Critique my assumptions in buy vs. rent analysis

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Startled Cat
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Critique my assumptions in buy vs. rent analysis

Post by Startled Cat » Wed Jul 26, 2017 2:51 am

Some backstory first: for the past six years I've been living in a 497 sqft. condo with my girlfriend. The condo is owned by my girlfriend's parents, and they have been extremely generous in charging us rent that's well below what the market would bear, especially with the rapid rent growth in the last few years in our market (SF). I've never been thrilled about sharing such a small space with another person, but at the time it made sense. She was in graduate school and I was starting my career, so upgrading to a larger apartment would have involved making major compromises on location and/or amenities. My girlfriend doesn't mind living in a small space and doesn't want to give up the prime location or the amenities she's used to (gym, doorman, dishwasher, laundry in unit, etc.).

Since I moved in, we've been fortunate enough to roughly triple both of our incomes. I'm finally at the point where I'm eager to upgrade, even if it means spending what seems like an enormous amount of money to get something we're both happy with. Normally I'm almost pathologically frugal, but a nicer living situation is the one material thing I've wanted for quite some time, and I think spending on it makes more sense than saving to an extreme degree. I also think we're well past the point where we should be getting assistance from her parents. Since I have the higher income, and I'm the one who really wants to move, I've offered to pay a substantial majority of the cost. My girlfriend is still reluctant to move, and I think a major reason for that is that she doesn't like the insecurity that comes with renting on the open market. She doesn't like the idea that we could be forced to move on relatively short notice if a lease is not renewed, or not offered for renewal at an agreeable rent. For me it's not such a big deal, but I understand her perspective. She has been encouraging me to consider buying a condo instead of renting.

As an aside, San Francisco has an extremely tenant-friendly rent control law which limits rent increases to half of local inflation and makes it nearly impossible to get rid of a tenant once they've moved in. However, the policy only applies to units in multifamily properties that predate 1979, and most of this rental stock is not up to par with the 2008-vintage building we live in now. In particular, rent-controlled units tend not to have dishwashers or laundry hookups, though there are definitely exceptions. So while rent control would be very favorable for us and resolve some of the concerns about renting, I'm not especially optimistic we'd find something eligible for rent control that would satisfy the location, amenity, and condition preferences.

I'm a bit biased towards renting, because I like the flexibility. I'm reluctant to enter a living situation where I'd have to stay put for several years just to break even on closing costs. Buying a condo would be a huge, leveraged, financial commitment, and there is definitely concern that we might end up buying at close to the market top (prices are way up over the past several years, though they have fallen slightly from the peak in the last year or so). Nevertheless, since my girlfriend is more comfortable owning than renting, I want to run the numbers on ownership and see if it could make financial sense, or at least be reasonable enough to consider anyway. I'm finding that this is very difficult to do. There are many inputs that have to go into the calculation. Some involve future predictions, and affect the result greatly. Others should be relatively predictable, but are difficult for me as a non-homeowner to get a handle on. I thought I'd post the assumptions I'm feeding in to the New York Times buy vs. rent calculator (http://www.nytimes.com/interactive/busi ... ulator.php) and get some feedback on whether my estimates make any sense. I'd also be curious if there are other calculators or spreadsheets people have used, because this one definitely has limitations (which I'll mention below).

Home price: $1,595,000
Monthly rent: $5395

These are taken from the asking price and asking rent for two similar units in a building we like. It's hard to know if they are good comps, and even whether the asking price is meaningful (I keep hearing about units selling above or below asking price, which is something I find very confusing about real estate). But these seem like the right ballpark figures. The types of units we're most interested in have asking prices around $1.5M - $1.85M, and asking rents around $4800 - $6000.

Down payment: 20%

Mortgage rate: 4.00%

Taken from bankrate.com (30 year jumbo)

Annual property taxes: 1.83%

According to http://www.bartlettre.com/san-francisco-property-tax, the rate is 1.19%. The number is slightly out of date, but probably close enough. There may be special taxes that are neighborhood-specific, and I'm not taking these into account right now.

Note that the NYTimes calculator seems to assume property taxes are tax-deductible. I believe this is not true under AMT. To work around the assumption, I've adjusted this number by my effective federal marginal tax rate.

