And how much home you can afford.
When I did a rent (and invest) vs. buy analysis back in January 2021 with a 2.6% interest rate, the results were pretty neck-and-neck. As rates climbed this year, I figured it would be fun (I’m using the word “fun” loosely) to revisit the exact same scenario with the higher rate.
Depressingly, when we recorded this episode just last week, the rate was 5.95%. In the course of a single week, it’s now surpassed 7% as of publish (9/27/2022). How have the rates changed the math now and how does one realistically budget for a median home in the US today with 6+% 30-year fixed rates? Let’s find out.
I'm also joined by Andy Taylor, VP & GM of Credit Karma Home (https://www.creditkarma.com/) to discuss breakeven costs, refinancing, and borrowing against home equity.
Episode transcriptions can be found at https://www.podpage.com/money-with-katie-show/.
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Katie: We are back with the controversial take I am most often flambéed for online, that home ownership as something everyone needs to do is a scam perpetrated on unsuspecting Americans by the real estate lobby. I will die on this hill. Okay, but really, with both interest rates and inflation climbing higher and higher, I wanted to revisit the math of this decision in this new environment, and how we’re in a bit of a rock and a hard brick rented wall. After today's episode, you may be more interested in switching teams to my dark side. Welcome—we have cookies. But I guess that remains to be seen.
Welcome back to possibly the longest question mark episode of The Money with Katie Show, #RichGirls and Boys, in an episode where I am going to once again fling myself down the rabbit hole of renting versus buying. The math is the math, right? Why do we need to have this conversation again, Katie? Well, that is true, except with the new average interest rates up from around 4% in January 2021 (under 4% in a lot of cases) to more than 6% in, what? July, August 2022. The math has changed, and changed quite dramatically. Making matters more confusing and frustrating is that rent inflation is also surging too, so it doesn't feel like there's any place to hide. When I originally performed this analysis for a blog post back in early 2021, renting did barely edge out buying from a financial standpoint, given the parameters of these national averages, but it was very close. It was easy to see how just by tweaking a few things, it could clearly shift in one direction or the other.
But when I reran the numbers with a new average 5.95% rate, well—not to spoil the lede, but it was not even close. Renting was far and away the most lucrative path forward, if the renter invested their down payment and the difference in their monthly costs. So we are digging into that analysis today. What could go wrong?
Today's guest is Andy Taylor, the VP and GM of Credit Karma Home. Andy's a big proponent of ownership, as he started a mortgage technology company in 2015, so I do look forward to him challenging basically all of my views. Now, the reason that I kind of wanted to share this cost comparison is because today, we're gonna examine a homeowner whose house basically doubles in value over the time they live in it, and compare their net cost or net profit at the end with someone who just rents and invests the whole time, factoring in rent increases, of course. I just think the results are fascinating because you would totally…if you just heard that on the street, you would totally be like, wow, the owner must have made so much money that they're head and shoulders ahead of the renter. But when you actually drill into the numbers, it's really not the case. We will talk about when math supports buying instead of renting in this newer higher interest rate environment. The TL;DR is, it's really not as often as you would think.
So there are a few caveats worth mentioning. Number one, this decision in real life does not occur in a vacuum. It is entirely possible that there won't even be rental homes available to you that fit your specific needs or your number of iguanas that live in your house, in your geographic area. If you would prefer to rent or vice versa, maybe you would prefer to buy and the numbers make sense, but there's nothing available. Secondly, renting and buying both have lifestyle upsides and downsides and preferences that play out more seamlessly in one or the other. We're not really focusing on those today, mostly because they're just so personal that we can't really debate them using math. And lastly, we're gonna look holistically at the monthly costs associated with both tracks, and do our best to compare apples to apples. Of course, this is a debate that is heavily skewed in favor of home ownership in the US, and when the media publish headlines like this one that I'll link in the show notes from CNBC, noting that homeowners’ net worths are 40 times greater than that of renters, I think it's easy to assume causality where it might not exist. So in this case, I fear that we have the causality relationship exactly backwards: that being the owner of your primary residence does not make you a rich person, but that a rich person is probably just more likely to buy their primary residence because they have more money to begin with.
So at this point you might be saying, okay, Katie, well, if owning sucks so much, then why the hell should I ever buy a home? When should I buy a home? Which is also known as, well, that's a lot of wasted rent money. Do you want my kids to suffer in silence in 800 square feet of rented squalor? Listen, renting has a bad reputation. Renting is not inherently a bad thing, and home ownership should not be a decision that is financially rushed because you feel like you're at an age where you should be doing it, or made without thorough analysis. I think when you are happy in your current situation, you are less likely to make life-changing, money-altering decisions using your amygdala that has been exposed to years of relentless Architectural Digest and American dream real estate porn, and you're more likely to look at your options objectively. We will be right back after this short break.
It is tempting to dive into the cool and sexy money stuff right away, like making millions and cheating the IRS and finding the next Amazon. There is a reason why so many courses purport to share with you, and only you, the secrets of magical wealth-building through real estate and stock picking and yada yada yada. But here's the actual secret: It does not matter how tax-optimized you are if you are overspending. The number one thing that is going to drive real financial progress…drum roll, please…is how much you have to invest in the first place, and how much time that money has to compound. A solid spending plan is the nonnegotiable foundation here, because if you don't spend it, you can invest it. I am personally trying to become a multimillionaire ASAP, and my approach to spending helps make that possible. So I'm sharing my specific step-by-step process via my signature take-at-your-own-pace, on-demand course, Budget Like a Millionaire, with over 500 graduates so far. If you would like to get a little taste, you can download my free money management routine at the link in the show notes.
If paying no taxes in retirement was my Super Bowl episode, this is my post-season playoff game. Please get out your notepads and your tissues and strap in. Prepare yourself for a wild ride. First, I think we should take a look at how much it actually costs to own a home, and we are gonna start with the costs that haven't really changed in 2022, since the crux of this dilemma right now is going to come down to those interest rates that we'll discuss later. Interestingly, I talked to Scott Trench, the CEO of BiggerPockets, earlier today, and he had mentioned, “Hey, you know, like at this point it's kind of crazy, but we're getting to the point with these rates where you might actually have higher returns over time buying in cash and not using leverage,” which blew my mind, especially considering where we were a year ago. Anyway, to quote Quit Like a Millionaire author Kristy Shen, the problem is that owning a house costs money way beyond the purchase price. It costs money to buy, sell, finance, and appraise it, and to insure and maintain it every year, which we logically know, but basically just dismiss when we are digging down deep for that down payment.
