Mortgage Q&A: “Why are mortgages cheaper than rent?”
Today we’ll discuss why mortgages often appear to be less expensive than a monthly rent payment, despite allowing you to build precious home equity.
For example, you might be shopping mortgage rates and see a sample loan amount of $240,000, along with a hypothetical interest rate.
Let’s pretend that rate is 3% and the loan program is a 30-year fixed, the most popular option available.
This would result in a monthly payment of roughly $1,012. Sounds pretty darn cheap, doesn’t it? Especially with how much rents are these days. But there’s more to the story.
The Mortgage Payment Isn’t Everything, Not Even Close
While an advertisement might highlight the monthly mortgage payment, especially when mortgage rates are low, it’s just the tip of the iceberg.
I assume a lot of folks could afford a monthly housing payment of $1,012 in most parts of the country these days.
That’s well below the U.S. Typical Monthly Rent (Zillow Observed Rent Index) of $1,843 as of July, the latest data reported.
In fact, it’s nearly half of the typical rent Zillow is reporting, which tells me a mortgage is a screaming bargain, at least on the surface.
But the $1,012 mortgage payment isn’t your all-in monthly housing expense. It’s really just a starting point.
After all, the typical U.S. home is valued around $300,000, so a $240,000 loan amount assumes a 20% down payment.
One of the biggest reasons more renters aren’t homeowners is due to a lack of down payment funds.
Many renters could probably muster a $1,012 monthly mortgage payment, but how many could come to the table with $60,000 cash?
Sure, there are low and no down payment mortgage programs out there, but even then there’s more to it.
There Are Many Other Monthly Expenses That a Homeowner Must Pay
Assuming you can qualify for a home loan after coming in with a sufficient down payment, you’ve got more expenses to worry about than a renter.
As I’ve said before, a mortgage payment is often expressed as PITI, which stands for principal, interest, taxes, and insurance.
That super low $1,012 is just the first half of the acronym, P&I. If you want an apples-to-apples comparison, be sure to include the T&I as well.
Using our same hypothetical $300,000 home purchase, we’ve got to add property taxes and homeowners insurance.
These costs are often paid out of an escrow account monthly, and thus increase your actual mortgage payment to the lender.
In California, you might pay around 1.25% in property taxes annually, or $3,750 per year. Broken down monthly, it’s about $312.50
With regard to insurance, you could pay anywhere from $1,000 to $3,500 annually, which is $50 to $300 a month in added costs.
Let’s pretend it’s $125 per month, which together with the $312.50 pushes the monthly payment up to $1,450. Still cheaper than rent!
Now Let’s Add Some Utilities and Maintenance to the Equation
Renting is pretty awesome in that you aren’t responsible for much more than your own personal belongings.
Everything inside the unit that’s bolted down is mostly the landlord’s problem, assuming it breaks.
For example, the landlord is on the hook if the fridge or washer/dryer malfunction, or if the HVAC system fails.
The renter simply calls the landlord and tells them it need to be fixed, on their dime.
If you’re the homeowner, these problems become yours, and you better believe there will be something, each and every year.
As such, you should generally earmark a couple hundred bucks a month for potential repairs and maintenance. It could in fact be a lot more than that, but at least start there.
Then there are the monthly utilities, which may have been paid by your landlord, or perhaps baked into the rent.
As a homeowner, you’re now paying for trash, water, sewer, etc. out of your own pocket each month.
Let’s add another $250 a month in utilities to the mix, along with the $200 in repair/maintenance.
We’re now up to $1,900 a month all in for your house, a far cry from the $1,012 you may have seen advertised.
It’s nearly double the original “estimated payment” you saw, which made homeownership look so enticing.
And remember, that monthly payment requires a hefty $60,000 down payment. If you don’t have that, expect an even higher monthly outlay, and possibly mortgage insurance as well.
Be sure that your rent vs. buy calculator factors in all those costs and doesn’t minimize or ignore them.
Homeowners Get Money Back Each Month They Own
Now the good news. Even if monthly rents and total housing payments are close to one another, you have a big advantage as a homeowner.
You essentially get “money back” each month you own your home or condo in the way of equity.
Remember the PITI acronym above – well, the first letter stands for principal and that’s money you pay to reduce the amount owed to the lender and accrue home equity.
For example, in the first year you pay about $400 per month toward principal, or $5,000 over 12 months.
That’s $5,000 in ownership, something the renter doesn’t get. Over time, you accrue more and more of this home equity until your mortgage is paid in full.
And once it is, you own your property free and clear, and only need to pay the taxes and insurance, along with utilities and maintenance.
At that point, your monthly payment could be well below what a renter pays for a comparable property.
You also wind up with a huge asset that you can sell for a lot of money one day, or pass along to a family member.
The renter just keeps paying rent and has nothing to show for it. They may also see their monthly rent increase each year during that time.
Meanwhile, the homeowner with a 30-year fixed could enjoy relatively stable payments for decades, less any minor adjustments in taxes and insurance, even as the value of the dollar erodes.