Annual home price change: 2%

This number is everything. If one chooses 1%, it's really hard to make home ownership look good. At 3%, it tends to look fantastic. It makes intuitive sense, because buying a home is really a leveraged bet on that asset. Historically, San Francisco residential property has appreciated much faster than inflation, but I'm uncomfortable extrapolating forward from this. The cost of housing is already so unaffordable that it's difficult to imagine the trend continuing over the long term. And assuming that prices will continue to go up in real terms seems like an unfair bias towards ownership - of course it makes sense to lever up if you can expect to sell later at a profit! So I chose 2%, the same value I estimate for inflation.

Annual rent increase: 2%

If I estimate that prices will match inflation, it seems only fair to estimate the same for rents, no matter how questionable this seems in the context of recent history. The model is not nearly as sensitive to this parameter as home price appreciation.

Condo fee/common charge: $912

Deductibility of common charges: 0%

I'm not familiar with the rules for deducting condo fees, but it sounds like in general they are not deductible, so it would only be a small part anyway.

Cost of buying a home: 2%

The calculator's default is 4%. I'm not sure how much these costs scale with the property value, and how much of it is fixed costs. I cut it down to 2%, but don't have much confidence in this figure.

Cost of selling a home: 6%

I left this field as the default. I don't have a good sense of it either. I know that realtors tend to charge a percentage of the sale price, even though that doesn't make any sense to me. I think there's a good chance this business model might be disrupted by the time I would sell, but that might be overly optimistic to bake into an analysis. Also, I understand there's a transfer tax of about 0.75%, payable by the seller, and I'm not sure if I should add this to the cost of selling in addition to the 6%.

Length of mortgage: 30 years

Annual renovation costs: 0.3%

The default is 0.5%, but I expect this doesn't fully scale with the cost of the property, so I lowered it a bit. I'm not sure it's really fair to include this in the comparison - renovation is only an option for owners, so counting it as an extra cost in comparison to renting doesn't seem quite right. I wonder if I should lower this even more.

Annual maintenance costs: 0.1%

Again, the default was 0.5%, and I lowered it significantly. All building-level maintenance would be covered by HOA fees. We've lived in a new-construction condo for the last several years and it has been basically maintenance-free. The only thing I can think of to account for here is replacing appliances occasionally.

Homeowner's insurance rate: 0.1%

The default here is 0.5%, and this seems very high for a condo. I don't have a good idea of what condo insurance costs, but online sources seem to say it's not a very significant cost.

Capital gains exclusion: $500,000

We're not married, but I assume we'd share title somehow. That's yet another thing to figure out.

Additional monthly utilities compared to rental: $0

Water and garbage are usually included in HOA fees. Electricity and internet service are usually passed through to renters (though internet service can be included in some cases).

Rent deposit: 1 month

Rental broker's fee: 0%

Renter's insurance rate: 0.50%

The calculator's default is 1.32%, but this seems like something that shouldn't scale with rent. I don't have a good sense of what renter's insurance costs, so I conservatively chose 0.50%. This isn't a very important parameter anyway.

Rate of return on investments: 4.5%

This one will be controversial on Bogleheads. It's another parameter that matters a lot, since the whole exercise is really a comparison between buying a condo or renting and investing the cash flow difference. I lean pessimistic about investment return forecasts, and expect somewhere between 2-3% real. Also, I made relatively pessimistic assumptions about home price appreciation, and I figure there should be some correlation between that and investment returns, especially in the Bay Area. I chose 4.5% nominal, but that's a fairly arbitrary guess. I'm not sure what assumptions the calculator makes about taxes on investment gains, and that could be a big source of error in the analysis.

Marginal tax rate: 44.3%

There are some inaccuracies here. My marginal tax rate for investment income is a bit higher. My girlfriend has a different marginal tax rate, and I haven't tried to take that into account. If I did, it would nudge the analysis in the "renting is better" direction. However, it's not clear how to blend the tax rates, and her tax rate may well go up in the next few years anyway.

Inflation rate: 3%

In general I think 2% would be the right estimate for inflation, but one of the things the calculator applies this to is HOA fees, and I've seen them grow pretty steadily at about 5% in the building I live in now, so I bumped the inflation estimate.


