Thursday, February 11, 2010

Equity and Financing Costs - Buying vs. Renting - Part 3 of 4

This is Part 3 of our 4-part series in toward establishing a methodology for determining whether renting or owning is more financially advantageous.  Part 1 can be found herePart 2 can be found here.  In Part 3, we will be discussing the Equity and Financing costs associated with owning a house.  Part 3 starts below:

Equity Costs
Let's assume that I buy a $300K house and pay cash.  Let's say the Ownership costs of my house are $1000/month.  Conversely, the going rental rate for my house is $2000/month.  Have I made a great investment?

Well, at first glance it looks like I am saving myself $1,000/month out of pocket, which is great.  However, I have failed to consider the lost earnings that I would have gotten from the $300K that is now being tied up in my house - so it's not really a fair comparison.

For example, let's assume that your $300K was previously invested in bonds and providing you with a 6% return - that's $1,500/month!  Now that you have put that $300K in the house, you are no longer getting that $1,500/month - and that is a real cost to you.  Reviewing the numbers and adding in this cost, you now find that you are actually LOSING $500/month by owning vs. renting.

But wait you say - the long term appreciation rate of housing is approximately equal to inflation - and if we assume that inflation is 3%/year , then our differential between putting the money in the house and earning 3% and investing in bonds earning 6% is only a 3% differential or only $750/month.  If I use those numbers, then I am actually coming out ahead $250/month by owning.

However, recognize that we have the opportunity to leverage the real estate purchase and consequently even if you have very low equity, the price of the house is still appreciating at 3%/year.  That is, the 3%/year return on the value of the house is independent of how much equity you have in the house.Consequently, we are going to take into account the appreciation of the house during our calculation of Appreciation in Part 4 - not during our determination of Equity Costs.

Also, let's take a look at the rate of return on equity.  We used 6% above - is that the right number? 
Well, some people might suggest that we should really use a long-term CD rate - more like 3%.  However, that does not seem appropriate because a CD is guaranteed to never lose value while a house can and sometimes does lose value.  That is, we should pick an investment with about the same risk profile if we are going to truly make an apples-to-apples comparison.  In that regard, therefore, it also seems like the 10% long-term return of the SP 500 might be contraindicated as a rate of return because of the additional risk and volatility.  US Government bonds? - Probably not because our housing lacks the government backing.  That kind of backs us into munis and corporate bonds.  More specifically, a diversified portfolio of munis and corporate bonds - and most likely one with low leverage.  In this regard, as we discussed in this earlier post, you have 5 muni funds to choose from that yield more than 6%.  Similarly, if you go with corporate bonds, you will have to remember to use the post-tax (not pre-tax) return.  Consequently, if you are in the 33% bracket, the 9% yield is really about a 6% post-tax return.  This is the source of the 6% return numbers that were used above.

On another note, recognize that if you finance 100% of your purchase with an interest-only loan, then your Equity costs are actually zero - although your Financing Costs are maxed.

Financing Costs
Here's where the mortgage comes in.  However, when discussing mortgage costs, people often make apples-to-oranges comparisons to rental costs - or miss some factors that impact the valuation.  This is because a typical mortgage payment includes both interest and principal.  However, I am going to slice the mortgage into two parts - the interest (which goes toward Financing Costs) and the principal payment (which goes toward equity).

Now, some people might initially suggest that the monthly principal payment should be considered as an Equity cost.  However, if you think about it, you have not really lost any equity from moving the money from your bank account into your "mortgage account" if you will.  Perhaps the clearest way to see this would be to consider a payment to a home equity loan.  If you move $1000 from your bank account into your home equity loan, then the loan balance goes down - but you could move it back out into your bank account at any time.

In short, the equity is just converted, not spent or lost.  Also, I recgonize that there is a cost associated with getting equity out of most mortgages (refinancing), but that is really a transaction cost rather than an equity diminishment.  Further, although the equity cost is based on the loss of investment income, on the actual day of the transfer/mortgage payment, there is not going to be any accrued interest for the equity that is being transferred to the mortgage.  However, going forward, the equity costs should include the newly increased equity value taking into account the principal payment.

That is, as mentioned above, once you transfer the $1000 to the mortgage, that $1000 is no longer earning interest for you anywhere else.  Thus, for most standard mortgages, the total equity cost is typically increasing each month and the total financing cost is typically decreasing.

Also, recognize that the financing cost is typically tax deductible and the true post-tax cost should be used.  For example, if you are in the 33% tax bracket and the financing cost is deductible, then the actual financing cost should be reduced by 33%.  Further, if purchasing the house causes you to transition from a standard deduction to an itemized deduction, recognize that you should really only reduce the financing cost by the actual amount reduced on your taxes.  Also, if you are impacte by the AMT, that should be taken into account.

Now that we have a way to determine our ownership costs from Part 2 and a way to determine our Equity Costs and Financing Costs, we will proceed to determining Appreciation and some examples in Part 4.

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