Author Topic: Am I right in my basic principles of estimating ROI on a first home purchase?  (Read 1672 times)

capnbike

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Hi,

I hope all the wise/experienced real estate folks here have good insight for me on this. My wife and I are planning on buying our first home about a year from now (once we go month to month on our lease and have our downpayment not require taking a loan from my TSP), and I want to confirm that I'm not thinking of the financials of the ROI incorrectly.

We live in the DC area, and so our downpayment will be around $90k and for this scenario I'm assuming a $450k house and a $360k mortgage. I looked up amortization payment tables to figure out how much I'd end up paying down the principal with the mortgage payments, which when accounting for all the extra homeownership costs put into a monthly payment it is equivalent to our rent currently.

So, if in the first full year of making payments, we paid down the mortgage principal by $7,120, would it be reasonable to consider that as part of the return on investment for the house? Since, that money would've only gone to rent before, and in using that money to acquire a home and take on debt for such, the decreases in the debt that are created by what were previously rent payments seem reasonable to count as "returns". If that's not crazy then it means in the first full year I'd increase the equity in the house at no extra cost (relative to paying rent before) by $7,120 with a $90,000 investment, resulting in a 7.91% return on that $90k investment.

Then, if the house appreciates in value (around here the average increase seems to be 1% a year at the moment, so that's just easy to go with), that'd mean another $4500 increase in equity in that first year. So, if I'm not crazy that means ($4,500+$7,120)/$90,000 = 12.96% ROI. I know I can't assume that increases in value will happen (in fact I'm preparing myself internally for whenever housing downturns happen - always plan for the worst, winter is coming, blah blah), but this is just a way of testing if how I'm thinking of this is correct.

So, what do you guys think? Reasonable to think of it that way or is there some principle that I'm not aware of I should be taking into account?

Thanks

sailinlight

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To me, counting on a 4,500 increase in equity for the first year should also take into account selling losses if you need to sell in the first year.  So instead of increased equity of $4,500, think about realtor commision ($27,000) and closing costs (maybe ~3-4k).  So your year one ROI would be more like -20%.  But of course after year 2,3,4, etc that starts to move positive and then eventually into the range of what you originally calculated.

larmando

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I would not count the principal payment as ROI on the down payment as that's money you pay in. Rather consider the cost of ownership for the house (interest, taxes, repairs,  plus opportunity cost on your equity) and compare with your rental cost.

ender

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Your house is an expense. Owning a home can reduce the cost of housing, but in almost all cases, it is ultimately an expense.

Anyways, the only way your math makes sense to include the principle/equity gain as profit is if your rent is identical to your mortgage/taxes/repairs/etc payment consistently. Not in an idealized sense, but in reality. Plenty of people underestimate costs of home ownership in their home-buying-frenzy. For example if your current rent is $2k/month then you almost assuredly are not coming out ahead buying this home financially (your principle/interest will be close to $1.6k for 30 years, not including property taxes, maintenance, or different utilities), so you need to subtract your other additional costs for home ownership from your gain.

Spending $10k on interest/property taxes to "save" $7120 on principle means you have a large cost associated with that $7120.

I don't see these factors included into your "ROI" calculation, which suggests you are looking at this with a pretty shortsighted perspective.

capnbike

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I have taken a fair amount into account on my math for this as far as I'm aware.

Our current rent is $1850 a month, including utilities.
On a $450,000 house, we would have at least $90,000 available for downpayment.
With closing costs rolled into the mortgage, and a 4% mortgage rate, the mortgage payment would be $1,737 a month, based on 30 year mortgage payment equations I found a while back and rolled into my spreadsheet.
Including the homeowner's insurance (minus what we currently pay in renter's insurance), plus a monthly payment for the property tax, yields a monthly payment of $2,183.
Since the paying of property taxes starts making it worthwhile for us to itemize on our taxes, that's when that information comes into play in the math.
I total up the interest, property tax, and state income taxes, and subtract the standard deduction from that total (because that's the actual value of itemizing over the standard deduction for me). I then calculate what my federal taxes paid on the original AGI would be vs the new adjust AGI with the deductions. That is split into a monthly value and the savings is accounted for in the total costs of owning a house per month math. That gives me $1911 a month.
Then, finally, I assume $120 for utilities and $100 for maintenance that I'm not currently paying. From our experience living in a house in the area before now that number for utilities doesn't seem out of line for us. So, that brings the number to $2,131.
(Fun enough, my equations in my spreadsheet are rolled up for a whole range of home prices and can have multiple factors changed quickly to make alterations - helpful as hell.)