...So after going through all these inputs, what do I get?

Image

Breakeven in 7 years. It's an interesting result to end up with, because that's the number I would have named which seems "fair". If I could break even in 4-5 years with conservative assumptions, I would be tempted to buy. If breakeven was forecasted for 8+ years, I'd be pretty unenthusiastic. 6-7 years is the middle ground where either option seems potentially reasonable.

Of course, this depends a lot on the assumptions I've laid out, which is why I'd really appreciate a sanity check. Tweaks to some of these parameters can change the forecast significantly. While unpredictable variables might dominate the actual outcome, I would still really like to have a handle on the costs and tradeoffs involved before seriously considering homeownership. I've already noted some deficiencies in the calculator, and I'm sure there are others that I've missed completely. Thank you for reading through a long and rambling post, and I'd be grateful for any specific feedback or even general non-financial advice about making this big decision!

BanquetBeer
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Re: Critique my assumptions in buy vs. rent analysis

Post by BanquetBeer » Wed Jul 26, 2017 5:57 am

Interest deduction?

Your budgeting maybe $6k/yr for repairs? I think in 4 years here we spent $30k on critical stuff (roof leak, driveway, and some updates). This may not be up to you.

Home purchase costs also include furniture, appliances, etc.

I might consider getting someone to rent a room for a year to cover transition costs.

liberty53
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Re: Critique my assumptions in buy vs. rent analysis

Post by liberty53 » Wed Jul 26, 2017 8:08 am

Wow - finally a rent vs buy thread that starts off with analysis using the NYT caclulator. Thank You OP!

Everything looks pretty reasonable in your analysis. I wouldn't agonize over the break even point. Will it change your decision if it goes from 7 years to 5 or 10?

One thing you may want to tell us (for those of us that don't want to plug the numbers into the calculator ourselves) is what the sensitivity analysis looks like. Most likely it's most sensitive to expected return on investments and home appreciation since the house is so expensive.

Although the result is not as sensitive to selling costs, you can probably assume a lower selling cost if the housing market stays red hot in the Bay area.

freebeer
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Re: Critique my assumptions in buy vs. rent analysis

Post by freebeer » Wed Jul 26, 2017 8:20 am

aaronl wrote:... My girlfriend doesn't mind living in a small space and doesn't want to give up the prime location or the amenities she's used to (gym, doorman, dishwasher, laundry in unit, etc.)...
Forget all the numbers. A happy girlfriend makes a happy household. 497 square feet is a spacious apartment in many parts of the world... it's right at average for 1BR in UK (http://www.bbc.com/news/magazine-22152622). And it's new construction in what sounds like a luxury building (doorman? In SF??) that you are unlikely to be able to afford (esp. with a larger footprint). Those values may be more important to your girlfriend than more raw space.

And, perhaps, she may not be 100% sure about the two of you having a permanent future, at least at some level. It is, after, all, still "girlfriend" not "spouse". So the move may be creating stress that isn't surfacing as you discuss the overt issues.

So I say compromise in this case to suit your girlfriend and stay put. But insist on paying closer to market rate (it can still be a very good deal but I agree it doesn't make sense for it to be a ludicrously low rent given your incomes), and bank some of the savings for a future REALLY nice place (and if & when you have kids more space will be much more of an imperative)... and spend some of the savings on trips (in which you can go for more spacious accommodations... enjoyment of which might even nudge your girlfriend towards your preferences.

equanimity511
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Re: Critique my assumptions in buy vs. rent analysis

Post by equanimity511 » Wed Jul 26, 2017 9:03 am

Stay in the small apartment. Bank your money.

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simplesimon
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Re: Critique my assumptions in buy vs. rent analysis

Post by simplesimon » Wed Jul 26, 2017 9:19 am

The NYT calculator is probably the best there is but it's conclusions are based on what gives you the higher number at the end of the day - not actual cash flow. Appreciation will make it seem like a no brainer, but you can't pay the mortgage and taxes with appreciation.

Did you calculate what the monthly PITI + condo fees would be?

Edit to add: If there's any uncertainty about long term plans with your girlfriend like whether you'll marry, whether you'll have kids, etc, I'd hold off and keep saving.
Last edited by simplesimon on Wed Jul 26, 2017 9:32 am, edited 1 time in total.

