3rd Decade Program Manager, Nikita Wolff & Lead Financial Mentor, Jennifer Edwards discuss the dilemma between renting or buying (depending on your situation).
In this episode, they cover:
We hope this episode serves as a resource to show you that owning a home is not the right choice for everyone, and that you don't need a home to be financially successful.
3rd Decade Program Manager, Nikita Wolff & Lead Financial Mentor, Jennifer Edwards discuss the dilemma between renting or buying (depending on your situation).
In this episode, they cover:
We hope this episode serves as a resource to show you that owning a home is not the right choice for everyone, and that you don't need a home to be financially successful.
Welcome to the 3rd Decade podcast. I'm Nikita Wolff. And today I'm hosting alongside our lead mentor, Jennifer Edwards. And we're gonna be talking about the dilemma between whether it's better to buy or rent depending on your situation. This is obviously a complicated issue depending on your finances, as well as a lot of other factors. But we're gonna spend some time today talking about specific questions to ask yourself well as how to calculate equivalent mortgages in comparison to rent.
Jennifer Edwards:So 3rd Decade takes kind of a unique approach to this topic. In our classes, we, cover, you know, why it may not always be a better choice to buy a house over renting. There are pros and cons to both, and we just wanna make sure that you're taking into account all the important factors as you make this decision. Cuz there are some hidden costs that come with homeownership that are worth making note of. And so we're just gonna basically tackle the myth about whether or not it's always better to buy, some of the tax benefits that come with owning and some of the assumptions around that.
Nikita Wolff:Yeah. I actually wanted to start with that. That's always the first thing the people here is that there are tax benefits associated with it. I remember hearing that whenever I bought my house in 2018, my family, i t was like, that's great. You're gonna get tax benefits. And I was like, I don't think I am, but I didn't know for sure yet. Are there tax benefits to buying at this point in time?
Jennifer Edwards:Well, for people there, are two trends that have happened over time. If you look, if you kind of turn back the clock on the tax code, about 30 years, you would've had high interest rates on the loans themselves as well as far lower standard deductions. And now we are in a kind of a flip flop scenario of that, where we have a very high standard deduction and very low interest rates on, on the mortgages. So you have to take out quite a bit of debt. You know, you have to have a very large mortgage to pay enough in interest to actually pay more than, you know, to have it be more than what you'd be paying on the standard deduction. Anyway. So the standard deduction right now is like$12,400 for an individual twice that for a married filing jointly. So you'd actually have to have about$800,000 in mortgage debt. The first year that you have the mortgage is the year that you're gonna pay the most in interest. And then it actually diminishes from there. And in that first year, you're, you're just barely getting over$25,000 with an$800,000 mortgage. So most people that's not their starter home. What we wanna do is just make sure that you're not buying a home specifically for the tax advantages because your chances of actually taking advantage of that are, are pretty slim. So just know that you, you know, if you're gonna buy a home it's for other reasons, it's time, you're ready. You're going to, you know, stay put for a while. You've got stable income. You're already funding your other goals consistently. Uh sure. Yeah. Start building up some home EC, but don't do it because you're like, oh, I wanna save on my taxes.
Nikita Wolff:Right. And that$800,000 number that we're referencing is for a married filing jointly situation. We would cut that number in half for a single individual would be a$400,000 mortgage still quite the chunk of change to put on a house if you you're living on a single income.
Jennifer Edwards:And that's just the mortgage itself. So if you're coming in with money down and your principle is less than the four, that's not the value of the home. Honestly, there are some tax benefits in that you don't have to pay capital gains on any, uh, you know, to a certain level. So that's, it's for a primary residents. It is good to, you know, if you, I, a house and then 30 years later it's increased in value and then you sell it. You're not very likely to have to pay capital gains on that, um, on that increase in the value of the home. But, um, if we did have to pay taxes on that, we would keep really close. We would keep really detailed records of all of the money that we put into the home because we'd want to know what our basis was. What, what did we, what did the house actually cost us? But because we don't have to, we don't really have to know that number when we sell the house because of the tax advantages there, we don't, we don't keep track of like, you know, every little thing that we put on, did you, did you, you know, get a hole in the wall and then spackle it up or something like, even that little bit right there,
Nikita Wolff:Did your fridge go out three months after buying the house and you have to replace it.