It's entirely possible that my numbers for maintenance will be higher, but $100 a month seems reasonable overall.

According to the nice website http://www.amortization-calc.com/, it seems that in the first year I'd accrue $7,300 in principal. My payments for home ownership (split into a monthly value) would be $281 in comparison to renting ($3,372). The increase in value of the home if a 1% increase happened (not saying I'm planning on it, just a for example) would be $4,500. And of course, if I just had the money in my funds, assume a loss from not investing of $6,300. So, if I added and subtracted those, $7,300 + $4,500 - $3,372 - $6,300 = +$2128.

Now, I'm not saying that I'm planning on buying a house for the sake of making myself wealthy, but I'm a planner, and being able to plot out these changes is helpful for me. If prices go up or down I don't care so much as I've plotted out what to generally expect in a reasonable way. For instance, should I assume that maintenance number to be $200 a month instead? I'm much more likely to try to work on something myself (within reason as my skills grow) when able.

ender

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It's entirely possible that my numbers for maintenance will be higher, but $100 a month seems reasonable overall.


Hard to know. People generally use about 1% of home purchase as a rule of thumb. But if it's a 1930 house with 15+ year old appliances that will be different than a brand new house with all new appliances (probably..). You have to be intelligent about this sort of thing, but your guesstimate seems pretty low to me.

One way to estimate this is to try to imagine "what will I have to replace in the next 5/10/20 years" and put a price on it. Roofs, major appliances, decks, etc. Then average that out per year. Often it's higher than one initially thinks.


I have taken a fair amount into account on my math for this as far as I'm aware.

I'm glad other folks are as interested in this as I am, hah :-)


Quote
Our current rent is $1850 a month, including utilities.

So the comparison for out of pocket costs is just about $22k/year that is "lost" completely for your current situation.

Based on your numbers, it looks like your total additional property taxes/homeowners insurance will run about $5.4k a year. Interest will be around $13k for the first year and it sounds like $1.4k for utilities (though $120 seems really low, depending on what "I'm not currently paying" means, maybe this is just the increase from current). So we're at about $19.7k out of pocket costs for your first year.

This is still ignoring maintenance, transactional costs (for selling), opportunity cost, and the deduction value to you.

Sounds like the deduction is worth about $2k a year to you (initially, it will slowly go down ever year), so we're down to $17.7k per year for your housing cost. I tend to not include the opportunity cost or appreciation factors because there is no way to guarantee either. Both could be hugely positive or hugely negative. YMMV here, I guess.

We're left with the additional factors:

  • Maintenance
  • Transaction costs

Maintenance, using $100/month is going to be 1.2k so we're back up to $18.9k/year.

Transaction costs is a big last one that is almost always forgotten in this equation. Assuming 5% of your purchase price in selling costs and that you live in the place for 5 years makes the transactional costs $4.5k/year, bumping you up to $23.4k/year. If you stay 10 years and have only 3% costs it becomes $1.4k/year, or $20.3k. Only you can know how long you will be there, but most people guesstimate this wrong as a lot of life factors affect it.

So all this to say: if you fully include everything, the numbers are pretty close (if you bump maintenance or other home related stuff to $200/month and use the 10 years/3% transaction costs number you are at $21.5k for homeownership vs $22k renting).

If you sell in 5 years and incur 5% transaction costs with maintenance costs much more than $100/month, it's likely you come out a fair bit behind (for $200/month you're looking at $24.6k buying vs $22k renting for total cost). A standard 6% commission realtor and other transaction fees will push that a lot worse, too.

And, naturally, the market for either housing/stocks could dramatically tilt this in either direction. The longer you keep the house the lower the percentage of your mortgage payment that goes to interest, too. I didn't include that because unless you keep the house for a long time the initial guesstimation for yearly interest is pretty reasonable. Eventually you end up paying enough less in interest to make a difference, just not in the first few years.