KlangFool
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Re: Critique my assumptions in buy vs. rent analysis

Post by KlangFool » Wed Jul 26, 2017 9:31 am

simplesimon wrote:The NYT calculator is probably the best there is but it's conclusions are based on what gives you the higher number at the end of the day - not actual cash flow. Appreciation will make it seem like a no brainer, but you can't pay the mortgage and taxes with appreciation.

Did you calculate what the monthly PITI + condo fees would be?
+1.

It is definitely higher than renting in your case.

KlangFool

TheHouse7
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Re: Critique my assumptions in buy vs. rent analysis

Post by TheHouse7 » Wed Jul 26, 2017 10:20 am

freebeer wrote:
aaronl wrote:... My girlfriend doesn't mind living in a small space and doesn't want to give up the prime location or the amenities she's used to (gym, doorman, dishwasher, laundry in unit, etc.)...
Forget all the numbers. A happy girlfriend makes a happy household. 497 square feet is a spacious apartment in many parts of the world... it's right at average for 1BR in UK (http://www.bbc.com/news/magazine-22152622). And it's new construction in what sounds like a luxury building (doorman? In SF??) that you are unlikely to be able to afford (esp. with a larger footprint). Those values may be more important to your girlfriend than more raw space.

And, perhaps, she may not be 100% sure about the two of you having a permanent future, at least at some level. It is, after, all, still "girlfriend" not "spouse". So the move may be creating stress that isn't surfacing as you discuss the overt issues.

So I say compromise in this case to suit your girlfriend and stay put. But insist on paying closer to market rate (it can still be a very good deal but I agree it doesn't make sense for it to be a ludicrously low rent given your incomes), and bank some of the savings for a future REALLY nice place (and if & when you have kids more space will be much more of an imperative)... and spend some of the savings on trips (in which you can go for more spacious accommodations... enjoyment of which might even nudge your girlfriend towards your preferences.
Please don't buy under these circumstances.
Get married/sit tight/or leave her. (Rent another place as last resort)
This has a high possibility of being the biggest mistake in your life. (All the possible D's when it comes to partnerships)
"PSX will always go up 20%, why invest in anything else?!" -Father-in-law early retired.

Startled Cat
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Re: Critique my assumptions in buy vs. rent analysis

Post by Startled Cat » Wed Jul 26, 2017 10:27 am

BanquetBeer wrote:Interest deduction?

Your budgeting maybe $6k/yr for repairs? I think in 4 years here we spent $30k on critical stuff (roof leak, driveway, and some updates). This may not be up to you.
The calculator takes the interest deduction into account.

I believe those type of repairs would be covered by the HOA, funded by HOA dues (remember, this would be a condo in a high-rise building, not a single family house). It's possible that there could be special assessments to fund unbudgeted repairs, but I'm not sure how frequent or significant this would be.
liberty53 wrote:Everything looks pretty reasonable in your analysis. I wouldn't agonize over the break even point. Will it change your decision if it goes from 7 years to 5 or 10?

One thing you may want to tell us (for those of us that don't want to plug the numbers into the calculator ourselves) is what the sensitivity analysis looks like. Most likely it's most sensitive to expected return on investments and home appreciation since the house is so expensive.
If the breakeven point went up to 10 years, I would be pretty hesitant to buy. There's no inherent reason we would move again within 10 years, but it feels like buying adds a lot of cost/risk if I have to project a longish time horizon to make the numbers work.

You're absolutely right about the sensitivity. Home appreciation and return on investments have the most impact, by far. In particular, it's so sensitive to home appreciation that the analysis is dramatically different at the various discrete settings that the calculator allows (single percent). There's another version of the calculator that allows this to be tuned more finely, but it's designed to calculate breakeven rent rather than breakeven time.
freebeer wrote:Forget all the numbers. A happy girlfriend makes a happy household. 497 square feet is a spacious apartment in many parts of the world... it's right at average for 1BR in UK (http://www.bbc.com/news/magazine-22152622).
Definitely an interesting perspective. I didn't realize that floor plans were so different in the UK. I'm sure living in the US has affected my concept of what is normal, and probably not in a good way. I remember chatting with an airport security screener at the Seattle airport a few years ago while he was patting me down, and how shocked he was to learn I lived in such a small space.

