Why would someone not save $15K more a year if they could?
The fact is everyone has opportunities they are not taking advantage of that could significantly impact their financial standing.
Every single person.
This is called opportunity cost and it's applicable to literally every single decision you ever make.
The problem is most people don't actually compare the opportunities available to them and go about making massive financial decisions without doing any math.
Introduction to Opportunity Cost
Opportunity cost is the difference in monetary gain or loss from making one decision over another.
Say you had $1,000 in debt and you happen to have $1,000 sitting in the bank. Many people would pay off that debt immediately or even worse spend the money and not even pay off that debt. But any wise investor knows that we can calculate the opportunity cost between our different actions to figure out which is mathematically the best financial decision for us.
If our debt happens to be at a 2% interest rate but we are confident in a certain investment that can yield a 10% return, the opportunity cost of immediately paying off the debt leads to an -8% return relative to the investment opportunity. (Rough math here, there are more subtleties like risk and more that we'll get into later.)
One decision that affects every single person is housing.
You have to live somewhere and one of the most impactful financial decisions you can make is whether you rent or buy a home. To figure out the difference between these 2 opportunities we'll need to figure out the specific financial impact of each decision.
We'll start with renting because the math is easier.
Total Cost of Renting a Home
When you sign a lease to rent any kind of home, you are agreeing to pay a set amount of money every month.
You might think this makes the total cost of renting quite simple to calculate, but it doesn't account for the most important part of most lease agreements.
Your rent amount is not fixed forever.
When the time comes for you to renew or convert your lease to some form of month-to-month contract, you are at the mercy of your landlord's rent increases. However, many people can expect increases to be capped at a certain amount due to rent control. This depends on where you live so make sure to research and learn about your local and state laws.
Either way, when your rent goes up periodically it makes it more difficult to calculate the true long-term cost of renting. We don't know what our rent will be next year, let alone 5 or 10 years down the road.
Additionally, you might still be on the hook for other variable costs like utilities and renter's insurance.
The fact that renting involves mostly variable costs in the long term, means it's quite challenging to calculate any kind of guaranteed long-term opportunity cost.
In the short term, we can consider rent payment, utilities, renter's insurance, and maybe even parking if you have to rent that too.
Total Cost of Home Ownership
Unlike renting, homeownership comes with potentially many more fixed costs that can make it easier to make long-term financial decisions.
While renters are trying to guess what rent might be in 5 years, homeowners know exactly what their last payment will be 30 years from now. This is due to the fact that many homebuyers leverage long-term fixed-rate mortgages that tell you a schedule on day one, laying out every single payment you will have to make for the life of the loan. You don't get that with renting.
Unfortunately, homeownership comes with many costs beyond just your mortgage payment though. And most of these other costs will be variable and highly dependent on your personal situation.
Take for example your property taxes, homeowner's insurance, and utilities. These can all change over time without much notice.
So again this makes it hard to calculate exactly how much money we might save or waste in the long term.
In the short term, I consider my mortgage payment, property taxes, homeowner's insurance, utilities, HOA, as well as maintenance and repairs needed every year for the property and miscellaneous expenses depending on the property's amenities. Think pools, snow removal, and landscaping-type stuff that renters usually don't have to worry about.
Add up these costs or what you would expect them to be to get your total cost of homeownership.
The Extra Benefits of Homeownership
We can't move on without covering the incredible financial benefits of owning your own home because it massively impacts the outcome of our opportunity cost calculation.
1. Principal Payments
First, every mortgage payment includes a portion that covers the principal balance of your mortgage. This directly decreases the amount of debt you owe (called debt paydown) and as your debt goes down your equity and net worth will increase by exactly that amount.
Real estate has been increasing in value fairly consistently over time, meaning if you had bought a house 30 years ago you have likely seen it appreciate and increase in value.
The appreciation of your property will increase your net worth (sometimes very, very significantly) and should definitely be considered in some way in your opportunity cost calculation.
3. Tax Benefits
Lastly, when you own your home you may be eligible for some significant tax benefits.
Typically the interest you pay on your mortgage every month is tax-deductible. Your property taxes might be too. And in the long term depending on how you utilize the property you may even be able to dip your toes in every investor's favorite tax benefit, depreciation.
All exciting things to consider but definitely consult a tax professional about this because I am not one!
Calculating Short-Term Opportunity Cost
In the above sections on the total cost of both of our options, we covered the challenge of calculating long-term opportunity costs.
So we'll start with the short-term!
We can break down the totals of each of our opportunities and subtract the difference to get our exact opportunity cost after 1 year.
Let's create a hypothetical example. Let's "pretend" we can buy a home for $500K, that's a steal here in California...
Rent: $2,000 a month
Mortgage: $3,000 a month
Now with all of our expected finances laid out, we can compare both options to find the difference between the two.
In this example, renting costs us $2210 a month.