So the average American family, right? They live in their home for 13 years, rather than for the full duration of say a 15- or 30-year mortgage. So most American families never outright own the house that they live in. So today we're gonna use 13 years as the timeline for context. This average has increased in recent years. Back in 2010, for example, it was about eight years, and I'm gonna verify national averages for all these numbers using my trusty steed, Emperor Google. In 2022, the median home value in the US is $428,700, according to the Motley Fool. Median is a good measure to use, by the way, 'cause it kind of helps us understand what is most likely going to be the number, as opposed to averages, which can skew kind of up or down, depending on crazy outliers. So in this instance though, we're gonna round up to an even $500k, partially for the sake of easy math and partially because I'm bitter that you can't even get a two-bedroom condo for $428,000 where I live.
So a $500,000 home. That would suggest a $100,000 down payment, 20% of its total value, to avoid mortgage insurance, which means you would mortgage the other $400,000. So keep that in mind for later, and if you're sitting there like “But Katie, you don't have to put 20% down,” you are right, but obviously the more you mortgage, the more you're gonna pay interest on, and you'll pay an additional insurance fee for the pleasure of mortgaging more than 80%. So in order to keep our monthly interest payments relatively reasonable in this example, we're gonna assume that you are putting 20% down. If your PMI payments are small and they will fall off once your equity eclipses 22%, which is standard for whatever reason, it might be worthwhile, but I will draw one line in the sand here. There is a big difference financially between putting down less than 20% because you want less equity and therefore you want to pay less of an opportunity cost on locking up a lot of your capital in a down payment, and putting down less than 20% because you cannot afford to put down 20%, if you are using all of your savings to put down 5% or 10% and it's gonna leave you with nothing. That is probably a good indication that you are either buying more house than you can afford or that you are rushing this decision, because if you're stretched extremely thin by the purchase of your home, that probably means this is not a good idea.
We address this in the Rich Girl Roundup at the end of this episode in a little bit more detail, but it really just comes down to the fact that the best time to buy a house is when you can afford to buy a house. And if we're really being sticklers here, we would include all of these smaller fees like the cost of a title search and recording fees and legal fees and all of the things that are required when you're buying a house. But for the sake of the exercise, I'm gonna ignore those. We're gonna focus on the big picture.
Okay, now that I've sufficiently shared 1 billion caveats, we're finally ready to begin. Let's start with insurance. You have to insure your home. In my Google searches, the average looks to be between 0.5% and 0.9% of the total property value per year, assuming this varies based on the liability that the insurance company assumes it is exposing itself to. For example, if you have a house in an area that floods really easily or is always getting hit with earthquakes, I don't know. So we're gonna pick 0.6% on the lower end. Assuming your home appreciates by the long-term national average of 3.7% per year and you bump up your insurance accordingly, your insurance premiums over the course of the 13 years that you live in that house will cost a total of $48,948. Now I calculated this number by determining the increase in the value of the home annually and then multiplying the home's new value by that 0.6% figure per year to determine the annual cost of insuring the new value of the home. That way you have enough money from insurance to replace it in the case of total loss, and that's how we got $48,948 over 13 years.
Next, let's talk about property tax, because this is one that can really make or break calculations, depending on if you live in a high property tax area or a low property tax area. Predominantly because this is an unrecoverable cost. You paying taxes on this property does not build equity in the property. It's just like a sideshow, right? So depending on where you live, it can be kind of a fat bill. The annual national average is about 1%. In Dallas, where I used to live, it was 1.93%—it was almost 2% of the property value per year, which if you are in an expensive house, that's a lot of money. So let's do some more arithmetic. Assuming that your property taxes are gonna be recalculated by the county every year—and like I said, that home is going up in value by 3.7% per year. Carry the one, dot the i, cross the t…note that some counties are gonna reappraise on different timelines, by the way; it's very hyperlocal. But let's say it's every year. You're gonna pay $81,581 in property taxes over the 13 years that you live in your home.
So let's pause for a moment. Between our insurance and our property taxes, we are looking at $130,529 over 13 years, or $10,040 per year, or $836 per month in expenses, in addition to the cost that you are actually putting into owning the house, like the actual mortgage and the interest on said mortgage. Taxes and insurance are just the small waffle fries on the side of your spicy chicken house, and they are waffle fries that cost about $10,000 per year on a $500,000 chicken sandwich.
Now is probably a good time to state the obvious: This is why buying more home than you can comfortably afford sucks the life force out of your finances. It is not just the home itself that is going to be more expensive up front or every month, but all of these add-ons cost more too, because they're all proportional to the overall tax assessed value of your property. Someone who believes that they can afford a $500,000 home should be prepared with an extra $100,000 ready for the next decade of guaranteed inevitable basic costs like taxes and insurance, which is fine if it is important to you, to be clear. It is fine, but it is good to go in with your eyes and pocketbook wide open so you are not surprised later.
Now, these are often the costs that we don't think about or plan for up front, which is part of what I am trying to discourage. We find other ways when we're faced with these bills to scrape together the additional metaphoric $10 grand per year, right? We skip vacations or we cut back on savings, but my point is that we can plan for them, because we know that we are going to have to pay for them. It's not a surprise. It's just not often discussed when we are being encouraged by everyone from our dad to our nosy coworker to “stop throwing money away on rent.” Start throwing money away on taxes instead, Carol.
Before we get to the mortgage meat, let's talk maintenance and repairs, because we know that hot water heaters will break and pool filters will go bunk, and 16-year-old student drivers may plow through your front windows. Real estate agents often recommend setting aside between 1% and 3% of your total home value per year just for maintenance, right? Just to make sure you can keep it up, depending on how old the house is. Conservatively, if we chose the lower end of the spectrum and we say we're just gonna set aside 1% in maintenance costs per year, or “capital expenditure” as the investors say, on average over the 13 years we live there, that's gonna be an additional $65k in maintenance and repair costs.
