Loading ...Here’s an idea you likely won’t ever hear elsewhere…consider not buying a home until you have enough cash to pay for it outright. You heard that right. Yes, it would take you many years to do so, but if your personal situation and risk tolerance suits it, this could add a boost to your net worth in the long run. Some may feel that this is unattainable. Fear not: there is a way that you can get the full amount! How It’s Done What you would do is rent instead and invest the difference. That difference would be between your rent payment and all of the costs associated with home ownership, mortgage, property taxes, repairs, maintenance, and insurance. You would invest that difference in a portfolio of stocks, ideally index or exchange-traded funds, for diversity and low cost. The rationale behind this is that over the long term, stock returns are better than gains in housing prices. Especially in current times, where stocks have crashed and houses are still near record highs in most places in Canada, this could be a very beneficial strategy for young people to consider. A Real Time Example Let’s look at an example to illustrate how this could play out: Option #1 – Buy house now for $300k, 15 year amortization Assuming 5% mortgage, zero down. Monthly costs
——- $2.854 Total monthly After 15 years, you own the property outright. Assuming the home’s value grows at long term average rate of 2.5%, your property would then be worth $435,000 at that time. Option #2 – Rent equivalent house now for $1,200, invest difference The difference between the monthly cost of owing and rent is $1,654 per month in the first year ($2,854 less $1,200). Rent will likely go up every year (assumption is 2.5%), reducing savings rate. Factoring this in and assuming you earn an average rate of 8%, you would then have $517,000 at the end of 15 years. The end result is that after 15 years, you could sell your stocks, buy the house that now costs $435,000 and put the $82,000 difference in your pocket. Obviously, there are many variables here that would affect the calculation, so if you are considering this, you should do calculations based on your own numbers. My feeling is that the net benefit as shown in the example is actually low, as I don’t believe house prices will grow by that high of a rate on average going forward. This is only my opinion, however. Some Important Factors to Consider Cons
If you’d like to see it, you can find the data used in my example here.
|
Posted under Investments, Mortgages, Passive Income, Real Estate, Renting, Taxes
This post was written by Bullseye on June 23, 2009
Follow Us
for option 2 you forgot to include tax when you sell those stocks.
Hi Ethan,
You’re right that tax is a consideration, but I opted to leave it out. Too many variables to consider, although I should have mentioned it as an issue, at least!
A couple could put $800/month into a TFSA and avoid the tax issue on that portion. The rest would depend on their tax rate upon withdrawl.
The analysis is flawed from both quantitative and qualitative perspective.
Quantitative:
Rent for 15 years accounted for 2.5% increase in rental costs amounts to $268,978.90
Mortgage Amortization Interest Cost for 15 years at 5% amounts to $123,890.71
Monthly Expenses (excl inflation) - 15×12x$450 amount to $88,200
Thus, owning is $56,888.19 cheaper than renting. And this has not yet factored into account the tax on capital gains (i.e. capital gain of $217,000, of which 50% is taxable at whatever the personal rate is). House, if deemed to be principal residence, is excluded from capital gains.
Refer to http://www.cra-arc.gc.ca/E/pub/tg/t4037/README.html
The numbers just don’t work in favour of renting and this does not even take into account qualitative considerations like the quality and enjoyment of the accommodations.
Where will you earn a guaranteed 8% a year?
In this interest rate climate you will come nowhere close to that without putting your principal at risk.
If rates go up you will have to take inflation into account.
Buying will always be better than renting in the long term.
Maxim - where you’ve gone wrong is in ignoring the other half of the equation, that being investing the difference in a higher yielding asset. You are not factoring Cost of Capital in.
With Option 1, your equity is tied up in the house earning 2.5%. With option 2, you would have the extra cash earning a higher rate, if historical norms prevail.
The entire basis of my theory rests on the fact that historically equities return a higher rate than housing.
I actually think my comparison was conservative and skewed towards helping the owning option. Stock markets for the past ten years have underperformed, and housing has not just overperformed, but blown the roof off the historical average trend.
House and equities will revert to the mean sooner or later, as they always have. estimating housing price growth at 2.5%/year over the next 15 years will likely turn out to be wildly optimisitic.
Bill - I didn’t say it was a guaranteed return, I just posed an example. 8% is in line with the long term stock market average.
Keep in mind that owning a home poses a risk as well. Prices could decline and reduce your net worth. If you have a mortgage, rates could go up and increase your cost of ownership. You could need a major foundation repair.
I’d love to a guaranteed ANYTHING when it comes to finances, but it just doesn’t exist. Even a GIC is not guaranteed, as inflation can make your real return turn negative!