No that isn’t a misprint. In today’s market, you can do better financially by renting rather than buying your next home. Using an old, yet little-known technique, you can own your dream home for less money, less down and lower monthly payment.
Let’s say you are in the market for a $250,000 house. For a conventional loan of that size, you’ll likely be required to put down 20%, which is $50,000. In addition, you would have to pay closing costs, origination fees, survey, appraisal and points for at least another $5,000. A $200,000 mortgage at 8%, 30 year-fixed rate would be $1,467 principal and interest. Add insurance and taxes and your payment would be about $1,800 per month. So, at closing you’d be out of pocket around $55,000, with $50,000 in equity.
After three years, assuming (for the moment) no increase in the market value of your property, you will have paid your $200,000 mortgage down to about $194,500. Thus, your initial $55,000 cash investment is now worth $55,500 in equity. You don’t need an Hewlet Packard 12C calculator to figure out that your return on investment (ROI) is just plain lousy.
Let’s look at another scenario – lease/purchase. Let’s say you can find someone with a house worth $250,000. Their company has transferred them to another city and they need a quick solution. You offer them a full price lease/purchase with $1,600 per month rent (about market for that price range) and 25% rent credit (pretty standard) towards purchase. You give them an additional two months’ rent ($3,200) as option consideration to be applied towards purchase.
You move in tomorrow – no points, closing costs, etc. After three years, your equity is your option consideration ($3,200) plus your rent credit ($400 x 36 = $14,400) for a total of $17,600. Your ROI is about 500%.
“Yes, but I haven’t bought the property, yet,” you say. Of course, yet equity is still equity; your equity in the first scenario is not realized until you sell. Likewise, your equity in the lease/purchase scenario is not cash until you exercise your option to buy and then sell it. Here’s the solution. . . sell your option before the end of your lease term.
If you live in the property, wait until about 6 months before the end of your term and start advertising the house for sale. If the market is somewhat good, you should have no problem selling it. Once you have a buyer lined up, you simply exercise your option to buy and simultaneously sell it for a profit (by the way, you don’t have to live in it the whole time; you can always sublease it if you find another house you would like to live in).
Why not just buy it, as in the first scenario, and sell it three years later? The answer is simple – you would be back in the same position as you started (probably worse, since your $55,500 equity would be liquidated into less than $50,000 after closing costs).
What about inflation? In either scenario, you would benefit from inflation, since the option price in the lease/purchase scenario locks the price. However, you would fare much better with a lease/purchase, since your ROI would be much greater.
Let’s look at some numbers. Suppose that over the next three years it appreciates a total of 10%. The house would now be worth $275,000. In the buy, hold and sell scenario, your total profit would be $30,500 ($25k appreciation + $5500 loan paydown), about 60% ROI. In the lease/purchase scenario, your profit would be $39,400, but your ROI would be over 1,000%!
Let’s look at the down side. Suppose the real estate market drops 10%. In the first scenario, you would have trouble selling the house for a profit. You’d be just like the guy you bought it from. In the lease/purchase scenario, you wouldn’t win either. BUT YOU WOULD ONLY LOSE YOUR $3,200 OPTION MONEY! (which could be a deductible as a loss if you argue that the money you paid for the option was a business investment). Isn’t it better to rent for a few years and walk away than to be stuck on a thirty year mortgage?
The final point you may be wondering about is the home mortgage interest deduction. In the first scenario, assuming you are in a 30% tax bracket, you would save about $14,200 in taxes over three years. However, you lost the use of the $50,000 you put up front to buy the house!
Let’s take the difference between the $3,200 option money in the second scenario and the $50,000 in the first scenario (total $46,800) and loan that money out as “hard money” secured by real estate. At 14% for three years, you would earn almost $19,656 interest (not including the generous points usually collect on hard money loans). Thus, the benefit of the mortgage interest deduction hardly compensates for the poor ROI in buying, holding and selling. In any event, Congress may decide next year to take away the mortgage interest deduction. History has taught us that we should NEVER buy real estate for the tax benefits!
Keep in mind that the figures I have used here are based on the best scenario for a purchase and the weakest scenario for a lease/purchase. You could probably negotiate a lower monthly rent and purchase price if you find a motivated enough seller.
Lease/purchase will not fare as well in lower-priced homes, because the rents will often exceed the typical mortgage payment. However, it works even better on the very expensive homes. On high priced homes ($500,000 and up), you’ll have to put down closer to 25% as a down payment. Your ROI goes way down when you have to plunk down $100,000 or more on a house. Try the above comparisons on a $500,000 home and you’ll really see that there really is no comparison, since the rent on that kind of house would not exceed $2200, yet the mortgage would sky-rocket to $3,500 or higher.
by William Bronchick