Now, even if you escape disaster for a few years, it is good to hang on to that house emergency fund to tap it in the future. You may go totally unscathed for like the first five years you live somewhere, and then everything could break in year six. You just never know when the furnace is gonna go bunk, and unfortunately we really can't plan for it. So I would say, set it aside and keep it set aside, just in case. I am not adjusting this one upward for appreciation; I probably should, since technically homes depreciate over time, as in, they get progressively shittier, right, and more outdated, and they require more and more work to keep them livable and modern and, like, up to normal standards. If we're being super pedantic, which, welcome to Money with Katie, it's not your home that is becoming more valuable. It's the land that the house is sitting on. This is why the government allows real estate investors to write off depreciation on their properties, because even the tax man knows that your house is getting progressively worse and requires you to spend more money to keep it livable and up to date.
Keep in mind, we're not talking about, like, the fun and sexy stuff like kitchen remodels and installing a bouncy castle in your basement. We're talking about pipes bursting, sprinkler systems breaking, washer/dryer sets crapping out, accidentally flushing a dog toy down the toilet and having to replace a septic system. If you wanna do serious renovations on your home, that's considered a separate expense. That's not what we're talking about.
All right, so back to the whiteboard. We're up to $195,529 on the upkeep, taxes, and insurance for our $500,000 home over the 13 years that we live in it, or $15,040 per year in addition to our mortgage and interest. That is right: We have not even begun paying down the mortgage and interest yet. That is an average monthly cost of roughly $1,253 toward what we call “unrecoverable costs,” or costs that do not build any equity, in the same way that rent builds no equity.
Do you think this maintenance number sounds like an outlandish estimate? Listen to this message that I received from a friend who has always engaged me in a healthy debate about my housing hot takes. She wrote, and I quote, “So I've always pushed back on your anti-home ownership views.” (Sidebar: I'm not anti-home ownership. I'm just like, let's be honest about how much this should actually cost.) “But girl, let me tell you a story. This week my furnace went out, and I, thinking I am a responsible homeowner, have obviously budgeted for random maintenance. I'm expecting a $1,000 repair at most. Lo and behold, the entire furnace needs to be replaced.” (In parentheses, “$5,000.”) “Oh, but also, it is so old that it runs on a refrigerant they don't make anymore. And since the AC runs off that same refrigerant, it has to be replaced too, because the chemicals can't mix. Another $5,000. Oh wait, since it's on the roof of my three-story complex, we have to rent a crane: $500. My goal this year was to build my emergency fund, but I did not have the full amount in cash. Thank god for the Federal Bank of Dad, and a 0% interest loan, but I feel so guilty he had to help clean up my problem. Valuable lesson that the emergency will happen. So that's way more important than replacing your rent with a mortgage. Also, your parents' bank account is not an emergency fund.” End quote.
I loved that. I thought that was very honest and self-deprecating and self-aware. But in general today, my intent is to paint this just mathematically sound, unbiased picture of the rent versus buy equation in today's interest rate environment. I don't want to rely on anecdotal evidence and, like, one-offs to convince you one way or the other. But like I said, I feel like we all get, pretty much most of the time, this, like, rosy, white picket fence view of home ownership, full of catered housewarming parties and custom drapery and in-feed Instagram posts posing next to the Sold sign in the front yard. And we don't often get that follow-up picture of, like, frantically calling an older, richer relative because an unexpected five-figure repair came out of nowhere. It is rare that we get to hear someone in their twenties speak so candidly about when owning a home is not the American dream. So I wanted to include it.
Let's pause here. We will be right back, after a message from the sponsors of today's episode: Rocket Mortgage. No, I'm just kidding.
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Katie: Finally, we have made it to our spicy chicken sandwich: the mortgage principal and interest. Here's where shit takes a dark turn in 2022. Now this is a pretty simple calculation, so let's assign the new national average interest rate. According to Bankrate, as of August 2022, the average US mortgage rate for a 30-year fixed mortgage was 5.95%. This factor will seriously impact these numbers as you run them for yourself. So I suggest using the rates that you are actually being pre-approved for, when you run your own scenario through the old calculator. As a reminder, when I originally ran this analysis in early 2021, the average rate was 195 basis points lower, a full 1.95% lower.
As a refresher, we are mortgaging $400,000 after putting $100,000 down. Our principal and interest payment every month is a fixed $2,385, according to the built-in Google mortgage calculator with the taxes and fees toggle-switched off. When I used last year's average rate, the principal and interest payment was $1,900 on a home of the same value. So this is a near-$500 a month increase for a home of the same value, which, as we'll see, ends up being the difference between making, like, a small profit, and ending up in the hole. It is that close. For reference, the $2,385 amount is usually the number that people see when they consider buying a half a million dollar home, and they think, “Well, hot damn, I can afford a $2,385 a month payment for a house that big. Let's pony up, baby.” To be fair, that is probably the strongest selling point for buying. You lock in your fixed monthly payment for the duration of a loan, and in periods of high inflation, like right now, your debt benefits from the tailwinds of being more or less inflated away. Owning is a good inflation hedge, through and through. And when we run the numbers for this scenario, we know without a shadow of a doubt what we are going to pay toward our mortgage and interest each month in year one and in year 12. It does not change as rent does. There's not this fluctuating happening.
But as you have likely deduced by now, that $2,385 a month does not tell the whole story. And we wonder, well, how much could all that other shit cost? Surely it's not that big of a deal. And in this $500,000 home example—on the conservative end of the spectrum, mind you, it is an extra $1,253 per month, on average. That's $2,385 for your mortgage payment and $1,253 in taxes, insurance, and routine maintenance, using all national averages, or $3,638 per month. That's kind of a far cry from what you would think you're getting yourself into, I think. Remember, these are the costs that we know about: taxes, insurance, interest, routine maintenance. These are guaranteed unrecoverable costs of owning a home. Now we're only living in this place for 13 years before selling, because we are your average American family. And if we're spending $2,385 per month for 13 years, that is a total cash outlay of $372,060 in principal and interest payments.
If you're like me, you're probably like, “Wait a second, that's nearly 400 gs. Does this mean that I have almost already paid off this house?” In a 5.95% average rate environment? No, nowhere close. Are your tissues ready? You're gonna need 'em. Over the full 30-year term, a $400,000 mortgage would cost $858,000 with a 5.95% fixed rate, $458,000 of which was just interest. Just interest. That's over the full 30 years, though. We know that our hypothetical average family is selling after 13. This means that they are paying majority interest for the entirety of the time that they actually live in this house. This is because interest is paid first in a mortgage. It is front-loaded into your payments. The bank wants to make sure that even if you're moving in year five, you have paid off a lot of that interest. So approximately $260k of your mortgage payment so far—years one through 13, right?—would've just paid interest on that loan. Meaning of the total $372,000 of the quote unquote “principal and interest” you paid over 13 years, only $86,000 of it actually went toward paying down the principal on the $400,000 balance that you mortgaged.