Owning costs us $3900 a month BUT also increases our net worth in other ways by $2875. Add that up and our total cost is actually only $1025.
So between both opportunities, the difference is
$2210 - $1025 = $1185 every month.
Therefore you could say that renting costs us $1185 more every month compared to buying this house.
Adjusting for Long-Term Opportunity Cost
The above example is pretty straightforward, we are using all of our known year-one costs.
But few of these will stay the same over time.
To get a more accurate picture of the opportunity cost over a longer period of time, we should calculate the differences over multiple years. The process is no different from what we did above, except that we need to change some of our numbers based on what we estimate them to be in the future.
Year one results in $1185 saved through buying over renting, but what about year two?
Let's assume rent went up 5%. That's commonly expected here in California. Utilities and insurance maybe increased a few dollars too but it's negligible for this calculation so we'll leave it out for now.
Rent: From $2,000 to $2,100 a month
Because we have a fixed mortgage, our payment doesn't go up or down but the amount going toward interest does change as most amortized loans do.
We can also assume our property taxes increase here by 2%.
Mortgage: $3,000 a month
So the total cost of homeownership year 2 comes out to
So it went down from $1025 to $958... while renting went up from $2200 to $2210?
Yep... and that's just the difference after the first year. As time goes on your mortgage amortization schedule leads to higher principal payments that result in more debt paydown. Not to mention the additional appreciation the property might see over time.
While your rent continues to go up and up... and up.
But there's something VERY important to keep in mind and you shouldn't take these numbers alone as evidence to support which decision is truly the better financial decision.
Other important factors include risk, the fact that you are now on the hook for a $3900 monthly payment as opposed to the $2200 rent payment, and all of the additional headaches and responsibilities of owning a home that your landlord would typically have to handle for you.
But most importantly, we didn't even once mention the down payment you have to make when buying a home.
The Opportunity Cost of Your Down Payment
To buy this $500K home we likely need to make a down payment of anywhere from $15K-$100K.
How much we decide to put down can again be influenced by opportunity cost calculations.
We know buying this house saves us between $1025 and $958 a month during the first 2 years and that savings will increase based on the trend.
But is the opportunity to save $1K a month better than the opportunity to instead invest and earn a return on that down payment?
That is the question.
Instead of focusing on the monthly cost, we should do the calculation based on the return on our capital. If we make a 20% down payment on this property (equal to $100K down) to save $1K a month, we are investing $100K to save $12K a year.
In other words, if we instead rent we get to keep our $100K allowing us to invest it in other things. But our rent payments will result in a hit to our net worth of $12K more a year. Our $100K investment would have to yield at least a $12K return to justify that.
In many cases, it might make sense, again due to opportunity cost.
If you believe you could get a 25% return on your investment, you would gain more by investing the $100K to earn $25K, because after taking the $12K hit (due to renting instead of buying) you are still left with about a $13K profit that you wouldn't have made had you simply bought a house.
|Monthly Housing Cost||-$2210||-$1025|
|Monthly Investment Gain||+$2083||$0|
In other words, your housing costs are more since you are renting as opposed to buying but because you can invest your down payment. The gain from that investment outweighs the extra costs of renting in this case.
But these are some highly speculative numbers and we can VERY easily sway the outcome by changing a few things.
First of all, 25% is a very high return and we aren't considering the risk that comes along with an investment like this. Additionally, we assumed we would put 20% down if we were to buy a house which massively impacts the opportunity for other investments.
A More Conservative Calculation
Let's now instead assume a more realistic 8% return through investing our down payment and that we can purchase a primary residence for ourselves with a 5% down payment.
Now, to buy this $500K home, we need only $25K (instead of $100K).
If we invest this $25K and believe we can earn 8%, we might see a gain of $2000.
We can compare that opportunity to the savings we get from owning our home as opposed to renting which saves us $15K as we calculated above.
Using these numbers, the opportunities we have are:
- Renting and investing our $25K to earn $2K a year
- Buying a home and not investing, saving us $15K a year
The difference between these opportunities is staggering, buying a home would be the better option by over $12K!
This is not an easy topic to write about and I truly hope I was able to get a few points across.
First, we are constantly making decisions that impact our financial future and most of the time we can calculate the best decision by comparing the opportunity cost.
Additionally, buying a home vs renting a home is a decision everybody has to make but few have considered the true financial ramifications. It's worth doing the math based on where you live and pulling together the numbers that you would see to figure out if you're leaving money on the table by not pursuing the best opportunity for your situation.
Lastly, I hope you were able to see how I was able to influence the opportunity cost just by changing a few things like the expected return on an investment or the amount of money I put into it. To get the most out of everything we talked about I would recommend trying the math out yourself to get a better understanding of how all of these factors are closely tied together.
As always, I love chatting about this stuff and if you have any questions you can find me on Twitter!