Is Renting an Apartment a Better Option for You?
Considerations from an Equity-Building Standpoint, with an Online Python Application
Introduction
Deciding between renting and owning a home is a significant financial choice that can shape your future wealth and financial stability. In this comprehensive analysis, we explored both paths from an equity-building perspective, considering the cost of capital and the potential for investing excess cash flow.
When you purchase a home, you embark on a journey of building equity. With an initial down payment and a mortgage, your liabilities and assets change over time. Despite initial debt, your home becomes a valuable asset that typically appreciates, increasing your net worth.
Alternatively, renting offers flexibility and the potential for greater financial returns if the saved money is wisely invested. By renting a home for less money, you gain a larger free cash flow compared to owning. Investing this surplus, along with an initial amount equivalent to the down payment, in the stock market could result in a significant net fortune.
The online Python application (that has generated all images) allows you to input your own numbers and see personalised results. You can even modify the code to suit your unique situation by accessing the GitHub.
Mortgage and Apartment Ownership:
Let’s first consider the typical scenario of purchasing a house. Suppose you plan to buy a house for $175,000. You have already saved $17,500, which is about 10% of the purchase price. This down payment means you need to apply for a loan of $157,500 from the bank, which represents the liabilities side of your balance sheet. For you, this is a liability, a negative value, as it is the amount you owe to the bank.
Assuming that your yearly interest rate remains constant at 4.5% and you will pay off the loan over 25 years using amortized loan payments, the outstanding loan balance will change over time as demonstrated in the image below:
Fortunately, you are not simply throwing your money away when you purchase a house. Instead, you gain a valuable asset that contributes positively to your financial portfolio. This asset, which you will own despite holding debt, is recorded on the asset side of your balance sheet. When you purchase a house, its initial value is the price you paid for it. Over time, as property values typically appreciate, the value of your house is likely to increase. Assuming a modest annual appreciation rate of 0.5%, your house’s value will grow, thereby increasing your total assets as follows:
Now that we have examined both the liabilities and the assets associated with owning a house, we can plot these together on the respective sides of the balance sheet. This will help us visualize your net assets (assets minus liabilities) and how they accumulate over time.
Owning a house involves various cash flows that contribute to both liabilities and assets. Understanding these cash flows is crucial to grasping how your net assets increase over time. Here, we will break down the different components of the cash flow involved in owning a house:
- $220 Condominium Fee: A fixed monthly fee charged as long as you own the house.
- Principal Payment $285: The sum dedicated to paying off the loan.
- Loan Interest $591: The accumulated interest since the last payment.
- Total Monthly Cost $1,096: The sum of the condominium fee, principal payment, and loan interest.
While the total mortgage payment remains constant, the distribution between principal and interest changes. The principal payment gradually increases, while the loan interest decreases, as demonstrated bellow. This change happens because, as you pay off the loan, the interest is calculated on a lower remaining balance.
Note that the condominium fee is likely to increase in relation to the house price, but this is not considered in this simplified example.
Renting and Investing
Imagine you have the option to rent the same house you are considering purchasing for $850 per month. (In reality, the rent cost is likely to increase, but this is not considered in this simplified example.) This rental amount provides you with $246 more in free cash flow compared to owning the same house.
While paying rent is typically viewed as an expense that doesn’t build equity, strategic financial planning can turn this into a profitable scenario. Instead of simply saving the additional money each month, you decide to invest this surplus into the stock market, targeting an average annual return of 7.0%. Additionally, you start with an initial investment of $17,500, the amount you would have used for a down payment.
By renting and investing the excess cash flow, you could potentially generate a net fortune of $287,608 before taxes. In comparison, owning the house might result in a net worth of $198,239 due to property appreciation and equity buildup.
This example does not consider that the homeowner can also invest excess money after fully paying off the loan. Additionally, there are taxation procedures for realizing capital gains, which can affect the final outcomes. These factors are considered in the more comprehensive analysis.
Longer Time Horizon with Taxes
After fully paying off the mortgage, a homeowner can also benefit from investing the surplus cash flow of $876. Let’s consider an extended period of 30 years after the mortgage is paid off, during which the homeowner invests this additional cash flow into the stock market. At the end of this period, all assets will be sold, and taxes on capital gains (30.0%) and on apartment gains (0.0%) will be realized. This will decrease the generated net assets from $264,306 to $262,670.
Note, particular taxation rates will vary according to yor own region, and will have a significant effect the results.
By renting and investing the excess cash flow of $246 over a 30-year period, you could potentially accumulate significant wealth. After accounting for capital gains tax, as in the previous part, the generated net assets will decrease from $418,289 to $326,448, but this still provides a clear picture of the financial benefits of this strategy.
Comparison
Both scenarios have their benefits. Owning a house offers stability and potential property appreciation, while renting and investing provide higher flexibility and potential for greater financial returns, particularly when excess cash flow is invested wisely.
Individual preferences, financial goals, and market conditions should guide the decision between these two strategies. However, based on the inputs provided:
Renting the apartment would be more profitable, generating $326,448 after taxes, compared to $262,670 from owning it.
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