Jennifer Edwards:Right? Or, or little even list, light switches and door knobs, you know, anything that's permanent, that's a permanent part of the house that would get sold with it. If you make a change to it or improve it, that would be part of your, what we're gonna refer to here as unrecoverable costs. So things that, um, you know, you don't, you don't get anything back from it when you sell the house. Um, so it's really difficult because there's not a whole lot of data. We're not keeping a lot of records on this. I think it would be an onerous task for all to keep track of our basis in our homes. Um, so I'm glad that the government doesn't make us do that, but we're gonna calculate that as we're, as we're talking about hidden cost to expect that to be around 1% per year of the value of the home. So that's, that's a round of average because like some years you're gonna replace a, a roof and you're gonna spend a lot mm-hmm<affirmative> and some years are not going to do that. Some years are gonna replace maybe your HVAC unit and some years are not, um, you know, things like that.
Nikita Wolff:So is it smart when buying a house to set aside a yearly goal or a monthly contribution to an account that, that at the end end of the year is funded 1% of the value of your home so that those expenses don't kind of catch you off guard so much and you're more prepared for them. Sure,
Jennifer Edwards:Absolutely. I would think of doing that. Um, just like you do with maybe hopefully your auto expenses, you kind of have a little account where you're like, okay, I don't know if I'm going to need some repairs, but anticipate because cars need repairs, I'm gonna need this same thing with like a home maintenance kind of a fund. And that would be separate from, um, you know, projects that are just for fun. You know, if it's like, I want to do this, but I don't need to, but techn, you know, like updates, um, gonna need to remodel the kitchen just to keep its value. Yeah. That would probably be part of that number. And you'd wanna consider keeping an account for that.
Nikita Wolff:Right. And I think it's important to note here. We're not even talking about major renovations here. There are some people that buy a fixer upper and they plan to gut it. They plan to redo, you know, the kitchen top to bottom, put in new floors, uh, vault the ceilings, you know, whatever it may be. We're talking just normal upgrades. Mm-hmm<affirmative> just to keep the house up to date with where trends are in time mm-hmm<affirmative>
Jennifer Edwards:And, and just functional.
Nikita Wolff:Yeah, exactly. So my favorite tool that we've recently incorporated into our curriculum is the 5% rule. Now I'm a total numbers person. So this really resonated with me. Could you tell us more about the 5% rule Jen?
Jennifer Edwards:Yeah. It's a really quick calculation to help us understand the total unrecoverable costs of home ownership. There's a YouTube video by Ben Felix, where he does a really good deep dive into the reasoning behind this, this number. Um, but just basically understand that, you know, the total unrecoverable cost of homeownership is not just the mortgage payment. So you can't just compare a mortgage payment to a rental payment and come up with, okay. That's if I can rent for less than what I could buy, get a mortgage for that's that's not actually gonna be, um, that's not actually gonna work out mathematically. There are gonna be things that are, you're still gonna have more unrecoverable costs, um, on the, on the home ownership side. So the
Nikita Wolff:Way that we do this calculation is you take the value of the home that you're considering you multiply by 5% and then divide by 12. If you can rent for less than that, then renting is probably more economically advantageous. Now, if you flip that to find a home value that is financially equivalent to your current rent payment, take your rental payment, multiply by 12 and divide by 5%.
Jennifer Edwards:Right, And most people will be a little bit shocked by difference in those numbers. Um, but that takes into account, um, the taxes, the property taxes, those aren't recoverable costs, maintenance and what we call cost of capital. So that's the combination of the interest and the opportunity cost of buying real estate over a diversified stock portfolio that we have a really good idea of how that's gonna behave over a 30 year period.
Nikita Wolff:Right. All right. So now let's talk about debt to income ratios. What do you see as the, I'll say, industry standard and then maybe what 3rd Decade would recommend.