Yeah, I'm gonna let that sink in. Let me repeat that for dramatic effect, because I myself find this absolutely fucking stunning. When you sell after 13 years, you will have paid, conservatively, $195k in taxes, insurance, and maintenance, as well as $372k to the bank, but you've only actually paid back around $86,000 of the original $400,000 amount that you borrowed (read, mortgaged), which means that you still owe roughly $313,000–$314,000 on the property. So in total, you've paid $567,000 over 13 years for approximately $86,000–$87,000 of equity, plus the original $100,000 that you put down, which is also equity, for a total cash outlay of $667,000 for around $186,000–$187,000 of equity.
Needless to say, home equity is very expensive. So I know someone could refinance, and if they intend to stay in this house forever, it will absolutely eventually pay off, but after just 13 years…well, let's keep going. In order for you to break even, meaning at least walk away with the same amount of money that you put in, as if this house was a piggy bank, right? And every dollar that you spent on all of these different things, if you wanted to be able to then get all of that out at the end, your home would have to net at least $980,000 after broker fees when you sell in year 13, since you've spent $567,000 over the 13 years in monthly payments and whatnot, and you put $100,000 down, and you still owe the bank $313,000 when you sell, to pay them back for the rest of the mortgage. Now, that's not totally unheard of, but it's also probably not something I'd wanna bet $500,000 on.
So hopefully our home has appreciated, right? Let's pretend for the sake of the example that we actually purchased a home in one of the top 10% of national housing markets. Though, keep in mind, we did only assume taxes and insurance increases based on the 3.7% national average. We would need roughly 6% average annual appreciation over the 13 years to make this work. So we're gonna pretend that that's what we got. If we could find a market that could reliably produce 6% annualized average appreciation over the long term—remember, long term, not 2020 through 2022—we would have a house valued at around $1,006,000 in year 13. So, great. It has doubled in value over that 13-year period, and it looks like it's gonna allow us to clear the break-even value that we needed of $980,000. But wait. We need to sell the house to make the profit, right? Right. And selling a house also costs money. When you sell a home, the broker's commission comes out of your end, the seller's end, and it's calculated based on the new value of the home. So the price that you're selling it for, not the price that you bought it for. On average, the total broker's commission is about 6%. So we'll pay our broker and the buyer's broker 3% each of our $1 million listing price, which is $60,000. That leaves us with about $940,000 on our $1 million home sale.
So we know we gotta pay the bank back, right? So we probably feel like, cool, we're walking away with quite a bit of money…except we already know from all the costs that we've been paying over the last 13 years that we actually need to clear roughly $980 grand to break even, or to walk away with the exact amount that we've put in over time without owing anything extra. We know we've already paid $667k for our down payment, our mortgage principal, interest, property taxes, insurance, and maintenance. We paid the broker $60k for the sale. We also have to pay back the bank for the $313,000 that remains on the mortgage principal.
So all in all, what is our net profit? Well, we can add all this up and see that it adds up to $1,040,000, offset by the price that the home can fetch at sale of a million dollars after 13 years of appreciating at 6% per year. Again, keep in mind, had it only really appreciated at that national average we've been using of 3.7%, it would've been worth about $733,000 at sale. So it is a good thing that we doubled our money and made a million dollars in our home sale in one of the hypothetical fastest-appreciating real estate markets in America, because after 13 years of glorious home ownership, using all of the average costs and rates, we are at a net loss of about $40,000.
Now, of course, we did have a place to live, and that is the true value of having a home. Absolutely. But we don't have any more money than when we started with; that's the point. In fact, we actually have $40,000 less. Our profit on our home that we bought for $500k and sold for a million 13 years later is negative $40,000. And we excluded certain expenses that don't apply to every state, like land transfer taxes, lawyer fees. We also totally ignored closing costs, which can easily exceed $10,000 on a $500,000 home, or $20,000 on a million-dollar home. 2% of the total value is pretty common.
So two years ago, when rates were just under 4%, you probably actually would've come out ahead in this situation. But now…not so much. And remember, our house doubled in value in the time that we lived in it, and that is, statistically speaking, kind of rare. The point is, there's a lot going on under the surface, and the monthly mortgage payment you can see is just the tip of the iceberg. This is why I am personally so hesitant to buy property, because I know that if I can rent that same type of home for even $2,385 a month, which is the same cost that our hypothetical family paid for their mortgage alone every month, I will have spent $446,981 in rent over 13 years, if my rent increases by an average of three percent per year, which is customary. So that's a net loss of $446,000 compared to a net loss of $40,000 if I just rented and did not invest the cost difference.
But this is a rent versus buy analysis. So we are going to dig in, because obviously that number sounds horrible, until you consider that my $100,000 down payment went into the stock market instead. And the difference between my cost to rent over 13 years, $447k, and the aforementioned cost to own over 13 years, excluding the down payment, $567,000, is about $120,000.
In other words, by not buying a home, I was given the opportunity to save and invest the additional $120,000 cost differential that I would've spent on the house's recoverable and unrecoverable costs along the way. Had I chosen to invest that amount, equally distributed as monthly contributions over the 13 years at $769 per month, I would've made a decent amount in the market, if you assume an 8% return before inflation, which is standard, historically speaking. So a hundred thousand dollars is my initial investment in the market. And then that difference of $769 per month incrementally over 13 years at an 8% annual return before inflation—you end up with $470,000 in the market after 13 years. So you would subtract your amount that you spent on rent, $447k from $470k in your investment account, and you see a net profit of $23,320, as opposed to our net cost of 13 years of ownership of roughly 40 grand. So we're talking about a $63,000 difference as a result of renting and investing, right? We're $63,000 ahead of where we would've been going down the ownership route with those rates for that amount of time.
