Sunday, March 29, 2015

Rent or Buy: A simple Condo illustration

Great news, my oldest is graduating this year with an engineering degree AND she has a great job lined up!  Shortly thereafter this wondrous news ushered in the reality of needing to find an apartment.  It was during this preliminary apartment quest that I interjected the wild idea – “would you consider purchasing a condo?” which in turn provided fresh fodder for my blog.

The renting option is certainly the simplest and most expedient route.  You look at apartments, pick one and plunk your money down – sort of.  With apartments come landlords and not all landlords are created equal.  Many of the apartments in the small town area where the position is located are within private homes.  This adds a layer of dynamic because the landlord is the home owner and you can expect your privacy may feel somewhat encumbered.  On the other hand, these types of arrangements may be more friendly and personal whereby you are made to feel welcomed and may have a starting point for settling into a new location.

One bedroom apartments in this area are hovering around $750 per month and typically the entry costs are first and last month’s rent plus a security deposit equal to 1 month’s rent ($2250 due on move in with $750 hopefully returned).  Leases are typical.  For the purpose of analysis, I have calculated the annual costs for 1, 2 and 3 years (for simplicity no annual increase was calculated).  I also have not included any renter’s insurance which could potentially increase these annual amounts.

1 year = $9000
2 years = $18000
3 years = $27,000

In examining condo offerings in the area, I selected a 2 bedroom that was listed for $89,000 and I am calculating based on an assumption that you might be able to offer $84,000 and have it accepted (and which provides an easy figure for illustration).  I will note that there was also a 1 bedroom listed for about $15,000 or so less, but if you are going to buy a condo and the only difference between 1 bedroom versus 2 is $15,000 I would highly recommend spending the extra money and going with the 2 bedroom.  It will be much more marketable when you sell.

When you purchase, there are closing costs – these include such things as attorney’s fee, survey, title, filing fees, maybe points (interest paid in advance).  For simplicity, I will estimate around $2,000 in closing costs.  Additionally, lenders will require a down payment and for this illustration I am assuming a 5% down payment so that one would pay $4,000 at time of purchase and finance the balance of $80,000.  There are currently many tools available to calculate loan amortization – just Google it and you will quickly find more than you need.  I prefer to use a template from Microsoft Excel which I find does a great job.  When I plugged in the principal of $80,000 at 3.5% interest for 15 years, I came up with a payment of $572.  (I strongly recommend a 15 year loan if you can afford it.  You will realize equity (ownership) in your home / condo much quicker than with a 30 year.  Please compare the amortization schedules of a 15 year versus a 30 year carefully to see the equity in your home in the first few years).  In addition to the loan payment, there are taxes and insurance which must be included and based on my conversation with the realtor; this would add about $230 each month.  Finally, there is a monthly condo association fee to cover exterior maintenance of about $160 per month so the grand total for recurring monthly expenses is about $962.  Annual outlay may be expressed as follows:

1 year = $11,544
2 years = $23,088
3 years = $34,632

At quick glance, one may say renting is a no brainer – clearly it appears cheaper in terms of cash flow.  Well not so fast – first off, recall that I compared a 1 bedroom rental with a 2 bedroom condo purchase.  If I used a 2 bedroom rental for comparison, the rental outlay would be much closer to the comparable 2 bedroom condo purchase.  Secondly, and of greater significance is that you “own” the condo and the amount of your ownership can be computed as the condo’s value minus the amount of your outstanding loan.  On the 15 year loan used for this illustration, the results are as follows:

End of Year Loan Balance Principal Paid
1 $75,871.27 $4,128.73
2 $71,596.28 $8,403.72
3 $67,168.65 $12,831.35
4 $62,583.55 $17,416.45
5 $57,835.36 $22,164.64

Assuming that your condo’s value stays the same ($84,000) any principal paid (plus your down payment) represents your equity (ownership) portion of the condo.  While there was a time when many were accustomed to only increases in home values, more recent times have included a decline in some values.  This underscores the risk of home ownership – your home value may increase in value (great) or stay the same (ok) or decrease (not good).  A longer period of ownership mitigates this risk as the housing market is much like the stock market – there may be dips, but over the long haul prices rise.

Another consideration that must be underscored is that there is a cost associated with selling real estate.  Typically there is a percentage to the realtor (5-7% is common), a flat fee for the attorney, costs to prepare the property for market (painting, touch ups, etc.) and other minor administrative costs.  As an estimate for illustration, I am going to estimate these selling costs at around $5,000 on this $84,000 condo.  If you apply this cost, the amount that you can expect to walk away with if you sell at the end of 1 to 5 years is illustrated below.  (Example computes $84,000 sale price minus selling costs and loan balance).

End of Year Cash in pocket at time of sale
1 $3,128.73
2 $7,403.72
3 $11,831.35
4 $16,416.45
5 $21,164.64

What this table clearly demonstrates is that the longer you expect to stay in the same home, the more compelling the financial incentive to purchase becomes.  If you expect to stay in your home for only 1 or 2 years; then buying probably isn’t worth the risk and headache.  On the other hand, if you are more likely to stay for 4 or 5 years, buying could be a much more affordable housing option.   There used to be a saying that if you rent, the only thing you have at the end of the year is rent receipts – you don’t acquire “ownership” in your apartment by paying rent and other than your security deposit, your landlord is not going to give you money when you leave.  On the other hand, when you rent you aren’t exposed to the fluctuations of the real estate market and neither do you have the ongoing responsibilities of ownership such as household maintenance.  The buy or rent decisions comes down to an assessment of your likelihood of staying in a single home for an extended period of time as well as your risk tolerance (of the market and of managing maintenance requirements).