(I rounded a bit here so the final numbers might not be dead on if you put them into a spreadsheet)
« Last Edit: August 03, 2016, 05:42:11 AM by ender »

waltworks

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It sounds like you really want to talk yourself into buying a house. But if you really want to war-game the darn thing, you need to make a big huge spreadsheet with the expected returns from your downpayment if invested elsewhere, expected increases in rent and home price, etc, etc.

Or you could just use the NYT rent vs buy calculator: http://www.nytimes.com/interactive/2014/upshot/buy-rent-calculator.html

:)

-Walt

capnbike

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Sounds like my overall math isn't terrible (particularly since I went through solid research for creating the equations that roll up in my spreadsheet). It does appear from researching maintenance costs a bit more that using an average of the 1% and the $1 per square foot rules of thumb would work well, with a 10% adjustment upward to that for the house being older or not in good condition. I'll have to create the math to run that in the spreadsheet for planning out the costs and what's affordable.

The transaction costs aren't something I'm as worried about since whatever we'd buy we'd likely stay in for a fair bit of time, only moving probably if/when school quality became an issue or some other factor made it relevant 7+ years down the line. If the schools our children ended up in were good we'd not even really need to move for 10+ years if the house worked for our needs. And this isn't so much a "yees, yeees, look at my profits!" kind of exercise as a "what's the reality here going to be?" kind of situation. I'd gotten to the point where I was like "well, looks like a house is a definite missed opportunity as far as what that money could've been invested in instead, oh well", but then I started thinking about how what currently goes to rent going to principal (in part) and that if the home increases in value, it wouldn't make home ownership quite as much of an opportunity cost as I'd thought.

It sounds like you really want to talk yourself into buying a house. But if you really want to war-game the darn thing, you need to make a big huge spreadsheet with the expected returns from your downpayment if invested elsewhere, expected increases in rent and home price, etc, etc.

Or you could just use the NYT rent vs buy calculator: http://www.nytimes.com/interactive/2014/upshot/buy-rent-calculator.html

:)

-Walt

I'm not really trying to convince myself - it's something we'll start looking to do next year, I'm just trying to plan it out and understand the reality of it beforehand. I am captain spreadsheet, as you might notice - I've used the rent vs buy calculator - it doesn't include that much information for actually making choices on affordability taking everything into account, and on top of that the math is all black box. So, I made my own, researching different expected costs, figuring out what the relationship of mortgage amount to closing costs seems to be, calculating out the property tax, blah blah blah, all in order to create the best estimate I can for what the actual costs would be. Now I'm trying to figure out the benefits a little bit better - since until now I'd just treated it as rent with a $90k+ deposit.

undercover

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Buying will always favor renting over a long enough period of time. The trick is determining that period of time, the "breakeven" point. With those numbers, and your uncertainty on living there permanently, I doubt that buying is going to be truly advantageous for you unless you also planned on renting out rooms.

capnbike

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Buying will always favor renting over a long enough period of time. The trick is determining that period of time, the "breakeven" point. With those numbers, and your uncertainty on living there permanently, I doubt that buying is going to be truly advantageous for you unless you also planned on renting out rooms.

I would've considered 7+ or 10+ years to be long term when considering living in a particular house. The NYT rent vs buy calculator has always given the breakeven point of being around 5 years here if I remember correctly.

ender

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Buying will always favor renting over a long enough period of time. The trick is determining that period of time, the "breakeven" point. With those numbers, and your uncertainty on living there permanently, I doubt that buying is going to be truly advantageous for you unless you also planned on renting out rooms.

I would've considered 7+ or 10+ years to be long term when considering living in a particular house. The NYT rent vs buy calculator has always given the breakeven point of being around 5 years here if I remember correctly.

~5 years matches my math, too ;)

sokoloff

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Principal paydown is not part of the ROI.

Imagine if you made extra payments of $1000/month. Your ROI on the purchase decision wouldn't be higher as a result of those extra payments. Same principal applies to the principal paydown that is required by the terms of the loan.