For most people, there is a big difference between renting a home and buying one. There is always a strong desire for most to buy a house and make it their dream home. There is a certain pride in home ownership, a desire that seems to become more of a dream than a reality these days, especially for the first time buyer. On the other hand, renting a home appeals to more mobile people who anticipate being displaced more regularly and not wanting to commit to a property nor have to invest in it other than pay rent and basic utilities. Surprisingly so, many wealthy people and jet-setters rent their luxury homes or condos and prefer investing in other wealth management vehicles.
But for the most part, when it comes to residential living, the majority of us own our properties… or do we?...
When it comes to disposable income and equity building, owning vs renting can be seen as the same, let me explain:
Renting a home is basically signing an agreement (lease) with the “owner” or Landlord, the Lord of the Land the house is sitting upon (there’s that Imperial language showing up!), to occupy his property in exchange for a monthly rent. Certain inclusions may be perked into the rental charge such as appliances, lawn care and snow removal, but in essence the purpose of a rental agreement is to satisfy both parties in carrying the inherent charges on the property itself such as mortgage charges and taxes which are imposed upon the Landlord by the government and the banks. The same principle applies to larger scale multi unit buildings, where if the rents cover the inherent charges, then the owner is, for all intents and purposes, “banking” on equity growth through time hoping the market values increase and therefore make a profit on the sale.
Home ownership, for the majority of people, is the same principle. It is simply “twisted” differently. In the Renting example, the Landlord is the buyer and the Tenant is the occupier. The true “owner” is the bank. So when people buy real estate, most must leverage their purchase via a mortgage… The word Mortgage is derived from the French words “Mort” meaning Death and “Gage” meaning To Warrant. So is a mortgage a death warrant?... Well probably not, but it can easily become a Debt Warrant. Central bankers lend you money to “finance” your purchase in the form of a MortGage. Simply put, it's a DebtWarrant against the property you occupy that holds it's “value” as collateral against any default of payment you warrant them.
To understand Mortgages, you must understand Time and the inherent impact Time has on both Your Debt and the Banks reasons of “investing” in YOU. There are 3 key aspect to mortgages: 1- Amortization which represents the amount of years you “stretch” your payments in order to pay off your total loan, 2- Interest, which is the amount charged above your principal as a means of profit to the bank for loaning you the money and reinvesting it into the stock market mostly in the form of mutual funds and pension plans, and 3- Insurance, which comes in 2 forms, a) Loan insurance for any mortgage that represents a loan above 80% of the property’s market value and is a security blanket you pay on top of your mortgage in case YOU default (this type of insurance is for the bank’s benefit and provided by the government’s institution called the Central Mortgage and Housing Corporation (CMHC), and b) Registration insurance which is equal to 20% more than your loan amount which appears on your deed of loan and represents the total amount of money (i.e. your loan amount + 20%) the bank can claim on the property.
Both Landlords or Banks have the same intent, both rely on market value increases through time, but banks profit on interest, which the Landlord does not regardless of other accounting strategies he may use.
Have you ever looked and read your mortgage agreement before signing it at the notary? Of course not! Why??? Because it would take you forever to read it! Ironic isn’t it that notaries will read you the deed of sale, yet never go over the deed of loan in its entirety with you… “Just sign here!” they say.
So when you are buying property, are you not simply renting it from the bank? Well from a “payment” point of view, it seems you are… The financial Irony here is that only Time is the motivator to home ownership: “As the market values increase and my debt goes down, I have more equity”. Thus Equity is the perceived financial advantage of home ownership. The question becomes, how long would it take to attain that advantage?
Say you want to buy a house for $500,000 and have 20% cash down or $100,000 to avoid the CMHC insurance premium. You would therefore mortgage $400,000. So what does that represent if we leave this scenario without changes in your life.
If you observe any amortization table, you will notice one important factor in the allocation of your monthly payments, or Banking Rent. The banks will always pay themselves first, simply because they know your life has a high probability of changing through time.
The normal tendency for people who buy is to try at best to reduce their monthly payments, given they know well that other bills must be paid in their monthly budget, from food to hydro and everything in between. So they have a tendency to stretch their loan to a longer amortization period, often at the suggestion of their banker or mortgage broker. After all, it's all about affordability isn't it?...
