The American Dream has long been ownership of your own home. This continues even with all the foreclosures and bankruptcy problems that are taking place in late-2009 as this article is being written. In fact, a marvelous window of opportunity now exists with attractive sales prices coupled with low interest rates. Eventually, home prices on Oahu will stabilize and begin to rise again with mortgage rates likely to be higher than they are today.
The question for many families, particularly first-time homebuyers on Oahu is whether it is better for them to rent or to buy. Many people make such a decision based upon a comparison of monthly payments. If their rent is less than their monthly payment on a home, they may decide that it is cheaper to rent than to buy. This approach, though, fails to take into consideration a number of other factors that influence the total costs of homeownership.
It is important for anyone considering buying a home to understand the tax savings involved in owning a home. The interest on the mortgage and property taxes are both deductible for federal and state taxes. Typical savings are 25% to 35% of the mortgage payment (principal & interest) depending upon the type and amount of the mortgage, the interest rate and the buyer’s tax bracket. If the mortgage payment were $3,000 per month, the tax saving for most homebuyers would be in the range of $750 (25%) to $1,050 (35%). The savings can be obtained each month by adjusting your withholding allowances by filing an amended W-4 form with your employer. This is perfectly legal; in fact the second page of the W-4 form is a worksheet to assist the taxpayer in calculating the additional withholding allowances they should claim.
Two compelling reasons to buy rather than to rent are: first, it enables you to lock-in a permanent monthly principal & interest payment at today’s rates. If you purchase using a 30-year fixed mortgage rate, your principal & interest payment 10 or 20 years from now will be the same as they are today. In contrast, rent payments are likely to be increased every year or two by the landlord so that they keep pace with inflation. Second, it enables you to use a mortgage to increase the profit you will make on the home. Assume a $500,000 property is purchased with a $100,000 down payment and a $400,000 mortgage and the home increases in value by 10%, the owner makes $10,000 on their $100,000 down payment and $40,000 on their $400,000 mortgage. Investors refer to this as using other people’s money (OPM).
Nationally, the average annual inflation rate over the past 15 years has been 2.90%, which is relatively low historically; e.g., the average inflation rate over the past 30 years was 4.35%. So, the cost of living has increased by about 4.35% a year over the past 30 years. Many economists believe that inflation will increase over the next few years to enable the government to be able to pay its debts. This analysis will use 3%, which is considered to be very conservative. At an inflation rate of 3% per year, a $1,000 per month initial rent payment would be about $300 or 30% higher in ten years. Compounding the 3% per year increases the percentage to about 34.4% over ten years. And, if the property value keeps pace with inflation, the home will be worth about 34.4% more in ten years than it’s worth today.
If you look at sales prices of homes on Oahu since statehood, prices have risen at about 3% to 4% a year or very close to the inflation rate. However, it has not been a gradual increase. The Oahu Housing Market has experienced soaring appreciation once each decade of about 30% with the exception of the 1990’s when our local economy tanked. The 1960’s, 1970’s, 1980’s and most recently, the 2000’s all had periods of soaring appreciation. In between the periods of soaring appreciation, the housing market has usually been relatively flat.
The following example assumes a 3-4 bdrm, 2-bath, fee simple house in a reasonably nice neighborhood with a value today of $500,000 that is available for either sale or rent. Property taxes are $120; insurance is $80. The property would rent for $2,000 per month. I’m going to assume an FHA mortgage is used at 5½%; which is a little high as this is being written, however, mortgage rates are going to increase. For simplicity, I’m going to round many of the numbers; I’m also going to assume that property taxes and insurance remain constant
There are two clients; the first decides to rent the home and will be referred to as the “Renter.” The second decides to purchase the home and will be referred to as the “Buyer.” The Buyer purchases the property using a 3½% down payment ($17,500), which is the minimum on an FHA purchase. The FHA loan amount is $482,500. The analysis does not include the return the Renter could achieve by investing the $17,500 down payment that is not being used to buy the home. The analysis also does not include any federal programs to stimulate home sales such as the $8,000 tax credit for first-time homebuyers.
The Renter pays $2,000 per month initially that will increase at 3% a year to keep up with inflation. The Buyer’s monthly payments are $2,740 for principal and interest, plus an FHA mortgage insurance premium (MIP) of $220, plus $120 for property taxes, plus $80 for insurance for a total of $3,160. The Buyer’s tax savings (refer to the bottom of the page) is about 28% or $770, reducing the out-of-pocket monthly cost to $2,390 ($3,160 minus $770).
