When it comes to buying a home outright or financing it or even renting one, there is always an ongoing debate about which is the smartest financial choice. Each would be valid depending on your business goals and personal needs. Are you looking to generate cash flow today or are you looking to build equity or seeking to grow your portfolio of assets that pay you in your retirement? Either way, there are significant factors to consider when making the decision. Income and social status definitely influence the potential to opt for the choice that gives a bigger bang for your buck. However, there are other hidden costs to be factored in when comparing mortgage vs. rent, such as: maintenance costs, service charges, and property management along with insurance.
However, for this post, we’re going to explain (what in our opinion) are the true costs of mortgaging (i.e., financing) your home:
1. Financing a Home Is Not an Investment.
Let me tell you why this ‘investment’ is misguided. When you get a loan from the bank (mortgage), you have a liability due. Simply put, you are in debt. You are technically paying someone (the bank in this case) to live in your own house. Hence, by mortgaging the house, you are lacking flexibility and optionality due to the fact that you will be tied up to market outcomes. The house isn’t considered an asset yet since it’s not generating any positive cash flow. Unless you can accurately predict the future of household prices or can cover up for the mortgage expenses, for example by renting your apartment, then financing your house is not an investment.
2. Timing Is Everything.
Ideally, when interest rates are extremely low, the cost of borrowing is relatively cheap. In this case, investment becomes attractive when the assets will bring in higher returns, given the fact that property prices are expected to rise. This would be the best time to seize the opportunity! Only then you can cover your expenses from cash flows and build equity. Otherwise, when there is a downturn in the market, consequences can be devastating.
3. Consider the Interest Rates.
We all know that investing in a property is coupled with a set of risks, particularly when it comes to market prices. Essentially, when you introduce debt into an investment, you are directly increasing the risk associated with it. As a result of being exposed to interest rate risks, you must substantiate that risk by generating higher returns than if you had purchased the property in cash. On the other hand, it also lowers your holding power which may lead to massive losses if you’re unable to keep up. Take the covid-19’s effects as an example, during the pandemic, many people lost their jobs and had to sell their houses for the worst rates and banks would claim repossession of the mortgaged houses.
4. It’s Not Only Mortgage vs. Rent.
SmartCrowd has provided a sample example calculation allowing you to run in numbers based on real world prices in the market. Click here to walk through the evaluation model. As mentioned earlier, there are some costs which people must take into consideration — maintenance costs, service charges, property management, and insurance. As you can see in the figure below, the formula is quite simple, if you believe the value provided to you after renting your mortgage would be satisfactory (the return is higher than the rate you would’ve expected to earn from the market), then it sounds like an ideal plan!
You can even use any of the free mortgage calculators available online such as Mortgage Finder.
Compounding is the secret key!
In conclusion, there is no right or wrong answer when it comes to investment options. One must evaluate different scenarios and decide whether it meets their business goals. Mortgaging may be the only viable option for some while others have different preferences. Nevertheless, it is essential for one to understand that wealth isn’t acquired overnight. Real estate investing is a long journey that requires patience and data-driven analysis. If you’re investing for the sake of hoping that in 10 years your property’s value will be worth tenfold, this isn’t a prudent investment strategy. Thus, my advice is to focus on how to leverage that income you’re building. Regardless of how small the amount, it’s important to use the income smartly, because if you don’t need it, you will most likely spend it on trivial expenses. Moral of the story: keep reinvesting your income for it to grow and to maintain a positive cash flow!