Buying a home can be a great financial move, but there’s no guarantee that you’ll always come out ahead. Renting can also be a smart way to build wealth, if you follow a few guidelines. Laura covers the pros and cons for owning and renting so you know which option will make you richer.
You’re probably familiar with the idea that homeownership is the American dream. While taking out a mortgage to buy a home can be a great financial move, there’s no guarantee that you’ll always come out ahead. Renting can also be a smart way to build wealth, if you follow a few guidelines.
No matter which side of the buy-versus-rent debate you’re on, it’s wise to carefully consider the benefits of each. In this post, I’ll review the main pros and cons for owning and renting a home so you know which option will make you richer.
How Can Buying a Home Make You Richer?
Let’s start by understanding four ways financing a home can allow you to become wealthier.
1. Building equity.
The first major attraction of buying your home is building equity. Equity is the difference between a property’s market value and what you owe on it. For instance, if your home is appraised at $300,000 and your mortgage balance is $250,000, then you have $50,000 ($300,000 - $250,000) in equity.
If you have a fixed-rate mortgage, each payment is made up of principal and interest in amounts that change over time. Each monthly payment helps you automatically grow richer because you reduce your outstanding loan balance by a slightly larger amount, which is called amortization.
In other words, with every amortizing mortgage payment, you own more of your home and owe less. However, there are home loans that don’t amortize, such as an interest-only mortgage.
With every amortizing mortgage payment, you own more of your home and owe less.
The benefit of having home equity is that you can cash it out by selling your home. Or you could tap a portion of equity by refinancing your mortgage or getting a home equity line of credit.
2. Having appreciation.
The second way owning a home can make you richer is price appreciation. For instance, if you buy a home for $300,000 and then the value increases to $375,000 over time, you have $75,000 of additional equity.
Historically, real estate has been an excellent long-term investment. But there’s no guarantee that a home’s value will go up or that it will appreciate as quickly as you’d like. If you bought a home in 2007 and had to sell it in 2010, you probably took an upsetting loss.
But if your home value goes up at the same time you pay down your mortgage, that’s a powerful way to build wealth. So, owning real estate gives you the opportunity to grow richer from price appreciation, paying down your mortgage, or from both. In contrast, paying rent is a pure out-of-pocket expense.
3. Cutting taxes.
To incentivize homeownership, the government created tax breaks to reduce the total amount of tax you must pay. Here are five expenses that are tax-deductible every year that you itemize deductions on your tax return:
- Mortgage interest – is deductible on up to $750,000 of debt on a primary or secondary residence for taxpayers who file jointly, or $375,000 if you file as a single.
- Home equity loan interest – is also deductible and included in the $750,000 limit when you use it to buy, build, or improve your property. You can use home equity for personal reasons, such as credit card debt or education expenses, but that makes it ineligible for a tax deduction.
- Points – are certain upfront charges and prepaid interest you pay for a mortgage. If you’re eligible to deduct all the interest on your mortgage, you probably are also eligible to deduct mortgage points.
- Property taxes – are deductible for up to $10,000 for joint filers, or $5,000 for singles. This limit includes the total of your state, local, and real estate taxes. Some states (such as Florida and California) give homeowners a homestead exemption, which further reduces property taxes and typically offers legal protections.
- Private mortgage insurance (PMI) - is deductible, unless your adjusted gross income exceeds $109,000 as a joint filer, or $54,000 as a single taxpayer.
In addition to these annual tax breaks, there’s an even bigger deduction that comes when you sell a home, which is the capital gains tax exclusion. This benefit allows you to avoid paying tax on up to $500,000 of profit, or up to $250,000 as a single taxpayer. But you must have lived in the home for at least two of the previous five years before the sale.
All these tax incentives are fantastic; however, many costs of homeownership—such as homeowners insurance, homeowners association dues, maintenance, renovations, and local tax assessments—are not deductible.
Renters don’t get any housing-related tax deductions. But they don’t have any expenses either, except springing for a renters insurance policy, which only costs $188 per year on average.