Now, I did not take you through this entire laborious exercise to, like, shit on home ownership. I only did it so you would believe me when I say that owning a home is expensive. We used national averages of guaranteed costs to come to these conclusions, and you can run these same calculations using your own interest rates, mortgage amounts, et cetera, and Google the tax rates and insurance rates in your zip code if you wanna get, like, total accuracy. And like we said in the beginning of this episode, not every market is going to have rental inventory that is that inexpensive, right? It's gonna vary by where you live and what the price to rent ratio is, what you can kind of get for the same price.
Of course, it's a good time to remind all of us, there are a lot of assumptions baked into this calculus, as there kind of have to be in order to do any sort of forecasting. But I will point out that we did use average costs, average rates, average increases, and above-average appreciation on the house. So if anything, I think this exercise was actually slightly more generous than it would've needed to be toward the owning camp. Since it assumed that there were no major repairs needed over the 13 years, and you had super healthy, above-average appreciation every single year. That said, it is possible that our average rent increases were too low, as some zip codes have seen rents rise more quickly than 3% per year on average.
On the other hand, some zip codes have historically seen rent increases less than 3%. So pick your poison. And I think it's tempting right now, on the heels of ahistorical rent jumps and housing appreciation since the pandemic, to just discredit all of this offhand. But I would argue that that is the exact wrong approach, because the last 24 months have been the exception, not the rule. Even when we utilize the tax breaks for homeowners, like deducting your interest from taxable income, the difference is stark, because 90% of Americans take the Standard Deduction since the Tax Cuts and Jobs Act raised the standard deduction in 2017. I would say, if you are a single homeowner with an expensive house, you probably should be itemizing, obviously…check, make sure it makes sense, but you will probably have an easier time having higher than $12,550 bucks or whatever the standard deduction is for single people in 2022 in your interest in property tax costs. But for most married couples, you're probably gonna be better off taking the standard.
As a reminder, I have no skin in this game. It is your decision to rent or buy. I am not a lender; I am not a landlord. If it were more financially advantageous for me to buy a $500,000 home than to invest in the stock market and rent something else, I would've bought the house already, because trust me, I want to have as much money later as I can. And if I genuinely believed that I was gonna make more money as a homeowner than as a renter, given the market conditions that we are in, I would've bought the house already.
Anyway, that exercise had to happen in order to set us up to ask this question: When does it make sense to buy your house? I introduced you to the rule of 150. The rule of 150 says that you can multiply your estimated monthly mortgage payment by 150% to get your actual out-of-pocket cost of ownership, as in, this is how much your home will actually cost per month once all of these expenses are factored in. So it's like a handy little tool. If that rule of 150 monthly cost is higher than your rent, then it makes sense to rent. And if it's lower, then it makes sense to buy. So let's see if our example checks out. What was our cost breakdown over a 13-year window, excluding closing costs and major renovations? It was $195k on insurance, taxes, maintenance, the extras, and then $372k on principal and interest: the main course. So $195k divided by 372, you get 52%. So in our case, our extras accounted for 52% of our main course, the monthly mortgage payment. So taking your mortgage monthly payment that you are looking at, right, for the house that you wanna buy, the rate that you can get and multiplying it by 1.52 would've given you the actual total all-in costs that account for things like insurance, taxes, maintenance—again, we're not including the down payment in this.
So calculate your monthly payment on that mortgage you could get for the house you'd wanna live in. Feel like you could afford it. Multiply by 1.52. If the rent you are paying now is higher than that number, it makes sense for you to buy, assuming that you have your down payment or that you can factor in the PMI costs for a sub 20% down payment. But if your rent is less than that number, it actually makes more sense to rent and invest. So for example, if we wanted to buy a house that costs $500k, we put 20% down, mortgage the remaining 80%, our payment, we know…$2,385 per month. Unless our rent for something comparable currently exceeds $3,625, which is $2,385 times, you guessed it, 1.52, it makes more sense to keep renting.
If your rent for something comparable is, say, $4,000 per month and you could own that same or a similar piece of property for $500k, and you cannot fathom living in anything that costs less than half million dollars, then it makes more sense to buy than to keep on renting at $4,000 per month. So remember, it's not like I'm suggesting that you start your family of five in like a studio apartment. I just want you to run the numbers and see if owning or renting a home makes more sense in your market. Because you may find that even if you think, oh god, we actually might come out with a net loss here, you might be okay with that, if you are really interested in the benefits of, like, long-term stability that ownership can bring.
Not every decision has to make financial sense. It's just important to know what you're getting yourself into when you sign on the dotted line for a loan whose name loosely translates to “death pact.” So if you are stressing out about getting a down payment for a house, because you cannot imagine renting for any longer, because you're too old for that and you shouldn't have roommates, don't. The last 24 months have been the exception, not the rule. And this episode should hopefully show you step by step how to calculate these same numbers for yourself based on A, where you are renting or considering buying, B, how much you are spending currently and C, the cost of the home that you want to buy. Renting conservatively is better than buying luxuriously, but renting luxuriously is worse than buying conservatively.
Buying a small two-bedroom home that is well within your means will definitely end up being better in the long run, if you are currently renting the penthouse at the W. The problem is that most people do not go from the penthouse to the tiny house. They go from the one-bedroom apartment to the three-bedroom home in the suburbs.
So how to buy a home if you've decided that you need to? I totally understand wanting stability, especially if you have kids. Totally get it. The key to buying a home, even if you recognize that it may be a less optimal path than renting and investing financially, is buying something that you can comfortably afford. Yay! What does comfortably afford mean mathematically? There are a lot of rules of thumb about this. We're gonna kind of dig in deeper in the Rich Girl Roundup, but this is my personal perspective. If your 20% down payment represents less than 25% of your total net worth, and the total monthly payments, right—mortgage, taxes, insurance, interest, maintenance, everything that we talked about, not just the mortgage payment—represent less than 25% of your take-home pay every month, I would say you can definitely comfortably afford it. So in this $500,000 home example that we just did, you would have to have like $400,000 in assets, total, so that after the $100,000 down payment, you still have $300k left over.
This is just a general rule of thumb that helps you avoid a situation where you're just house-poor, and like your whole net worth is tied up in this illiquid structure prone to foundation issues. Now, knowing that your all-in monthly payment costs are gonna be about $3,500, right? You'd have to be making around $14,000 per month after taxes in order to be considered comfortably affording the payment. Because as a reminder, there's nothing comfortable about draining your savings account for a down payment, and then spending half of your income every month on monthly payments. And as you can see from the prior hour of your life that you spent listening to this, there's really almost no point, because it's not likely to end up a superior investment that's going to help you walk away with a gajillion dollars later.
