to neighborhood rules, of course). When your daughter wants her bedroom walls black, you can be the cool parents who show her how to use a paint roller.

Owning a house gives you some flexibility, but also requires flexibility. When you get a bonus from work, you can upgrade your housing by adding a hot tub or more landscaping. Renters don’t have that option. When you lose your job, you can defer replacing the carpet. Flexibility is required of you, too. When the roof starts to leak, there’s no telling the rain that this is a bad time. You need to have reserves for unplanned repairs.

So now you’re ready for the analyst to give you a conclusion. However, there are too many emotional factors for a mathematical solution. I recommend running the numbers as best you can, then asking yourself if the psychological benefits are worth the cost.

If you are thinking of purchasing a home or investment property, one of the first things is to get with your financial planner and a home finance professional before shopping. The parameters have gotten harsher with the ‘after effect’ of the housing ‘bust’, and the implementation of Dodd Franks and all the punitive parameters it puts on lenders. That said, there are a lot of misconceptions as shown by many of the current surveys of consumers.

While nearly 70% of Americans surveyed agree that now is a good time to become a homeowner, a large number remain reluctant due to their own misguided understanding of the financing process, according to different survey results from FNMA, FHMA, Wells Fargo, and others. All the surveys have a common theme of over 70% feel that now is a good time to buy a home, and 90% percent want to own if they don’t already.

The common theme found by these surveys is people say they “know and understand” the financial process involved in buying a home, but large numbers also expressed doubt or misguided notions about home buying requirements. For example, Wells Fargo reported 30 percent of respondents expressed belief that only people with high incomes can obtain a mortgage at this point, and 64 percent said they believe only those with a “very good”” credit score can buy a home right now.

FNMA, Wells Fargo, and other surveys about consumers’ needs in the housing market showed that over 60% of respondents said they have an understanding about how much of a down payment is needed to purchase a home, nearly half said 20 percent is required. Forty-four percent also said they know little or nothing about closing costs. Is that true?

Most lenders report that lending requirements at the moment are still high as a result of enhanced regulations and reluctance to take risks, so lending standards are tighter. But the consumer and the industry would be well served to work on educating homebuyers about all programs available to them—especially the millennial crowd, most of which pointed to lack of down payment funds as one of their biggest hurdles to homeownership. It is important for consumers to ask lenders and real estate agents questions about available options, such as down payment assistance or FHA (Federal Housing Administration) or VA (Veterans Affairs) loans for veterans. Informing prospective homebuyers about their options is the first step toward helping them realize their goals of owning a home.

These same surveys find that most consumers are confident in managing their personal finances, with 82 percent saying they know how to save, invest, and work within a budget. In addition, 63 percent said they have a “rainy day fund,” including more than half of millennial-aged respondents, potentially the largest group of homebuyers over the next 5 to 10 years.

If the latter is true, then they need to get with a lender to understand how to buy, because there will never be a more affordable time to buy, whether first time, move up or move down. Should you buy in Texas? If you think I am going to say anything else but an absolute yes, then you must be new to the blog, and not watching what is happening here.

Here in Texas and in most metros across the country, the home you look at today will not be there tomorrow!

Should you buy or rent?

We’ve been asked numerous times if this is a good time to buy a home. The short answer is ‘Yes!’. Prices continue to steadily increase in most areas of Texas’s four metros; mortgage rates are bouncing off of historic lows and beginning to rise; inventory is diminishing; and home values are rising; and rental prices and occupancy rates are moving up. Currently, in most cases, it is more affordable to buy than to rent. And while all of these are compelling reasons, one of the biggest incentives to buy is the tax benefits to homeownership.

Buying a home is a major life investment and should be taken very seriously. Consideration of your current financial status and your future plans should play a part in when and where to buy and how much to pay. Understanding the tax benefits to buying a home is critical to your decision making process so that you understand the full value of your purchase.

But, let’s back up. Presently if you compare home prices vs. rents in your Texas metros, rents have increased rapidly in some markets such as central and west Austin or Houston’s Woodlands. Most regional rentals have had steady annual increases, sometimes out stripping home value appreciation in the same sub market. That said, homeownership is cheaper than renting by quite a bit in all Texas metros.

