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May 28, 2008

Comments

Erik

Hey Jeff, great post. I remember reading in Michael Masterson's book "Automatic Wealth" that he used a rent ratio of 10 as a good rule of thumb for the point at which a property became appealing. This was for investment property, so he was not receiving the mortgage interest deduction.

The buy vs. rent spreadhseet I use indicates that a $250,000 home with a rent ratio of 15 will become profitable (i.e. post a greater return than renting) in ~18 years. However, this assumes no home appreciation over the entire 18 year period - a more realistic appreciation rate of 2% gives a breakeven point of a little under 10 years. All of which is to say, prices seem to be returning to "fair" value, at least in Minnesota. Out here in Boston, not so much.

Jeff Allen

Excellent comment.

Just another reason that Boston will never be as sweet as the Deuce Cities. Boston may steal all of our best athletes away, but, like, their houses are expensive and stuff.

Cold comfort for having to watch KG lead the Celtics to the Eastern Conference Finals.

Jeff Allen

Oh, and a serious question:

Does this calculation of yours take into account mortgage amortization and the escalating principle growth that comes with it?

Erik

Watching KG win a championship in a rented apartment is just not the same...

The calculation does include mortgage amortization. I tried to account for many of the factors for and against owning.
For: Increasing principle, home appreciation, mortgage deduction
Against: Loss of investible income due to increased cost of home ownership relative to renting

The model requires a number of assumptions, and the results may be very dependent on those assumptions. The key parameters I used:
$250,000 house
$50,000 downpayment (20%)
Assume long-term annual inflation of 4% (slightly above historical average)
Long-term home appreciation of 2% per year (lower than long-term averages, to reflect a possible further decrease in home-prices). 2% appreciation for 10 years leads to home price increases of only 22%.
I assumed one could get 7% on other investments.
Mortgage rate of 6.25%
Yearly rental payments of $250,000/15 = $16,700, or about $1400 per month.

This seems to be a fairly conservative set of assumptions, from which you still get a 10 year breakeven point. If you are more optimistic about long-term home price increases, you may achieve different results.

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