Jennifer Edwards:Of course, a lot of this is gonna depend on where in the country you live. So some places it's gonna be where you, you know, you just can't get into a house without paying, um, you know, a higher mortgage payment, but hopefully for most people we can kind of keep this relatively low. So the typical mortgage industry standard for pension loans is a mortgage ratio of 28% of gross monthly income. So that's before taxes and deductions, that's not what you're bringing home. And that's what, you know, that's, those are very different numbers. Um, and then they use a 36% total debt ratio. So your mortgage payment plus any other debts that you have, they're saying really can't be more than 36% of your total gross monthly income
Nikita Wolff:That would include both student loans and car payments, right?
Jennifer Edwards:Student Loans, car payments, any minimum credit card payments. Um, and then when I'm running the calculations with a participant, I'm certainly gonna take into account things like if have, uh, a family loan, you know, something that might not show up on a credit report, but they still throw an obligation to pay. I would say, well, that's kind of part of your debt obligation. So let's take that into account when calculating your debt ratio. But the problem that I come across for most of the people in our program with moderate incomes is that it doesn't really leave a lot of room for saving and investing if you're actually borrowing into those limits. So I suggest aiming for more like a 20% housing ratio, and this would be a good, a good measurement for rent payments as well, and then a total debt ratio of the 28% or less. So again, the way that you would calculate that is your gross annual income divide, that by 12 times it by 0.2 for 20%, and then try to keep your housing payment lower than that. Um, if you can, you know, that's gonna be, that's gonna hopefully leave enough room for you to be able to save adequately for retirement and have enough for discretionary spending.
Nikita Wolff:Okay. So now, as far as some general recommendations go, I have three things that I always emphasize. The first being that before you buy a house, you should have an emergency savings. In addition to your down payment, keeping a minimum of 10k to$15,000 is a, in general, a pretty good reference for homeowners, especially, and I can speak from personal experience. I talked about this in our episode. Uh, the housing decision with Scott that my first year of home ownership was way more expensive than I had expected. Uh, I had moved in and the first month I had to replace a gas line and I, I furnished it with furniture off of Craigslist, but that's still added up quite a lot. Um, we had other little things here or there that it was somewhere around$8,000 if I'm, if I'm remembering correctly. So all of that's just to say, don't go into a house where you use up all of your savings, getting into it, make sure that your emergency fund stays intact, that it's set aside and that any down payment you have, uh, and any furnishing expenses that you're gonna have are separate of that entirely. Uh, the second thing that I always emphasize is that I don't recommend buying a house that feels tight in your budget and the last being don't buy for the amount that you're pre-approved for. Um, speaking personally, when my husband and I bought our house in 2018, we were approved for a mortgage that would've made it hard to afford our basic needs. Um, I still don't understand how or why they did that, but I'm glad that I knew to run those numbers. I'm glad that I already was working with a budget, cuz I was able to plug in what our new mortgage rate would be or what our new mortgage would be, what our taxes and insurance and PMI would be, et cetera. And I was like, we're gonna, you know, we're gonna go hungry some nights if we actually would<laugh> if we would try for a house that size. Um, and so I ended up buying one for about two thirds of what we were approved for. Um, if that says anything mm-hmm<affirmative>
Jennifer Edwards:And that would actually kind of, that would kind of line up with not doing, you know, the 36% or the 28%, but doing the 20 and the 28 that's about right. Um, you know, exactly if you're making a standard kind of average income in this country to have enough leftover to fund Roth IRAs, in addition to meeting, at least you're getting your minimum, your at least getting the matching contribution from your employer in your 401ks. And then you still wanna have some money left over to say for short term things like car replacement and vacations and things like that. You just can't go to the edge of that limit.
Nikita Wolff:I guess I might also say make sure that you are investing goals are already being met before you buy and that they can continue to be met before you buy. So if they that's maxing out your Roth every year, that's$500 a month per person, um, make sure that you don't make your house fit by making other goals, um, suffer because of it. Right. Mm-hmm<affirmative> okay. So let's go over. I, I don't wanna, I don't want it to come across wrong where to not saying don't buy a house,<laugh> it it's just
Jennifer Edwards:We get accused of that sometimes
Nikita Wolff:<laugh> just to make a more informed decision. So I wanna go over some of the benefits of each of them. Let's start Jen, with the benefits of renting.
Jennifer Edwards:One of the biggest perks of renting is that you're not responsible for any of the repairs.
Nikita Wolff:Yeah. Oh man. So I missed the days. Yes. The days when it would rain and I didn't have to like cry a little inside. If my roof started leaking mm-hmm<affirmative> those days are gone. Yep.