If you have not sat down with a mortgage professional to see what you qualify for, now is the time. You may not be able to afford or find where you want exactly, but the forced tax savings and value appreciation over the next 3 to 5 years in Austin, San Antonio, Houston and DFW will help purchase that next property. The other markets should have healthy appreciation over the next 3+ years. Why the difference? The entitlement process in Austin slows down how quickly we can address the need for shelter (housing), so they will play catch up for a while. Also, financing is still a challenge, both from a mortgage side as well as from banks. That said, banks have more capital than they have had in the history of US banking. Mortgage companies are looking to help as many people get into homes as possible. You won’t know unless you start the process.

To determine for yourself whether renting or buying a home costs less, do the following:

• Calculate the average rent and for sale price for an identical set of properties. If you currently lease 1500 sq ft., find something comparable. You want to estimate prices and rents for similar properties in the same neighborhood, to get an ‘apple to apple’ comparison. Even if there is nothing available in the area, you want to know what costs will be. You should not compare the average rent and average price of homes in your submarket, which would be misleading because rental and for sale properties are very different. More importantly, for sale homes are 45+% larger than most rentals in the same submarket.

• Calculate initial total monthly costs of renting and owning, including maintenance, insurance and taxes.

• Calculate what future total costs will be for owning and renting by looking at the history of the submarket. Take into account inflation, price, and rent appreciation.

• Factor onetime costs and proceeds like closing costs, down payments, sales proceeds and security deposits. Factor in the opportunity cost of spending money now (that is, examine where else you could put the money for a better risk/return ratio).

• Presently affordability is the best it has been in the last 60 years. I would not wait for rates to come down, they will continue to increase based on most factors. In addition home values in all Texas metros continue to increase. So waiting to make a decision will cost you.

Now compare the payments; rental and to own. How close are they?

When confirming buying costs know that in most cases, homeowners can take the following tax deductions: (disclaimer; I am not a CPA, Tax lawyer, etc.)

Mortgage interest

The interest you pay on the mortgage you obtain for your primary residence is deductible from the income you report in your Federal Income Tax filing. In many cases, this is a substantial amount and, in the early years of your loan, account for most of the payment you make each month. There are limitations to the amount of interest that can be deducted as well as other important considerations for those who wish to utilize this deduction. Even better, unless changes are made by the IRS, this deduction remains in effect for the life of your loan.

Generally speaking, your mortgage payment will remain relatively steady throughout the time you own your home. As you make payments, the amount of interest you pay goes down while the amount you pay towards the principal goes up. In other words, early in your loan you will pay more in interest (which is deductable) while later in the loan you will pay less interest. Regardless of where you are in the life of your loan, the interest is deductable, meaning your purchase today could benefit you tax-wise for years and years to come. This is one of the key advantages to owning over renting. When you rent, you may not deduct any amount of your payments from the income you report to the IRS. Therefore, every dollar less you pay in taxes due to the mortgage interest deduction is an advantage you would gain from owning instead of renting. The difference is not just between paying rent and buying.

Points and/or origination fees when obtaining a mortgage

When purchasing a home using a mortgage loan, certain fees will be charged for the purchase to be finalized. One is the origination fee, which is the amount charged to the borrower (buyer) to cover the costs of providing the loan including processing the loan application, credit checks, evaluating the loan, and other expenses related to the purchase. Buyers also have an option when applying for their mortgage loan to pay discount points in order to lower the interest rate charged to the balance of the loan. In other words, a buyer can pay extra up front to decrease their monthly payments for the life of the loan by locking in a more advantageous interest rate. In some cases, the seller will pay the discount points as an incentive to the buyer to purchase their property. According to the IRS, origination fees and loan discount points are tax deductible to the buyer, in most cases. Even better, it doesn’t matter who paid the points or fees, the buyer is allowed the deduction. So even if the seller paid the discount points, the buyer gains the tax advantage. What moving costs do you deduct when you rent? Not much!

Mortgage Insurance Premiums (MIP)

Certain mortgage loans require buyers to pay mortgage insurance and is stipulated at the time of purchase. In many cases, borrowers who obtain a mortgage by paying less than 20% of the purchase price as a down payment will be required to pay mortgage insurance premiums. Different loan products have different requirements, so be sure you understand the structure of your mortgage loan by having your lending professional explain the loan terms to you in detail.