Staying put is definitely an option, and obviously makes sense from a purely financial perspective. However, I'd only want to do this with a clear goal in mind, not stay indefinitely to save money as an end in itself.
simplesimon wrote:The NYT calculator is probably the best there is but it's conclusions are based on what gives you the higher number at the end of the day - not actual cash flow. Appreciation will make it seem like a no brainer, but you can't pay the mortgage and taxes with appreciation.

Did you calculate what the monthly PITI + condo fees would be?

Edit to add: If there's any uncertainty about long term plans with your girlfriend like whether you'll marry, whether you'll have kids, etc, I'd hold off and keep saving.
The calculator shows yearly cash flows, adjusted for tax advantages, and with my parameters it indicates that owning takes about 1/3 more recurring cash flow. This is definitely a concern, and another reason why I find myself biased toward renting. I'm not really familiar with mortgage underwriting, but I get the sense that the mortgage I'm simulating may be on the edge of what we would qualify for. That said, we don't spend much money on other things, so there is plenty of cash flow available to devote to a mortgage assuming a bank would let us. Another factor that might make cash flows more manageable in the buying case is that my girlfriend would be willing to put more of her income towards a mortgage than towards rent. She doesn't want to spend much more on rent than she already does, but she sounds open to taking on a significant mortgage if she can think of it as an investment.

I don't think there's much long term uncertainty. We don't plan to have kids. I agree that if we did, it wouldn't make sense to buy now. I'm not sure that getting married would make any difference to this, except in mundane details like tax rates. I guess there might be implications on how the property is titled, which is something I need to learn more about.
TheHouse7 wrote:Please don't buy under these circumstances.
Get married/sit tight/or leave her. (Rent another place as last resort)
This has a high possibility of being the biggest mistake in your life. (All the possible D's when it comes to partnerships)
I really think the word "girlfriend" gives the wrong connotations here. I could have said "unmarried partner", but I guess that has some connotations of its own...

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Re: Critique my assumptions in buy vs. rent analysis

Post by KlangFool » Wed Jul 26, 2017 10:32 am

aaronl wrote:
we don't spend much money on other things, so there is plenty of cash flow available to devote to a mortgage assuming a bank would let us. Another factor that might make cash flows more manageable in the buying case is that my girlfriend would be willing to put more of her income towards a mortgage than towards rent. She doesn't want to spend much more on rent than she already does, but she sounds open to taking on a significant mortgage if she can think of it as an investment.
aaronl,

What happened if you split up with her? Will the property be split 50/50?

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randomizer
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Re: Critique my assumptions in buy vs. rent analysis

Post by randomizer » Wed Jul 26, 2017 10:36 am

There are a lot of assumptions in there, and small errors in estimates can turn your analysis from mildly favorable to disastrous. I'd rent. The Bay Area scares me.
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Startled Cat
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Re: Critique my assumptions in buy vs. rent analysis

Post by Startled Cat » Wed Jul 26, 2017 10:51 am

Since this has come up, I thought I should mention that being unmarried isn't due to a lack of commitment. I didn't want to go too deeply into this, but some people seem to see the marital status as a red flag. We've been together for quite awhile, and the idea of getting married has come up, but we haven't felt any urgency, particularly because we don't plan to have children. I find the idea of having a wedding stressful and costly, so I'm in no rush to do it. There would be cultural expectations from both families, which would conflict in some cases. Note that we are registered as domestic partners under city law, and technically have financial obligations to each other because of that. Buying a condo together could potentially be the thing that pushes us into getting married, though ironically it would add to our tax bill and make it harder to afford the condo.

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Re: Critique my assumptions in buy vs. rent analysis

Post by simplesimon » Wed Jul 26, 2017 10:54 am

Do I have this right? Even with this analysis, it doesn't sound like renting the $5,500 place is an option given your girlfriend's aversion to renting. So you are going from paying some small subsidized amount to something that is double, triple that amount? That's a pretty big jump and while it may be most efficient from a net worth perspective to buy if you're eventually going to buy anyways, the psychological impact of having your finances make that dramatic of a shift is unknowable...no matter how sure you are right now. Sounds like you have a decent support system with her parents so maybe that will be your fallback.