So you buy that nice house for $500,000 and set your amortization period at 25 years on a 5% mortgage rate, reasonable in today’s standards. What many people think is that the monthly payments handle both interest and principal, and they do, but in an almost unfair way. The first set of payments are always “Interest heavy”, meaning that if you are paying a $400,000 loan amortized over 25 years, at a rate of 5%, your Principal and Interest payments would be $2338.00. The first payment would then be fractioned by allocating $1667 in interest payment and only $672 in principal… That’s 71% paying off interest and 29% paying off the principal on that equity you are trying to build up.
SOURCE: investinganswers.com
Oh so what? you will say… Yet if we look at year 12.5, which would be halfway down the amortization period (assuming rates don’t change nor do you refinance), you would look at your balance at the 150th month (12 months x 12.5 years = 150) and your balance left would be $260,424 left to pay of the original $400,000 amount, which is $60,424 more than anticipated at the halfway mark… Since your monthly payments are $2338 each month, times 150, that represents a total investment at the 12.5th year or 150 times the $2338 or $350,700. Yet you still owe $260,424. So the EXCEEDING interest paid off to date is equal to $90,276 which represents 18% of the value of the house. Since you paid $100,000 in cash down or 20% of the original value of the house, now the bank is secured for 38%, perfect positioning if you ever default on your payments after 12.5 years time…
But of course life doesn't work that way does it? In fact, historical real estate data shows that in North America, the average turnaround time for house ownership is 7 years, which means that, on average, people move every 7 years. Think about it, a young couple gets married, buys a first house, births 1 or 2 children, and 7 years later new needs arise… High School is in a different location, they need bigger as the kids are growing up, they end up having to upgrade. What happens when they upgrade?, they need to refinance the new house and the debt cycle starts over… A new amortization table is at their disposal where “interest” is the first order of business.
Let’s look at the cash flow impacts. If you buy into this scenario, here’s what happens:
1- You put a cash down of $100,000 (assuming you have it saved up, which most people don’t, but let’s say you do). Over the period of 25 years, assuming you bought a house that will be convenient for 25 years, that $100K represents an investment of $333 per month + any loss on ROI you may have had in another investment vehicle;
2- Typical taxes on this value of property is easily $3600 per year, or $300 per month. Now we are at $633 per month;
3- We know the mortgage cost is $2338 per month, so now we are invested for a total of $2,971 per month;
4- Now say throughout the course of 25 years, you will need to maintain this baby. So spending on average 1% of the value in upgrades and maintenance, or $5000 per year, that’s $416 per month. Now we are at a monthly cost of $3,387. If you find that too high, we'll throw in the furniture and all the crap you will accumulate over the years!
5- Add on acquisition fees at the onset, (i.e. notary fees, welcome tax, home insurance, and any other cost, now you’re most probably looking at a Bank Rent of nearly $3,400 for a $500,000 house.
Now the counter argument to all of this is: “Ya but Marc!... if I sell it for higher in a few years, I’ll have more money in my pocket for the next one!... OK, granted… but 1) are you aware of the costs attached to selling? and 2) If your house increases in value, doesn't your next one increase as well?...
Most people love their homes and the experiences they create as they live together as families and witness the milestones of each other’s lives in that house. In fact, even if the market is screaming at you to sell, like in the past 5 years, they don’t dare leave their nest… They are comfortable and have created an emotional bond with their bricks and mortar.
Here’s the irony: Houses valued at $500,000 in today’s market are renting for around $2000 a month and the fact is that Landlords can’t ask for much more because that’s where the market for rentals sits… They are just happy to cover part of their own Bank Rent, instead of no rental income at all…
Food for thought. So, do you buy or rent? Well that's up to you, your desires and your personal lifestyle situation.
If you have a lot of equity in your home and are nearing retirement, perhaps it's a good time for you to cash out and rent a more convenient home while spending your money on those activities you've been dreaming about.
If you are young and struggling to buy your first home, perhaps you should rent and get to know what you like and don’t like about living in a house or a condo, that way, once your financials are more abundant and you have a true vision of what you want, then you are ready to make the move with experience behind you.
Oh for the kicker…
Here’s how much interest the bank took from you in those 25 years… Read the Totals after line 300. Total payments $701,508, total interest $301,508, total loan $400,000.
SOURCE: investinganswers.com
And if you default 3 months in a row… They take it back! That’s when you sell it fast before they do. That I do not wish on anyone! But if ever you receive a formal notice from your lender, make sure you call a good real estate broker a.s.a.p.!!!
BLOG 7 will be about how the Governments and Banks work together in respect to YOUR PROPERTY.
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