This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.
Recently, I made the worst financial decision in my life. I bought a house.
I say this half tongue in cheek. Half, because I didnt buy the house for investment reasons. Half, because owning the house will cost me.
In this article, I decided to share some financial details surrounding the purchase of my house and give my thoughts on those details.
Lets start with the price I paid for the house. I dont want to share exact details, but the price is in the region of $350,000. In London, Ontario where I live, that price still fetches a decent 4 bedroom home, though it may not for much longer if prices continue to skyrocket.
I decided to put 20% down for the house. The minimum down payment is 5%, but putting anything less than 20% down would have required getting mortgage insurance. Mortgage insurance protects the lender if I default on my mortgage by making payments on my behalf.
Unfortunately, getting mortgage insurance is not cheap. If I had paid only 5% down, the insurance would have cost some $12,000, which together with the higher mortgage amount would have added roughly $3,500/year to the mortgage payment.
Lets look at this from an investment perspective. If I had paid only 5% down instead of 20%, I would have paid down $17,500 instead of $70,000, a difference of $52,500. Looking at it another way, I could pay $52,500 in order to gain $3,500 per year for 25 years. The rate of return on this investment is roughly 4.5%.
Theoretically, I should choose to get the mortgage insurance if I think I can generate more than 4.5% per year in returns with the $52,500. However, the 4.5% is an after tax figure, so I should feel confident about getting 6% or more per year before tax returns from my investments.
Now, I do think I can generate more than 6% per year in returns. However, the other part of the investment consideration is risk. Investing the money will obviously entail risk, especially given that the Canadian stock market would be lucky to return more than 4% per year for the next decade, as these models show.
Using the $52,500 as an additional down payment on the other hand, would entail no risk. Thus, given the tradeoff between risk and returns, I decided to pay down more and forgo the mortgage insurance.
Next, let me talk about what owning this house would ultimately cost. I went beyond calculating how much it costs to own a home, and answered a more relevant question - would it be more expensive to own a house rather than rent? If so, by how much?
One way I could answer this question is by using the excellent Rent vs. Buy Calculator provided by Jeff Lam. However, I chose not to use the calculator, creating my own spreadsheet from scratch instead. Doing so has forced me to think carefully about all the assumptions underlying each calculation. The link to my own spreadsheet is given below:
My rent vs. buy calculations consist of three spreadsheets (the Mortgage Insurance sheet is separate, and used for the previous topic). Let me go through each of these in turn.
The Homeownership Costs sheet lays out the annual costs of owning a house. In year 0, it shows that I would pay $75,000 in down payment as well as other fees (legal, etc). In subsequent years, I would pay for mortgages, maintenance and other items. I assumed that I would sell the house after 35 years.
During years when I own the house, I assumed that I would pay roughly 1% of the value of the house on maintenance, with that number rising slightly faster (3% per year) than inflation over time (implicitly assumed to be 2% per year). I also assumed that utilities would go up slightly faster (3% per year) than inflation.
The Renting Costs sheet, on the other hand, shows the costs of renting my current place. I should note that my rent is rather low, even by the standards of London, Ontario. Thats because I live in a housing co-operative, which is a government sponsored non-profit set up to promote communal living. I believe an equivalent private rental would cost at least $200/month more. That said, the co-ops rent may rise faster in the future as the buildings are getting old. Therefore, I assumed that rent would go up by 3% per year.
The Rent vs. Buy sheet shows the differences between the costs shown in the Homeownership and Renting sheets. The Comparative cash flow column shows the straight difference in the total cash flows between Homeownership and Renting. The final row of that column shows the Net Present Value (NPV) of the cash flow. You can understand this number as the total amount I would be losing by buying the house.
The NPV calculation heavily depends on the after tax rate of investment. Let me explain why this rate matters. If I chose to rent instead of buying a house, I would have more cash each year to invest, and I would therefore make more money in the future from investments. If I chose to buy however, I would miss out on those investment gains. The higher the rate of return I could generate from investments, the more money I would miss out on, and the higher the cost of home ownership.
I chose the after tax rate of return of 8% because I think I can generate a rate of return of 10% before taxes over the long term. The 10% number is based on the analysis of the valuation models of stocks I own. As long as the assumptions underlying my models are correct, Im confident of reaching this rate of return.
Based on this rate of return, the NPV of the Comparative cash flows is roughly -$175,000. In other words, I believe I am $175,000 poorer for buying my house.
As another way to look at the cost, I asked myself another question : What amount would I have to pay as a renter every year in order to get the NPV down to 0? As it turns out, the answer is approximately $13,000/year. In other words, there is no financial difference between renting and paying an extra $13,000/year (little over $1,000/month), and buying my house.
Given these numbers, heres the question I had to ask myself: do I really want to spend over $1,000/month in order to live in my new house? After much deliberation with my family, I said yes. The worst financial decision of my life indeed.