Killing Money without Renting

Post date: Jun 11, 2017 5:30:29 AM

"Buy your home, rent money is dead money", a piece of advice we have all heard but perhaps haven't taken the time to interrogate. Having just recently purchased a home myself I thought I would take the time to draw my own conclusions. The home I purchased was 10km out of Brisbane and as such, my findings are specific to this area.

Dead Money

When calculating dead money involved in renting or buying what is core is that the rate of dead money changes over time. The economic climate and personal financial situation therefore plays greatly when deciding if you are better off buying. When we look at dead money at a single point in time we must consider:

1. Home loan interest depends on interest rates and the amount of money borrowed from the bank -

   1. If interest rates go up, so does the dead money spent

   2. If the amount owing is reduced (as it does through the course of a loan), so does the dead money spent

2. Inflation impacts all expenses other than the amount spent on home loan interest

3. Opportunity cost at the outset, for example, if you have $180,000 of capital tied up in the property, this amount will increase over the course of the loan

Weekly rent in Brisbane covers charges that the landlord pays. Below is a comparison of the dead money that will be spent in purchasing a place compared to renting.

At the outset, given for someone in the circumstances above, they would be spending more dead money buying then if they rented. Let's now start modelling to answer the question when this will change.

Scenario 1 - everything is static

Change is the only thing we can be sure of therefore, this is a scenario we can be certain will not occur.

Scenario parameters -

In this scenario, we see rent increase with inflation and interest decrease as the loan is paid off.

The point of intersection for dead money is ~ 2 years into the loan when rent and buy dead money is ~ 500/ wk. At this point the amount owing on the home loan would be $451,000.

When opportunity cost is considered, this point is pushed out to ~ 5 years when rent and buy dead money is ~$487/ wk. At this point the amount owing on the home loan would be $421,000.

Scenario 2 - As expected, economist predictions occur, additional repayments made

Economists are predicting that interest rates will increase by about 2 pts, people taking home loans are being asked to budget accordingly. In this model we assume it happens within the next two years and then the average over the remainder of the loan stays the same.

For this scenario, we also assume additional repayments can be made on the home loan, cautious borrows plan to do this.

Scenario parameters -

In this scenario, we see rent increase with inflation and interest decrease as the loan is paid off. However, more interest is charged and it is assumed that the opportunity cost is also higher, this is because average interest rates are higher - the cash rate has gone up.

The point of intersection for dead money is ~ 8 years into the loan when rent and buy dead money is ~$558/ wk. At this point the amount owing on the home loan would be $321,670.

When opportunity cost is considered, this point is pushed out to ~ 17 years when rent and buy dead money is ~$350/ wk (note, rent is actually $672 per week however, you have $553,972 invested that helps to reduce the cost). At this point the amount owing on the home loan would be $95,000.

Scenario 3 - an historical scenario - bought a home in 1959

In 1951 the standard variable homeloan rate was 5%, it is 5% right now too. From this year onwards through to 1989 interest rates grew until they reached an annual average high 16.45%. In this scenario, I have modelled if this was to happen again.

What is also obvious is that inflation was also very high. As such, this is the only scenario where I have also adjusted inflation over the period. This means that rents and even return on the assumed cash investment are a bad thing for renters.

Scenario parameters -

In this scenario, we see rent increase with inflation and interest decrease as the loan is paid off. However, more interest is charged and it is assumed that there is a greater return on investment too - the cash rate has gone up.

The point of intersection for dead money is ~ 1 year into the loan when rent and buy dead money is ~$495/ wk. At this point the amount owing on the home loan would be $438,140.

When opportunity cost is considered, this point is pushed out to ~ 5 years when rent and buy dead money is ~$477/ wk. At this point the amount owing on the home loan would be $349,829.

Conclusion

Minimising Dead Money

As demonstrated by this article, the amount of dead money you spending on your home (buying or renting) can be modelled easily. The lever that can be moved to minimise dead money is the size of your deposit relative to the cost of the property.

Consider that the points of intersection for me across scenarios (including opportunity cost) was -

Massive Omissions and Assumption

In an model there are a lot of assumptions or omissions, in this case, off the top of my head:

1. The model does not take into account capital growth, when you sell a house it may be worth more or less, for a lot of people it is worth more.

2. Calculates opportunity cost as though it was invested in a term deposit or netbank saver, there are more aggressive investments that could make more money.

3. Assumes that rent and home ownership dead money will stay consistent with inflation rate.