There is a new way to look at your home, and if you do it, you will never make a financial misstep again – at least when it comes to the biggest personal purchase that you are ever likely to take …
… but, I warn you: your wife may not like it 😛
You see, we tend to describe our homes as an ‘investment’ but the reality is far different: we buy emotionally and we justify rationally.
The truth is: we [most of us] want a home … then we want a bigger one … always, just a little/lot more than we can actually afford. And, to be totally truthful … I not only succumb to this line of thinking myself, I actually encourage you to do the same!
I subscribe to the old-fashioned notion that you should buy your own home – even if it means breaking my rules to get into the home in the first place – as a way of ‘forced savings’ …
… but, once you are in your first home, I then want you to rationally examine the true current resale value of your home, and the equity that you have in it (i.e. what the home is curently worth against what you currently owe), at least ONCE EACH YEAR, to ensure:
(a) that you don’t upgrade until you can afford the payments, and
(b) that you put any excess equity to work for you.
But, these rules are only ‘proxies’ for what you should be doing, if you could be trusted to manage your money rationally, instead of emotionally …
… if you could be trusted to treat your home – at, least from a financial aspect – as a house:
You should charge yourself rent!
This is the only way to ‘prove’ that your house is an investment. It lets you know two things:
Am I living beyond my means?
To find out, simply ask yourself these two questions:
(a) How much rent could you get on your house if you rented it out? Ask a Realtor or two … scour the listings in your local paper … look it up on rent.com … do this properly!
(b) What rent can you afford to pay, according to the 25% Income Rule?
If (a) is more than (b) then you have a problem … you are living beyond your means: either increase your means (e.g. get a second job; charge your children board; etc.) or decrease your living (e.g move out; rent out a room; etc.).
Am I investing wisely?
This one is easy; if you charge yourself rent, you can see if your property is positive cashflow or negative cashflow …
You have some ‘advantages’:
– You have a great tenant
– Your tenant has a great landlord
– You get to tax deduct your mortgage
– There’s no tax to pay on the ‘rental income’ … it’s all in your head, remember? 😉
To find out if you really are investing wisely, simply ask yourself these two questions:
(a) How much return on my money (i.e. equity currently in the house) could you get if you sold the house and reinvested the equity elsewhere?
(b) What rent would you have to pay (remember that you want to take the lower of your current rent or what the 25% Income Rule allows) if you lived elsewhere?
If (a) is more than (b) then you have a problem … you are investing badly: either sell your house or see if pulling out some equity and investing helps.
If the answers don’t please you, and you are unwilling to make the necessary changes, then the 20% Equity Rule and 25% Income Rule are still there to stop you from getting into too much financial trouble … make sure you obey them! 🙂
Thank you for this insight. Posts like this one have kept me coming back on a daily basis to ensure I haven’t missed anything.
This is exactly why I bought a house, but you leave off one variable that must be considered when deciding whether or not the rent is equitable to rent you would pay to another, altho you do mention it at one point: the tax benefits.
Since there are no tax benefits to paying rent, that is strictly a 25% proposition. On the other hand, while first you should consider whether you can pay the mortgage payments at 25% of your net income, it will end up being cheaper than comparable rent because you will reduce your taxes by part of those “rental” payments. If you can manage your tax exemptions correctly you might not even overpay during the year (i.e., you reduce the payments to Uncle Sam (in the U.S.) made from each paycheck, thereby increasing your net income with each paycheck rather than calculated at the end of the year).
@ Diane – The tax benefit is variable: on your own house, it depends on (a) your level of income, (b) your size of mortgage, and (c) whether you itemize or not.
But, you are right if the interest rate on your house is Y% and an equivalent rent would be Z% then you are really comparing:
(Y% – Tax Benefit) : Z%
That’s how I decided to by the condo I am living in today- the monthly rental value is about 1% (actually it’s 0.8%) of the full price of the property. When this drops down below 0.5% then purchasing is a bad deal in my estimate from a P/E perspective.
You should also deduct property tax from the rents charged to get the true net income of the property. Also deduct money to put in a fund for major repairs….
PS- for the Deal or No Deal post, what the contestant end up doing???
@ Mike – The contestant was offered $677k and said ….
…. time for a message from our sponsor, but hang around to find the answer, we’ll be right back [with a wrap-up post] 😉
I know I read somewhere that we should have our homes be owned by our corporation (since we will need to start a business sooner or later). I think that this will make it easier to charge yourself rent making the home profitable to your landlord (your own corporation). What are the TRUE benefits to this (if any)?
@ Adan – None that I know of … I didn’t recommend having a corporation own your own home (I did suggest this as worthy of exploration for true INVESTMENT real-estate), but you could check with a good accountant.
But, you make a timely reminder that this article is about doing the math on the new / upgraded home as though it were an investment and as though you were paying rent … except that – other than on ‘paper’ – you don’t REALLY charge yourself any rent, or evict yourself if you miss a payment 😛
Great Post. I never would have thought of renting my home to see if I was in over my head as far as finances go.Thanks for the help on this one.
Diane states there is not tax benefit to renting. But that depends on the state you live in. I lived in Indiana for 11 years, and was able to deduct the rent payments off my taxes. Some state will allow this.
@ Steve – I didn’t know that … thanks for the tip!
Here I lived in Ohio, right next to Indiana, and didn’t know that. But I was thinking more along the lines of FEDERAL income tax since they take a much bigger bite than state or local taxes.