So, the first year the Renter would seem to be far better off paying $2,000/mo compared to the Buyer’s out-of-pocket cost of $2,390. At first glance, the Renter would appear to be ahead by $4,680 (12 x $390). However, the Buyer will have paid the mortgage down by $6,500 to $476,000 by the end of the first year, plus the value of the home will have increased by 3% or about $15,000 to $515,000. So, the Buyer’s equity that started with their down payment of $17,500 has increased by $21,500 to $39,000 ($515,000 less $476,000).
The Renter’s monthly payment does not match the Buyer’s cost until the end of year #6. At that time, the mortgage balance has been reduced by $44,930 from $482,500 to $437,570 while the property has increased in value from $500,000 to $579,640 for equity of $142,070 ($579,640 less $437,570). I acknowledge that property taxes are likely to increase over the years and there will be both repairs and fix-up costs to improve the home that are not included in the analysis.
At the end of year #10, the Renter is paying monthly rent of about $2,690 while the Buyer’s payment remains constant at 2,390 for a difference of plus $300 per month. At the end of ten years, the mortgage balance has been reduced by $84,240 from $482,500 to $398,260 while the property has increased in value from $500,000 to $671,960 for equity of $213,700 ($671,960 less $398,260). Eventually the FHA MIP will end; for simplicity, I’ve assumed it is a fixed expense.
Tax Savings: You need to use a calculator that will amortize. Assume the Buyer is married with $80,000 of taxable income and uses a $482,500 FHA mortgage @ 5½% with a $17,500 down payment. Further assume property taxes are $120/mo:
$482,500 @ 5½% = $2740/mo. for principal & interest
End of first year balance (PV) using 348 (360 minus 12) months for (n) = $476,000
Initial balance ($482,500) minus $476,000 = $6,500 to principal the first year
$6,500 divided by 12 months = $542/mo. average principal payment the first year
$2,740 monthly payment minus $542 = $2198/mo. average interest payment the first year
$2198 interest payment + $120/mo. property taxes = $2318/mo. deductible the first year
$80,000 income = 25% federal tax bracket & 8.25% HI tax bracket for calendar year 2009
25% federal + 8,25% HI = 33.25% combined bracket
33.25% of $2,318 deductible = $770 tax savings using 5½% as the interest rate
The tax savings thumb-rule for an FHA mortgage @ 5½% is about 28% of the principal & interest for most buyers; 28% of $2,740 = $767 compared to $770
Thoughts on Buying a Home
The American Dream has long been ownership of your own home. This continues even with all the foreclosures and bankruptcy problems that are taking place in late-2009 as this article is being written. In fact, a marvelous window of opportunity now exists with attractive sales prices coupled with low interest rates. Eventually, home prices on Oahu will stabilize and begin to rise again with mortgage rates likely to be higher than they are today.
The question for many families, particularly first-time homebuyers on Oahu is whether it is better for them to rent or to buy. Many people make such a decision based upon a comparison of monthly payments. If their rent is less than their monthly payment on a home, they may decide that it is cheaper to rent than to buy. This approach, though, fails to take into consideration a number of other factors that influence the total costs of homeownership.
It is important for anyone considering buying a home to understand the tax savings involved in owning a home. The interest on the mortgage and property taxes are both deductible for federal and state taxes. Typical savings are 25% to 35% of the mortgage payment (principal & interest) depending upon the type and amount of the mortgage, the interest rate and the buyer’s tax bracket. If the mortgage payment were $3,000 per month, the tax saving for most homebuyers would be in the range of $750 (25%) to $1,050 (35%). The savings can be obtained each month by adjusting your withholding allowances by filing an amended W-4 form with your employer. This is perfectly legal; in fact the second page of the W-4 form is a worksheet to assist the taxpayer in calculating the additional withholding allowances they should claim.
Two compelling reasons to buy rather than to rent are: first, it enables you to lock-in a permanent monthly principal & interest payment at today’s rates. If you purchase using a 30-year fixed mortgage rate, your principal & interest payment 10 or 20 years from now will be the same as they are today. In contrast, rent payments are likely to be increased every year or two by the landlord so that they keep pace with inflation. Second, it enables you to use a mortgage to increase the profit you will make on the home. Assume a $500,000 property is purchased with a $100,000 down payment and a $400,000 mortgage and the home increases in value by 10%, the owner makes $10,000 on their $100,000 down payment and $40,000 on their $400,000 mortgage. Investors refer to this as using other people’s money (OPM).
