“I want to buy my own place. I don’t want to ‘throw my money away’ on rent anymore.”
As a banker, I hear this sentiment often.
Amongst the reasons renters want to purchase their own place is because it annoys them to “give their money to a landlord” every month, allowing the landlord to get rich.
For most people, buying real estate is indeed a worthwhile and sensible economic decision, to say nothing of the pride of ownership and positive sense of responsibility that comes with owning a home. However, many renters have a twisted idea of how their finances will change once they purchase. To illustrate, I will use “Bob,” a typical renter.
In Bob’s marketplace, he pays $1000 per month for a 1-bedroom apartment with den, with hot water and cable TV included. He hates the idea of throwing away $1000 every month, so decides to purchase a condo in the same area.
Bob buys a $260,000 condo, using a down payment of $30,000 and a $230,000 mortgage. Bob’s monthly mortgage payment is $1234.69. He pays an additional $200 per month for condo maintenance fees and $100 for property taxes, for a total monthly payment of $1534.69. Bob is pleased with his decision. What Bob is not aware of is that he is actually “throwing away” more money now than he was prior to his purchase.
Bob’s first monthly payment will be $1534.69, of which $958.33 will be interest, $200 for maintenance fees and $100 for taxes, with only $276.36 going toward the principle. That is, Bob is now “throwing away” $1258.36 ($1534.69 – $276.36) - a full $258 more than before, not including the utilities and cable that he now has to pay for himself. Over time, more of Bob’s money will go toward the principle, but at the moment Bob is deeply in the red compared to his previous situation. Did Bob make a mistake?
In order to make a wise real estate investment decision, certain rules are best followed:
1) Don’t buy into a declining market (or an exceptionally “hot” market which could soon decline) unless you plan to stay in your home for several years. It is best to purchase when values during the previous 6 months have been roughly flat or rising. There is no point paying $276 toward the principle every month (like Bob), if the value of your property is dropping more than that.
2) Don’t purchase unless you intend to stay in a place for 3+ years, with 5 or more being optimal. During shorter periods of time market values can decline (see Rule 1), and fees (such as moving fees, agent commissions, taxes etc) will take a bite out of any potential profits.
3) Buy something well within your comfort zone. No more than 32% of your monthly pre-tax income should go toward mortgage payments and condo fees.
4) Make sure you have fallback funds. Too many people put all of their savings toward a purchase, leaving nothing for emergencies.
If Bob intends to stay in his property for 5 years or more, has funds set aside for emergencies, and has purchased in a flat or rising market, he has probably made a wise investment decision. Over the years, his monthly payments will remain the same while local rents rise, with more of his payment going toward the principle (and less toward interest) every month. And, he will see his property increase in value while he enjoys living there.
Real estate can be a great investment. Just make sure you do it right.
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“The only difference between a cult and a religion is the amount of real estate they own.”
Frank Zappa, musician
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Bob’s Mortgage
Principal = $230000
Interest Rate = 5%
Amortization Period = 30 Years
Bob’s monthly payment is $1234.69
First year mortgage amortization schedule (click to enlarge):