Basically, to help buyers purchase homes without having to save 20% of the purchase price for a down payment, they may have the option to pay a smaller down payment along with a Mortgage Insurance premium every month. This helps borrowers purchase their homes sooner. While this deduction may or may not remain in the future, as of today the premiums paid for mortgage insurance are generally tax deductible. In fact, the IRS recently announced that mortgage insurance premiums paid in 2011 will continue to be tax deductible. Some rules and limitations apply, so be sure to check the IRS website or with your tax professional for the details on this deduction or speak with your tax professional for advice.

These three deductions can amount to a significant sum of money that you can deduct from the income you claim in your Federal Tax filing, potentially lowering the amount of tax you are required to pay each year and ultimately the cost of your payment. More importantly, those who choose to rent are not able to enjoy these tax benefits. That’s one of the primary reasons why owning a home is actually more affordable than renting in most cases today. With rental occupancy rates going up, rents are rising. As rents increase, those who are able to buy should be do so.

The tax benefits to owning a home don’t stop there. Barring any changes to the tax code by the IRS, besides the points and origination fees from the issuing of the loan and the mortgage interest and mortgage insurance premiums that can be deducted for the life of the loan, homeowners also have two additional tax benefits they can take advantage later in the life of the loan. Tax benefits that can be enjoyed later in the life of the loan include:

Interest on home equity loans

Over time, as you’ve continued to make your mortgage payments, the principle of your loan will decrease. At the beginning it will drop slowly (since more of the payment goes towards interest), while later in the loan it will begin to drop more rapidly. At the same time, the value of your home will change, hopefully for the better. Generally speaking, over time, a home becomes more valuable. In other words, the amount you could sell it for in the future is usually more than the amount you bought it for, especially when you look at it over a time period of five years or more.

As you owe less principle on your mortgage loan and the home experiences appreciation, the difference between those two amounts is known as ‘equity.’ Many people use the equity in their homes to secure a loan to pay for projects, major upkeep or upgrades, or even paying off balances owed to credit cards, auto loans, or other creditors. Homeowners who consider a home equity loan must understand that they are putting up the equity in the home to act as collateral for the new loan. That means, if/when the home is sold, the home equity loan will need to be paid off in full. Just like the main mortgage loan, interest paid on the home equity loan is also tax deductible. In other words, even while you are decreasing your reported income in your Federal Tax Filing to the IRS for your original mortgage, you can further reduce your taxable income by deducting the interest on your home equity loan. There is nothing like this available to those who rent their homes.

Profits from the sale of your home

If you decide to sell your home, another tax advantage comes into play. Whether you are moving up, downsizing, relocating, or selling for other reasons, the profit on the sale can be exempt from Federal Income Tax. Again, barring any changes to the IRS Tax Code, sellers may be able to avoid paying income tax on up to $500,000 worth of gains made from the sale of their home. Couples can claim up to $500,000 in profits without paying income taxes on the gains while singles can claim up to $250,000 in profits. Currently, it is an IRS requirement that sellers must have lived in the home as their primary residence for at least two of the past five years to qualify for this tax benefit. In other words, if your home goes up in value while you are living in it as your primary residence and you sell it for more than you paid, the IRS will not tax you on the gains up to $500,000 (for couples). If you made gains from nearly any other investment, you would be required to report it as income and pay capital gains taxes. That is one of the main reasons why purchasing a home is a better overall investment than nearly every other option. While there are other tax exempt investments available, few will have the same potential as the purchase of a home.

The tax benefits to owning a home start from the date of the purchase and continue to the date of the sale. Especially right now in Texas the advantages of owning versus renting are becoming more and more important. If you are currently renting and would like more information about preparing for your first home purchase, please contact a financial professional. The first step is gaining the knowledge you need to make the right decision and we highly recommend that you speak with professionals in the industry before moving forward.

Here are some quick summary thoughts on benefits of renting vs. buying.

Rent
• Easier to Relocate
• Limited cost & responsibility for repairs
• You can split rent with roommates
• Renters insurance is cheaper than homeowners insurance.
• No property tax payments
• No equity lost to foreclosure

Buy
• Homes builds equity
• Buy low, sell high. There has never been a better time to buy
• No rent hikes
• Low interest rates for a while
• No land lord
• Christmas time every April, when you get money back.
• Numerous tax benefits.
• The pride of ownership