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Re: Critique my assumptions in buy vs. rent analysis

Post by KlangFool » Wed Jul 26, 2017 10:59 am

aaronl wrote:Since this has come up, I thought I should mention that being unmarried isn't due to a lack of commitment. I didn't want to go too deeply into this, but some people seem to see the marital status as a red flag. We've been together for quite awhile, and the idea of getting married has come up, but we haven't felt any urgency, particularly because we don't plan to have children. I find the idea of having a wedding stressful and costly, so I'm in no rush to do it. There would be cultural expectations from both families, which would conflict in some cases. Note that we are registered as domestic partners under city law, and technically have financial obligations to each other because of that. Buying a condo together could potentially be the thing that pushes us into getting married, though ironically it would add to our tax bill and make it harder to afford the condo.
aaronl,

My niece divorced her husband after one year of marriage. They had been together for 6 to 7 years before they got married. So, even marriage is not a guarantee that the couple will stay together. In this case, they bought a house together too. But, the house is cheap enough that she bought his portion out. So, she does not have to sell the house immediately.

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Re: Critique my assumptions in buy vs. rent analysis

Post by TheHouse7 » Wed Jul 26, 2017 12:18 pm

KlangFool wrote:
aaronl wrote:Since this has come up, I thought I should mention that being unmarried isn't due to a lack of commitment. I didn't want to go too deeply into this, but some people seem to see the marital status as a red flag. We've been together for quite awhile, and the idea of getting married has come up, but we haven't felt any urgency, particularly because we don't plan to have children. I find the idea of having a wedding stressful and costly, so I'm in no rush to do it. There would be cultural expectations from both families, which would conflict in some cases. Note that we are registered as domestic partners under city law, and technically have financial obligations to each other because of that. Buying a condo together could potentially be the thing that pushes us into getting married, though ironically it would add to our tax bill and make it harder to afford the condo.
Sorry to pry about seriousness of your relationship,

I didn't think about common/city law because I know anything about it. Be really careful about big D's: Death, disability, departure(one of you leaves), drugs, disagreement(she or you change your mind about kids).
"PSX will always go up 20%, why invest in anything else?!" -Father-in-law early retired.

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bligh
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Re: Critique my assumptions in buy vs. rent analysis

Post by bligh » Wed Jul 26, 2017 12:29 pm

If the numbers were strongly in favor of one or the other, your decision would be simple, if the numbers are just border line, and you cannot predict the future.. there is a good chance you could look back in 10 years and see either one as the better decision. So pick the one that lets you sleep better at night and gives your more options.

In other words, if the buy vs rent analysis is so close it could go either way, why not err towards the side with more flexibility, more liquidity, less risk and lower transaction costs?

If you have the income, the downpayment and the savings rate to buy that $1.6 mil house today.. chances are you will be able to do it even more comfortably 2 years from now if you change your mind. If, your situation changes adversely, you will be glad you didn't commit to anything. Renting, in effect, puts off the decision to a later date. A lot of people buy a place right away because they fear that in the coming years they will be priced out of the market and will have to settle for less ideal size and location.

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Re: Critique my assumptions in buy vs. rent analysis

Post by junior » Wed Jul 26, 2017 12:42 pm

I prefer the Michael Bluejay calculator:

http://michaelbluejay.com/house/rentvsbuy.html

It gives a yearly cash out amount and has more options for taxes and other assumptions.

liberty53
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Re: Critique my assumptions in buy vs. rent analysis

Post by liberty53 » Wed Jul 26, 2017 6:14 pm

junior wrote:I prefer the Michael Bluejay calculator:

http://michaelbluejay.com/house/rentvsbuy.html

It gives a yearly cash out amount and has more options for taxes and other assumptions.
Thank your for that link - it looks like a great calculator!

lostdog
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Re: Critique my assumptions in buy vs. rent analysis

Post by lostdog » Wed Jul 26, 2017 8:08 pm

Stay in your current place and save.

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Re: Critique my assumptions in buy vs. rent analysis

Post by Iliketoridemybike » Thu Jul 27, 2017 10:46 am

Love the calculator. I put my current situation in and it showed buying paying off after the second year. Makes me happy.

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