Anyway, in the late 20th century when our parents were buying their first homes, the median home value was three times median income, and today the median home value is nearly seven times median income. It is just a completely different decision today. It carries a completely different risk profile now, and I think that we still kind of hang onto that conventional wisdom from the past that is really endemic of a completely different economy and a completely different housing market. So in conclusion, run the numbers.
With that, let's welcome our guest, Andy, to the show. Andy, thank you so much for being here.
Andy Taylor: Hey, thanks for having me.
Katie: Absolutely. Today's episode covers a hot topic. We went over a lot. We've been here for awhile already. Renting versus buying, and knowing that like the financial ramifications of this decision are gonna be hyper-local to the individual and vary drastically by zip code and personal situation. Why is this a topic that so often gets treated as a black and white issue? Why/where did home ownership get kind of so entrenched in our national rhetoric?
Andy Taylor: My guess why the topic of home ownership is covered in a blanket manner is just because owning a home is what people correlate with achieving the American dream. And it's one of the most effective ways to build wealth in the country. So when it comes down to it, many folks make that decision to buy a home for personal and emotional reasons. It's not simply a matter of what makes the most economic sense. They're not running a spreadsheet in the back of their heads. And while you're absolutely right to say the decision to rent or buy is not black or white, it's impacted differently, you know, really depending on where you live. There's no denying that consumers across the entire country really have been experiencing housing affordability crises in the last few years. And so what is it, like, Credit Karma ran a study and we looked at our own members and we found that, you know, 29% of zoomers are still living at home with their parents or relatives. You know, nothing wrong with that. 40% of Americans are saying that rising rent prices have made housing unaffordable, and home buyers are saying that rising mortgage rates have really just made it impossible for them to buy a home this year. And I think there's something very deeply psychological about that too.
If you're looking at two and a half percent in February or March, and all of a sudden it's now 6% or higher, yeah, that can just be really demoralizing when you're thinking about it. And it's not just me and it's not just our own data. When you look at the inflation data, it shows that people are really feeling the pinch. Rents rose almost a percentage point from June to July, making that the fastest monthly increase since like the nineties. And so we're seeing kinda some crazy things going on in the market, and you know, why am I talking about that affordability? Well, really that decision to rent versus buy depends on where you live, you know, how feasible it is for you just in the first place to even buy. And then of course that depends on your financial situation and where you're living and how that all affects you. So perhaps one of the reasons why people can't shake this conversation at cocktail parties is just because renters and potential buyers are in a tight spot and misery loves company. People love to talk about it.
Katie: Yeah, well, you gotta have somewhere to live. So it makes sense that the one thing we all have in common, besides, like, maybe also needing to eat and buy food. It's like, well, we all need somewhere to live.
Andy Taylor: Absolutely. And you always find that person in the corner at the cocktail party who doesn't wanna talk about it because they secretly own a home.
Katie: One of the most common pieces of pushback…because I do, I like to run these numbers a lot, and I know that a lot of people that listen to this show already know this, but for your knowledge and context, Andy, I am a renter by choice. The zip code that I live in, the area that I live in just so happens it's one of those communities where the price to rent ratio is super outta whack, and we can live in a much nicer home via renting than via buying it. It's just, you know, it works out that way for us. We also tend to move around a lot for the military. So for this stage of life, it's been a net positive for us financially to just take care of that housing expense via the rent payment and invest in other things.
So when I run these numbers, though, or bring this up to people, typically I'll get pushback around this idea that, you know, well, I can borrow against my home equity someday and that's a good enough reason to buy, that I can borrow against my own equity and basically take out a loan against my home, if you will. What, I guess, would you say to someone that's kind of approaching this decision with that in mind? Like are there any risks to be aware of? Is there anything that you would caution, or like, is this a totally fine kind of approach in your mind?
Andy Taylor: Buying just to be able to borrow against your home isn't really the sound reason to take on the biggest financial responsibility of your lifetime. And, and I get it. I mean, building equity as a homeowner is a very effective way of building wealth in America. And there's a lot of homeowners sitting on record levels of home equity, which is an appealing opportunity if you're, if you're a prospective homeowner, but a house isn't a piggy bank, and when you tap into that equity, either through an equity loan or a HELOC, a home equity line of credit, you use your home as collateral. So while there could be a lot of upside when it comes to using your home's equity, with great power comes great responsibility. You gotta ensure that you can make those on-time payments so you don't risk losing that home. And then of course, it's kind of a wild market out there. The process of building home equity usually takes time, years, really. And yeah, the past few years have just been outliers in terms of home value appreciation. So I'm not saying that we're gonna see home values start to tumble, but equity in your home really does fluctuate over time. And during the last housing crisis, 2007, 2008, property values plummeted and that really impacted homeowners who had borrowed against their home’s equity, so they were upside down on their loan. So gotta be sort of careful in that approach.
Katie: Yeah, and kind of in that same vein, when we talk about like refinancing, I hear it often discussed as like, well, when the rates change, I can just get the lower rate. Are there costs? What are the costs associated with refinancing that someone should take into consideration?
Andy Taylor: Yeah, absolutely. Now, you know, locking in a lower rate is certainly one of those primary reasons why people choose to refinance their mortgages. And people are doing that in droves over the last few years. You know, since March 2020 when rates were unexpectedly dropped, it was a great opportunity—why wouldn't you do that? But when you refinance, you're essentially taking out a new mortgage to replace the old one. So whether your goal is to change into that lower rate or you know, maybe you wanna move to a shorter loan term, or perhaps you wanna secure a different loan type, you could do an adjustable rate mortgage versus a fixed. Really the decision to refinance comes with a few key considerations, and whether that benefit outweighs the cost.
So I should note that while it sounds kind of crazy that to anyone who owns a home that like, you know, anyone might be considering a refi right now, given the high rate environment that we're in, like literally who could, who could refinance? The truth is that even with rates hovering around 6%, there are still hundreds of thousands of people, according to Black Knight, that could benefit from refinancing. Who these people are, I have no idea, but they're out there. And what that means is that those hundreds of thousands of people might have that opportunity to shore up themselves with some extra cash, with the cost of living rising.
