John M. Lee: Benefits of Buying vs. Renting

With rents going down in the past year, interest rates at very low levels and the spring home buying season coming up, this would be an appropriate time to go over the "buy versus rent" decisions in economic terms. This month, I will use a real case scenario to illustrate the numbers involved in buying versus renting (see chart).

I assume that the purchaser is a first time buyer, a couple, no children, earning $120,000 per year with no income tax deductions other than the standard exemptions. The purchase price is $600,000, they are putting 20 percent or $120,000 down and getting a loan of $480,000 at an interest rate of 7 percent.

First, let's look at their income tax situation. Their wages are $120,000 per year. In the rental case, they have to add interest from the $120,000 they saved, subtract their deductions and exemptions to get their taxable income of $110,400. Their total federal and state income tax then is calculated to be $31,282.

If they were to purchase, they can deduct the mortgage interest, property taxes and their exemption from their wages. This lowers their taxable income to $74,056 and their total taxes to $17,908, resulting in an annual income tax savings of $13,375.

Next, we will use these numbers to calculate the true costs of home ownership. Our couple's true out-of-pocket expenses are the mortgage, which includes interest and principal, real estate taxes, maintenance and insurance, which totals $46,865.

Since they used the $120,000 as down payment, they lost the interest of $3,600 they could have earned from that money. We have to add this to the cost of home ownership. However, they saved $13,375 from income taxes which we subtract from the cost to arrive at the annual cost of home ownership of $37,090, or $3,091 monthly.

Renting an equivalent home in this market will cost about $2,500 per month, resulting in a monthly difference of $591, or $7,090 per year. However, the mortgage payment includes an amortization of the loan or reduction in principal of $4,721, resulting in a total annual difference of $2,369. This means that if the home were to appreciate $2,369 per year, it would make economic sense to buy versus rent. These calculations have not factored in future appreciation and larger amortization amounts in later years. But even without these benefits, the results are at about the break-even point and this couple will be better off owning rather than renting in the long term.

However, purchasing real estate is not for everyone. For example, someone facing uncertainty in his or her life and anticipating a move within the next few years should not purchase a home because with the high transaction costs and uncertainty in prices, they will probably lose money by buying now and selling a short time later.

Also, if someone is living in a rent controlled unit now and the rent is low as compared to the current market rent, it might not make sense to buy.

Buying a home is not for everyone or every situation. I have set up this model to evaluate the true costs of home ownership on a purely financial basis. Before making the big decision of investing in a home, one must evaluate his or her personal situation in addition to financial position.

John M. Lee is a top-selling broker at Pacific Union. For questions regarding real estate, call him at (415) 447-6231 or e-mail him at isellsf@aol.com.