I have had several great comments and suggestions both on the site and via e-mail. These comments focused on 1) clarifying the tax deductibility of real estate taxes and mortgage interest, 2) including rental increases, and 3) identifying the ultimate online calculator for the buying vs. renting comparison. We will discuss these further below:
Tax Deductibility Clarification
The general principle here is that real estate taxes and mortgage interest are tax deductible. Consequently, you MAY be entitled to discount their cost in your calculations. However, you need to take the standard deduction into account and compare it to the total of your deductions - your mortgage interest and real estate taxes are only deductible to the extent that they exceed your standard deduction.
For example, for a married couple, the standard deduction in 2009 is $11,400 (for singles, it's $5,700). Let's assume that you and your wife together pay about make about $150K and pay about 3% of that in state taxes ($4500). Let's also assume that you paid $15K in mortgage interest and $6K in real estate taxes last year. Let's also assume that you have no other deductions, but are in the 33% tax bracket. Let's also assume that you are not impacted by the AMT.
In this situation, you would transition from taking the standard deduction at $11,400 to taking an itemized deduction of $4,500 +$15,000 + $6,000 = $25,500. Compared to the standard deduction, that provides you with an additional $14,100 worth of deduction. At the 33% tax bracket, this reduces your total cost for real estate taxes and mortgage interest by $4,653. That's a reduction of (4653/21000)= 22%
Note that the 22% reduction is not the same as the 33% of your tax bracket. That's because some of the deduction is lost by switching from the standard deduction to itemizing. Additionally, if you are impacted by other deductions or by the AMT, you should take them into account and use your actual values. Additionally, note that some states have higher or lower state taxes - or no state income taxes at all.
When I started answering this question, I was thinking more of a system for determining the price differential between renting and owning at any one specific point in time - rather than a system for determining the financial impact over the lifecycle of your decision. However, then I realized that appreciation really needed to be included - and then I realized that the transaction costs also really needed to be included. Finally, when it came to potentially including rental increases, I drew the line. Part of the reason for this is that the rental market where I live has been substantially flat since about 2002. Yep - We really have not seen much of a rental increase at all over the last 8 years.
Additionally, with the economy the way it is - and unlikely to recover anytime soon - it doesn't seem like there will really be much in the way of rental increases in the next five-or-so years. Further, what about rental reductions? Do we include them in the consideration as well? For example, it seems more likely that next year will lead to a reduction in rent rather than an increase.
Further, while your average person will probably know the rate of return of bonds and the current inflation rate, it was my belief that most people were pretty unfamiliar with the fluctuations in the rental market - and it really does fluctuate quite a bit. For example, in Illinois, according to this Census publication, rents varied like this:
Adjusted to 2000 dollars
2000 1990 1980 1970 1960 1950 1940 Illinois $605 $569 $487 $476 $419 $286 $339
As you can see, rents declined significantly from 1940-1950, but generally rose in other timeframes. The adjustment here appears to be an adjustment in light of the CPI (which may not be completely accurate), but considering this adjustment to be "the rate of inflation". We find that rents from 1990 to 2000 exceed the rate of inflation by only about 0.6% - a very small amount. Further, rents from 1940 to 2000 exceeded the rate of inflation by less than 1%.
However, a number of commenters and people sending me e-mail were viewing the housing situation in a much more long-term view and I agree with them that over the long term - say 20 years or so - rents will certainly be increasing and even small rental increases will be felt.
Overall, my general feel is that rent increases are going to be flat for the next 4-5 years. However, after that I would expect them to rise at about the rate of inflation or a little higher. If you are looking 40-50 years out, I would think that the average rate of increase over that time period would be about the same as the rate of inflation - or maybe half a point higher.
Consequently, if I am running an owning vs. rental comparison for the next 5 years, I personally would not include rental appreciation - this is why I left it out of the original calculation. However, if I am running a comparison for a longer period, I would use rental increases as I discussed above.
Ultimate Online Calculator
One commenter alerted us to this online calculator. When I saw it, I was immediately jealous - it is very inclusive and exhaustive and just the thing for a quant-minded, semi-control-freak like me. I recommend that anyone who is trying to get a handle on these costs try out this calculator. However I had a few issues that I brought up to the author of the calculator. Here are my questions and the author's responses in red.
1) [This is with regard to a specific example of a 300K purchase with 20% down] At the end of the first year, your calculation puts the paid equity at 60364. However, the initial cost was 300K and the loan balance is 236459 - shouldn't the paid equity then be the difference of 63541? A difference of 3177 from your number? One thing that you may be doing is (assuming a 5% sales commission) reducing the 63541 equity be 5% (which then gives you your number of 60364). However, that does not seem to make sense because the fee is 5% of the appreciated value, not 5% of the paid equity. Similarly, the appreciation numbers seem like you might be reducing them to 95% -which does not seem to make sense.
(1) The paid equity calculation is explained in both the "Explanation and Discussion" as well as the "Mega Data Table results explained". Your Total Value is the $300k, x 1.03 for 3% appreciation, x 0.95 for 5% sales commission. The commission is paid on the sale price, not the amount the house appreciated.
Note: I agree with the author's comments in that the "Total Value" seems right, but I am still not sure what he is doing with the "Paid Equity" and "Appreciation". Just be aware of the differences in those two columns.
2) Real estate tax payments are tax deductible (if they exceed the standard deduction), but it doesn't seem like that is taken into account in your calculator. (Insurance payments are not tax deductible.)
I was unaware of this, thank you for letting me know. I upgraded the calculator to take that into account, and linked to your site in an acknowledgement at the bottom of the page.
Note: Thanks for the link, Michael!
3) When renting, the landlord often pays some of the utilities. However, when owning they are typically all the responsibility of the owner. Should there be some entry for an increase in utilities? Similarly, owners often have to pay condo or homowner association fees - should there be some place to add these? Additionally, for people moving from an apartment to a house, there will be a cost in time and money for the upkeep to the house that was previously performed by the landlord - shoveling snow, mozing grass, etc. Recognize that for someone moving from an apartment where the landlord pays water and heat to a house in a townhome association, the cost difference for the utilities could be $1500 for the year - and the town home association could be anywhere from $1000-$3000. These are big numbers that don't appear in your calculator.
There are any number of variables I could add to make the calculator more accurate, more cumbersome, and more confusing. I already just added to the complexity by separating out Taxes and Insurance, which used to be combined. The calculator is already more detailed than anything else out there. I'm not interested in bogging it down any further at this point. Anyone who *really* needs to account for extra expenses on the buying side will be clever enough to just add that amount to the maintenance, taxes, or insurance fields (as I now point out in the intro).
Note: The author is certainly right - his calculator is far more complex and accurate than anything else that I have seen. I highly recommend that you use it. Just go ahead and ass the values into the maintenance filed as he recommends!