But to get to your specific question, like what are those considerations that you need to evaluate when you're thinking about refinancing? What are those extra costs? Well, like I said, you're taking out that new mortgage when you refinance, so you have to pay that same or similar cost that you did when you got that original mortgage. That's things like origination fees, taxes, appraisal fees,
Katie: So like closing costs, again?
Andy Taylor: Closing costs, etcetera, etcetera. Someone's gotta pay the lender; they wanna stay in business too. And so they're taking it out, and everyone in that value chain is making money somehow. Technically speaking, you know, when you also, you have to look and see if you have a prepayment penalty to refinance, because you're essentially paying off the former loan to get a new loan. If you have a prepayment penalty, you also have to ask your lender if they're willing to waive that penalty. Now there's a lot of lenders out there that if you go and you talk to them directly, you can ask them, hey, would you waive this prepayment penalty if I was to refinance with you? And oftentimes they just don't wanna lose that loan. So if you can work with the same lender, then they might be willing to waive it.
And, you know, given that those fees that come with a…with that refinancing, you're just gonna wanna make sure you crunch those numbers to make sure it's worth it. And so, just like you hopefully shopped around for that first mortgage, you're gonna wanna do the same thing with shopping for a refi. Getting a few quotes, negotiating with your lender to maybe cover or reduce some of those fees, especially if you're sticking with them.
There's some other things that are involved in this that aren't like specifically fees-related that actually do factor into the overall cost of this too. One of which is just simply, are you almost done paying off your mortgage? So what I mean by this…well, in the early days of your mortgage, most of those payments that you're making are actually going to paying off interest. As you get further along, slowly but surely you're making more and more towards the principal, or the amount that you owe. And there's like, you know, about halfway through, you kind of switch and you're paying more principal than your interest, and isn't always necessarily halfway, it depends on the terms. But let's say you’ve been paying off your current 30-year mortgage for 10 years. If you refinance into a new 30-year mortgage, you're just pushing that big ol’ red Reset button. So you start over, and you're gonna be paying more in interest, and therefore you're gonna be making less in overall equity that you have in that house. If you're thinking about, like, where is that break even point, meaning the amount of time it's gonna take for you to recover those closing costs and all the other expenses that you're gonna be paying that I was just talking about, you just wanna make sure you plan to stay in that current home long enough to actually reap those refinance benefits. And then the other thing, of course, is that just making sure, is your credit in good shape? Because that plays a significant role in determining what that rate is. You know, we, we talk about like…
Katie: Credit Karma has entered the chat.
Andy Taylor: Absolutely. I didn't say them specifically…You know, we can infer this,
Katie: Hey, I use…I'll say that. This is not sponsored, but I do use Credit Karma to check my credit score and keep an eye on things.
Andy Taylor: Well, this is fantastic. Well, and a lot of people do, and you know, what we try to do is we try to match you up with a lender who's got these real, honest rates based on what we know about you on the finance side. And to credit purposes, like we talk about 6%, like it's just some magic number that everyone gets. Well, the rate that you get depends on a variety of factors, credit being one of like the strongest factors that goes into it.
Katie: Totally. You mentioned break even points. That was something that kind of surprised me in the analysis that we did today. I just used averages, right? Because I am not in the business of trying to estimate somebody's specific situation. So I said, let's just use national averages for everything and flesh this out. And what I had learned was that the average amount of time that someone spends in a home before they sell it and move to the next one? Around 13 years, give or take. That's actually been going up, I think, or it used to be closer to eight years, and now in the last few years we've seen it rising. In your opinion, though, given the fact that you are…there are high transaction costs with buying—that first mortgage origination, right? And with your closing costs and whatnot and a lot of this interest that's front-loaded into your amortization schedule. Is there a point in your mind, Andy, that you're like, if you're gonna live in that house for more than X years, it almost doesn't matter what the price to rent ratio is? Or if you think you're overpaying for it, if you're gonna be in that house for this many number of years, you're probably gonna break even, it's probably gonna be fine? And I know that that's gonna vary by area, but I'm just curious if there's any number that for you, you're like, anything beyond that, it's gonna kind of take care of itself and you'd consider it more of like the break even point?
Andy Taylor: Yeah, I mean like you said, there are just so many different factors that go into it. I always thought of the general rule of thumb being like around every five to seven years. Like you…if you can stay there for five to seven years, then that's roughly a good break point. But things have been so crazy, like the past, like you know, few years, you know, home appreciation, interest rate spikes. Yeah, those blanket estimates just don't work when market conditions vary, both based on time, you know, like literally like a couple weeks ago rates were significantly different than they are now, but it also varies significantly based on where you are in the country.
So I'm not sure where that…where this particular household resided, but you know, my assumption's probably a high-cost market. So for instance, if you buy in a home in New York or Bay Area, it can take 15 years to break even, just because it's so darn expensive. You're buying like essentially a tear-down shack on a lot in Palo Alto, and you're spending way too much money for that.
Katie: Yeah, yeah.
Andy Taylor: But it might take you five years or less if you bought in Houston or Atlanta, depending on the neighborhood, too. And so it's just highly, highly local. So I'd need more detail on that particular household situation.
Katie: No, I actually, I like that answer, because I think that it highlights that like for everyone, you just need to run the numbers. You need to look at where you are living, what you are paying in rent, what is available to you to buy, what kind of rate you can get, and kind of see like, well, let's actually see for these specific variables how long we have to be in this house and if we think that that's feasible and something that we would be interested in.
Yeah, so I guess where I wanna go next is, this is something that I heard on a podcast a while ago from these two wealth managers that work up in Canada. And for our listeners that may not be familiar, the Canadian housing market is a little bit different from the US housing market, in the sense that like they never really had a correction in the way that we did in 2008. Like they didn't have this big crash. So they've kind of just been, like the rising values have just been continuing to ascend. And not only that, but their mortgages work differently. So like they have adjustable rate…I think pretty much everyone has an adjustable rate mortgage, whereas it…like after the first five years, the rate changes. They're in Canada and obviously that may impact things a little bit. But, they had made this point that when you own your home outright, like when you no longer owe the bank anything and it's all your cash, that is the equity that's tied up in the house, that that is paradoxically the most expensive time of your ownership journey, because of the opportunity cost of that equity. What do you think of that, Andy? Does that resonate? Does that feel like, how do you…how would you conceive of that kind of idea about like the opportunity cost of having all of the equity yourself?
