There’s a new article on moneyweb this morning.
Here is the question:
How much of your savings should you liquidate to use as a deposit when you decide to buy a house? Let’s say you are in your late-twenties and have about R500 000 invested in various domestic high-equity unit trusts, and are now interested in buying a house.
Investment books I have read show that historically, equities have outperformed property. I also know that to enjoy the full benefits of equities, you need to leave them alone and let compound interest work in your favour. But on the other hand, we all need a roof over our heads, and most people need to loan money from the bank in order to purchase a house. The more money you loan, the more interest you pay.
So you have a trade-off: do you sacrifice long-term gains in equities in order to put down a sizeable deposit on a house, but the benefit of this is that you pay less interest.
Basically, the answer from the author is “No”. Although I’m simplifying a lot. The expanded version went something like:
- Buy a house that you can afford.
- Don’t dip into retirement savings to buy a house.
- There are other ways to reduce your interest cost quicker.
Some of which I kind of don’t really agree with.
But what I really disliked was this comment at the bottom:
And I cannot abide bad math.
And comparing a “10% deposit” to the “full value of the house today” is just bad math.
That R10,000 deposit is worth R61,400 today (ie. 10% of the house).
It seems that the “numerous additional factors” that went unmentioned included:
- The other 90% of the house that had to be paid for; and
- The interest repayments over the duration of the mortgage.
To say nothing of the fact that the prime rate of interest has been fluctuating like mad for the last 20 years.
So Let’s Compare It
The deal is one I’ve looked at before. You can either:
- Buy the house, and save on the rental; or
- Rent the house at a ±5% rental yield, and then invest both the deposit and any rental savings (versus the mortgage repayment).
How the buying option looks, with all those fun changes in prime interest rates:
Which is exactly what you’d expect. If you had bought a R100,000 house 20 years ago, and you’ve now paid off the mortgage, and housing prices have increased by around 9.5% per year since, then your net worth is R614,161 (the value of the house).
And here’s the comparison:
For the first few years (in this case, the first 10), the renter is making quite a nice saving – because the rental yield is much lower than the interest rate, and the value of the property has not quite caught up yet.
But inevitably, there is a point at which rentals will start to exceed the mortgage repayments – as rentals are based off the current home value, while mortgage repayments are based on the value of the home on the date that you purchased it. And this is the big benefit of property ownership – the fact that you get to “fix” the price that you pay for the property.
At which point, the renter has to start eating into his savings in order to cover the higher debt.
With that in mind, a picture of net worth:
Which is really saying that: where interest rates are high – both higher than the rate of property price appreciation, and higher than the rental yield of similar properties – then buying property is more costly than simply renting and investing the money elsewhere.
This analogy also leaves out one of the primary benefits of renting – which is that you do not incur the costs of home maintenance. If we assume that the home owner needs to budget a further 2% of the home value every year in order to keep the house in order, then the picture looks like this:
The difference looks dramatic because the minute you have home maintenance costs, it increases the relative saving potential of the renter. And over time, those compound. And it also means that the homeowner is now subject to costs that vary with the market value (ie. not all home ownership costs get to be fixed by a mortgage).
Having said that, consider what happens if we make the rental yield a little higher (say: 8%):
Well now the difference is far more marginal.
And more importantly, the whole concept is predicated on the assumption that the renter will actually save those savings.
This…seems unlikely. We’re a generation of instant gratifiers – and at least home ownership keeps that tendency in check.
And really, as we get older, indefinite renting can get really inconvenient. Sometimes, you just want the security of knowing that you can do what you want to do in your own home, without fear of being kicked out.
But speaking as a fresh 30 year old, I’m going to try and defy my instant gratification need and continue renting. Because here is my other point:
Based on those initial return rates, “saving” on the interest and paying a lower rental yield meant that the renter may have been able to buy the house outright, for cash, in year 8 of the mortgage. Which is a lot sooner than “at the end of the 20 year mortgage period”.
I know it’s just a model, based on high interest rates, and on higher rates of return for equities over property.
If you’ve already decided to buy the house, then we’re dealing with something quite different. Because once that decision has been made, you’re now choosing between:
- A potential equity return on an investment; and
- A guaranteed saving “return” equal to whatever the interest charge is on your mortgage.
In which case, I’d take the guaranteed saving, and then start investing the “relative” saving in a new unit trust portfolio. Because there are times to take chances on future market performance, and then there are times when you must just be sensible.
Which is why I sort of disagree with some of the original article’s answer.
Just some thoughts.
For more of the same, check out the Rent or Buy posts (start at the earliest post, then move forward).
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.