Nationally, the average annual inflation rate over the past 15 years has been 2.90%, which is relatively low historically; e.g., the average inflation rate over the past 30 years was 4.35%. So, the cost of living has increased by about 4.35% a year over the past 30 years. Many economists believe that inflation will increase over the next few years to enable the government to be able to pay its debts. This analysis will use 3%, which is considered to be very conservative. At an inflation rate of 3% per year, a $1,000 per month initial rent payment would be about $300 or 30% higher in ten years. Compounding the 3% per year increases the percentage to about 34.4% over ten years. And, if the property value keeps pace with inflation, the home will be worth about 34.4% more in ten years than it’s worth today.
If you look at sales prices of homes on Oahu since statehood, prices have risen at about 3% to 4% a year or very close to the inflation rate. However, it has not been a gradual increase. The Oahu Housing Market has experienced soaring appreciation once each decade of about 30% with the exception of the 1990’s when our local economy tanked. The 1960’s, 1970’s, 1980’s and most recently, the 2000’s all had periods of soaring appreciation. In between the periods of soaring appreciation, the housing market has usually been relatively flat.
The following example assumes a 3-4 bdrm, 2-bath, fee simple house in a reasonably nice neighborhood with a value today of $500,000 that is available for either sale or rent. Property taxes are $120; insurance is $80. The property would rent for $2,000 per month. I’m going to assume an FHA mortgage is used at 5½%; which is a little high as this is being written, however, mortgage rates are going to increase. For simplicity, I’m going to round many of the numbers; I’m also going to assume that property taxes and insurance remain constant
There are two clients; the first decides to rent the home and will be referred to as the “Renter.” The second decides to purchase the home and will be referred to as the “Buyer.” The Buyer purchases the property using a 3½% down payment ($17,500), which is the minimum on an FHA purchase. The FHA loan amount is $482,500. The analysis does not include the return the Renter could achieve by investing the $17,500 down payment that is not being used to buy the home. The analysis also does not include any federal programs to stimulate home sales such as the $8,000 tax credit for first-time homebuyers.
The Renter pays $2,000 per month initially that will increase at 3% a year to keep up with inflation. The Buyer’s monthly payments are $2,740 for principal and interest, plus an FHA mortgage insurance premium (MIP) of $220, plus $120 for property taxes, plus $80 for insurance for a total of $3,160. The Buyer’s tax savings (refer to the bottom of the page) is about 28% or $770, reducing the out-of-pocket monthly cost to $2,390 ($3,160 minus $770).
So, the first year the Renter would seem to be far better off paying $2,000/mo compared to the Buyer’s out-of-pocket cost of $2,390. At first glance, the Renter would appear to be ahead by $4,680 (12 x $390). However, the Buyer will have paid the mortgage down by $6,500 to $476,000 by the end of the first year, plus the value of the home will have increased by 3% or about $15,000 to $515,000. So, the Buyer’s equity that started with their down payment of $17,500 has increased by $21,500 to $39,000 ($515,000 less $476,000).
The Renter’s monthly payment does not match the Buyer’s cost until the end of year #6. At that time, the mortgage balance has been reduced by $44,930 from $482,500 to $437,570 while the property has increased in value from $500,000 to $579,640 for equity of $142,070 ($579,640 less $437,570). I acknowledge that property taxes are likely to increase over the years and there will be both repairs and fix-up costs to improve the home that are not included in the analysis.
At the end of year #10, the Renter is paying monthly rent of about $2,690 while the Buyer’s payment remains constant at 2,390 for a difference of plus $300 per month. At the end of ten years, the mortgage balance has been reduced by $84,240 from $482,500 to $398,260 while the property has increased in value from $500,000 to $671,960 for equity of $213,700 ($671,960 less $398,260). Eventually the FHA MIP will end; for simplicity, I’ve assumed it is a fixed expense.
Tax Savings: You need to use a calculator that will amortize. Assume the Buyer is married with $80,000 of taxable income and uses a $482,500 FHA mortgage @ 5½% with a $17,500 down payment. Further assume property taxes are $120/mo:
$482,500 @ 5½% = $2740/mo. for principal & interest
End of first year balance (PV) using 348 (360 minus 12) months for (n) = $476,000
Initial balance ($482,500) minus $476,000 = $6,500 to principal the first year
$6,500 divided by 12 months = $542/mo. average principal payment the first year
$2,740 monthly payment minus $542 = $2198/mo. average interest payment the first year
$2198 interest payment + $120/mo. property taxes = $2318/mo. deductible the first year
$80,000 income = 25% federal tax bracket & 8.25% HI tax bracket for calendar year 2009
25% federal + 8,25% HI = 33.25% combined bracket
33.25% of $2,318 deductible = $770 tax savings using 5½% as the interest rate
The tax savings thumb-rule for an FHA mortgage @ 5½% is about 28% of the principal & interest for most buyers; 28% of $2,740 = $767 compared to $770