Andy Taylor: Yeah, absolutely. And this does typically come up when people are deciding whether or not they're gonna pay their mortgage off early. For a lot of people, it's just like this peace of mind that you don't owe the bank anything. But on the flip side, are you leaving money on the table, to your Canadian friends? And so, you know, sometimes you're better taking that money that you would've used to pay off the home loan and investing it, but it really depends on that relative rate of return. I mean, money should follow the best rates of return, and so if your mortgage rate is, say, 3% and you could earn 5% somewhere else, well then, yeah, you should go invest that 5% somewhere else.
Although, I don't know if you've taken a look at the markets, they are pretty volatile right now. So yeah, you might think that you could get 5%, but you might end up, you know, eating your hat at the same time. There's a lot of different considerations that go into that and again, it's really a personal preference. You know where you are in your life. You know, are you a young family and you've got financial goals and aspirations that mean that you want that flexibility? Or are you nearing retirement, and you wanna be debt free? You know, the same thing goes when deciding to buy a home outright with cash. There are people who are sometimes fortunate in life and they can say, “I'm not even gonna get a mortgage, I'm just gonna pay this with cash.” And yes, you might save a lot of money on the interest, closing costs, PMI, but again, those savings might still earn you less than if you were to invest. And so I wish I had a crystal ball and I could tell you the right answer, but it really does…
Katie: Come on, Andy.
Andy Taylor: Let me pull it out and tell you. There are other potential…
Katie: You didn’t bring it?
Andy Taylor: Yeah, well, right, there are other pitfalls too. I mean, for example, if you put all of your money into your house, then you don't have any liquidity anymore. That money's tied up in your home, it's difficult to access it. So, and if you're putting your entire home budget in the home itself, what happens if you have an emergency expense? Do you have enough cash on hand outside of the home to cover those expenses? Because right now, I'm telling you, if you're a seller and you would need to sell your home to actually gain access to that cash, you might be in a pinch, because that doesn't happen very quickly and it isn't necessarily a seller's market anymore.
The other thing to think of too, and this is always…you gotta think about the IRS. Like, come tax day, are you going to miss out on the tax break? So those who have a mortgage typically qualify for a mortgage interest reduction. This gets complicated state by state; Fed is also very different. And it also differs depending on the administration, 'cause this thing has changed a couple different times. But that generally allows borrowers to count their paid interest against their taxable income, so you're not sort of taxed twice on it. So if you have private mortgage insurance, you can also deduct that mortgage insurance payment on your itemized tax return. There's a lot of tips and tricks. Consult your local CPA; they'll guide you through it. But you know, honestly, it's a personal choice. It's not black and white. I would say, just like consider where you are in your life, what your risk profile is, and you know, ultimately how much risk you wanna take on to chase that return.
Katie: Yes, that totally makes sense. Andy, thank you so much for being here. I really appreciate you adding your knowledge to this very fraught topic.
Andy Taylor: Absolutely. Hey, thanks for having me. Anytime.
Katie: Welcome back to Rich Girl Roundup. As a reminder, we will take listener questions every month. I'm gonna put out calls on Instagram, so follow @MoneywithKatie on Instagram if you are not already—shameless plug. And we're gonna pick one every week that feels interesting and widely applicable and will answer it. As always, my standard disclaimer: I am not a licensed financial professional. This is not financial advice. This is merely, how do I think about this problem? How would I approach it if I were in your shoes? This segment is brought to you by Betterment, giving you the tools, inspiration, and support you need to become a better investor.
Here's this week's question, from Aaron. How much house can I afford? I feel like there are so many rules of thumb out there, from the 28% of gross income to the Ramsey 25% of take-home pay for a 15-year. What is reasonable?
This is a great question, and the 28% of gross income figure referenced is part of what's colloquially known as the 28/36 rule, or 28 36 rule that most lenders use, which suggests that the individual's principal, interest, taxes, and insurance, or PITI, cost no more than 28% of gross income, and that their total loan payments for anything, not just housing, don't exceed 36% of gross income. Here's how I think about this, though. Calculating based on gross income seems like a recipe for disaster, because you don't receive your gross income, you receive your net income, or your income after you pay for taxes and benefits and things of that nature.
For example, if my gross income is $60,000 per year, that means my monthly gross income is $5,000 per month. But if I pay a thousand dollars per month in taxes, or you know, 20% effective tax rate, and I pay, let's say, $500 for my benefits, my monthly take home pay is $3,500. So the lender may look at my gross income and say I can spend up to 28% of it, or you know, 28% of $5,000 on my principal, interest, taxes, and insurance, which is $1,400 bucks. But $1,400 represents 40% of my take-home pay. When nearly half my monthly income is going to the roof over my head, I'm gonna feel strapped no matter what other decisions I make, even though it's within the, you know, lender-approved amount.
So the way I think about it is that the lender's gonna approve me for the absolute maximum amount that they feel comfortable I can repay them. They are not approving me for the amount that's going to be most beneficial for me in the long term. So I'm inclined to use 25% to 28% of net income—that is, my take-home pay—as my absolute maximum that I would feel comfortable spending. And I know the Ramsey rule is for a 15-year. I have traditionally been in the camp of going for the 30-year just because of interest rates, but we won't get into that too much today. Otherwise it makes it too difficult to spend on the other things that I want and need, and still be able to save.
Another consideration that I'll throw out there: If you're approaching this decision in a dual-income household, consider how much house you can afford on just one income. Otherwise, you may find yourselves both needing to continue to work in order to afford your mortgage, which does not leave you with much flexibility if one person decides later that they would like to take some time off or to start a family, if they wanna enjoy a sabbatical, or they wanna switch career paths. If you both need to keep working in order to afford your mortgage, it's not gonna put you in a very good spot.
All in all, your home is likely the largest purchase you're ever going to make. And while it's tempting to spread yourself thin or buy as much house as you can afford, erring on the side of buying more conservatively than you think you need to is likely going to pay dividends in the long run.
All right, y'all, that is all for this week. I will see you next week, same time, same place, on The Money with Katie Show. Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin. With our audio engineering and sound design from the talented Nick Torres. Sarah Singer is our VP of multimedia, and additional fact checking comes from the lovely Kate Brandt. Sam Cat is, as always, our VP of chaos, and Beans is our chief bark officer.