Jennifer Edwards:Or you just, something, something goes wrong and you're like, oh, I don't have any idea how much this is gonna cost, but I am not happy about having, you know, nobody's excited about having repairs and maintenance come up in their home and you get to just call a landlord and that doesn't, you know, that's a headache that you never have to deal with. Um, when you're renting, um, also you've got, uh, you know, a assume that there's gonna be an increase in rent every year. Uh, but you can kind of plan for that. Hopefully that actually corresponds with maybe an increase in pay. That's the idea. Um, so there's some consistency there without kind of big surprises in terms of expenses. Mm-hmm<affirmative> um, if you can rent for, for less than what your mortgage payment would be, then you can save for retire more easily. Uh, if you're saying to yourself, yeah, I'm just gonna keep funding my Roth IRA or other investments. And there's also just some flexibility in terms of geography, job changes. If you needed to move, you know, you've got a lease, maybe you could just even pay that off by the end. You know, you don't have to sell a house if you're, if you're deciding to, to relocate somewhere.
Nikita Wolff:You've got a crazy, if you've got a crazy neighbor yeah.<laugh> and you wanna leave
Jennifer Edwards:Kinda step with them. Yeah. I've had a few of those and, and there's, you know, honestly, just a, a lot lower cost of insurance. You're not covering the liability levels of risk that you would be as a homeowner. So, you know, in terms of be sure to factor that in when you're trying to figure out, if you can afford for, to buy a home, your insurance is gonna be higher.
Nikita Wolff:Yeah. Yeah. So as far as some perks of owning, uh, the first one would be a forced savings. So as long as you are not refinancing over and over again and extending your 30 year loan into a 45 year loan,<laugh> over the course of time. Um, and, and as long as you don't borrow against your house, eventually your home is an owned asset after 30 years.
Jennifer Edwards:Which you could sell for and, and have, you know, some capital there or you access that capital and put it into a diversified portfolio at that point, if you needed to. But the idea is not to borrow into it and then just spend it cuz then you're turning, you're turning an investment into, it's not gonna be an investment lost money.
Nikita Wolff:Yeah, exactly, exactly. Another thing that a lot of people find valuable is the stability that it provides. You don't move until you really want to move. Um, somebody else doesn't call the shots. You aren't gonna be displaced by another tenant who might pay more, personalization is another perk of owning. You can do whatever you'd like with your house. You can paint the walls, any colors you want, you can put a new back splash in the kitchen or paint your cabinets. Um, you can personalize it as much as you want. Privacy is another benefit that I think people feel when they own. You don't have a landlord unexpectedly showing up to, you know, check out something on the property. Typically you'll feel like you have a little bit more space to be separate from your neighbors. Um, and lastly, inflation protection, a primary house tends to be an inflation by about one to 2% on average, over 30 years.
Jennifer Edwards:So if nothing else comes to mind in this episode, we just, we want you to know that you don't have to buy a home to be financially successful. It's really important that we're beating inflation over time. And so we have to be invested. Um, in some cases you can actually be more financially successful without it, if you in invest that money instead. But eventually we want you to own your primary residents. We're just saying that most people actually just get into a house soon and they buy too much,
Nikita Wolff:Right? If you're 28 years old and you're feeling stressed because all of your friends are buying their house and you feel like you're behind, don't let that influence you into thinking that that you're failing somehow by not owning a house yet, because that is not the case. You can definitely make it work in your favor. Yes,
Jennifer Edwards:You can retire comfortably and never have been a homeowner, but you really can't. Um, you know, gone the days of ubiquitous pensions, where you could just focus on paying off your primary residents and then your pension plan payment plus social security would cover all of your expenses in retirement. That's not gonna happen anymore. So, um, just understand that you need to be investing in addition to your, your primary residence. And so make sure that you're taking advantage of the growth of a diversified stock portfolio.
Nikita Wolff:So thanks for tuning into today's episode. We hope that this was helpful for you and as something that you can share with your friends who might be looking to make this decision in the near future, let us know how you like our podcast by rating and reviewing it on the platform that you're listening on. And we hope you all have a great, and we'll talk to you soon.