Monday, April 26, 2010
Evaluate Opportunity Cost - Rent or Buy?
Tip # 252 – Evaluate Opportunity Cost. Rent or Buy? Should we go with Door Number 1 or Door Number 2? Opportunity Cost is a term that many business majors are introduced to in Economics 101. Others may or may not be aware of the term. Basically, opportunity cost is what you give up when you make the decision to do something else. For example, suppose you have one free hour each evening. And suppose that you are a personal trainer who can make $50 an hour in the evening training a client on exercise, but instead you decide to watch an hour of television one night. Your opportunity cost for that evening is $50 because you lost out on making $50. In other words, you chose to watch t.v. and relax so you lost out on making $50. If instead you choose to train your client and earn $50, then your opportunity cost is an hour of relaxation, which is what you lose out on.
So how do we apply this to our own lives? Well, there is opportunity cost in most everything we do. And it’s not always related to money, but since this is blog on how to save money, that is what we will discuss. Opportunity cost is helpful in making financial decisions. One particular decision that comes up in most households is "is it better for us to buy or rent?"
Let's look at an example. Suppose you have $50,000 saved for a down payment on a house. You also know that you have $2,000 available per month to put toward housing costs (rent or a mortgage payment). You can rent a 3-bedroom home in town for exactly $2,000 and keep your $50,000 in a money market account earning 5% interest. On the other hand, you can put the $50,000 toward a down payment on a $250,000 home leaving you with a $200,000 mortgage that over 15 years with principal and interest and taxes costs you $2,000 per month. The local economists predict that houses will increase in value at 1% per year in your neighborhood for the next 15 years.
If you rent the house for $2,000 per month, after 15 years, your $50,000 is worth about $105,000. On the other hand, if you buy the house, after 15 years, your home will be worth $290,000. If you decide to rent, you are giving up the opportunity cost of owning a home free and clear in 15 years that has a worth of $290,000 (and also living in a house you own and can do what you want with). If you buy the home, you lose the opportunity cost of having a very liquid $50,000 in your bank account for emergencies or other expenses plus earning $55,000 in interest during that time period (as well as the ease of picking up and moving whenever you want).
Clearly, in some cases, we don’t fully know the opportunity costs since some financials are based on estimations. Do we put our money in a CD earning a sure 3% and miss the opportunity to possibly make much more if we invest in stocks. Or do we invest in stocks and miss the opportunity to have a guaranteed rate of return. Only you can make these decisions, but make sure you evaluate not only what you will get if you choose A but also what you will lose if you don’t choose B.
In Real Life (IRL) – I’ve read many discussions online regarding whether it’s better to rent or own. Clearly, we can never 100% accurately predict whether we’ll have to up and move in the future or whether the housing market will bomb or skyrocket in the future. Unfortunately, when we make decisions, we have to work with only information we have at the time as well as our best predictions fro the future.
So, is it better to rent or own? Clearly, as my example above shows, waiting to buy is not always the best case scenario. Of course, that may not be a realistic example. Perhaps homes selling for $250,000 would not rent for $2000 per month. And maybe housing prices end up dropping by 1% every year rather than increasing by 1%. On the other hand, I have a real life example that shows why putting a down payment on a home at the right time has been better for us than to keep on renting. And I'm anxious to share it since many people are down on home-ownership today.
We bought our home in November 2000 for $290,000. We put $70,000 down, which is a fairly hefty down payment (24%). According to tax records our home was only worth $231,000 in 2000 (so it appears as if we overpaid!). Even taking that into consideration, we got a good deal. The value of our home steadily increased over the next 6 years according to tax records:
When the economy started a downturn, housing values dropped across much of the nation. But in the DC area, while prices did fall, they didn’t drop by as much as in other places.
(Note that the 2009 and 2010 values reflect a $12,000 addition we did on the house, so to be fair, the value would be lower without it). Even taking the addition into consideration, our house would still be worth over $500,000 today. And houses in our neighborhood still consistently sell for above tax assessments.
So had we rented for a couple more years we would have lost the opportunity to buy a “low priced home.” We would have never gotten our foot in the door. The difference between the rent we were paying (on a smaller place in not as nice of a neighborhood) and our home mortgage was $600 per month. Over 4 years, we would have only saved about $30,000 more had we kept renting. But in 4 years our home was worth over $100,000 more than we paid for it. Clearly, renting for longer would not have been a good decision on our part.
Our opportunity cost by buying was loss of flexibility to move fairly quickly and savings of $600 per month plus interest as well as interest on our initial $70,000 down payment which totals about $125,000 (if I'm earning 5% interest and our rent didn't go up at all in 9 years, which it has dramatically). Had we continued renting our opportunity cost would have been about $300,000 in net worth (the amount the house is currently worth minus the amount we owe on our loan minus the down payment of $70,000 which we would have had in either case).
(I can also give you an example where renting would have been better for us than buying but I’ll save that for another day.) How do you evaluate opportunity cost? Has renting or buying been better for you? Did you make the right decision?
***I used Bankrate to do some of my interest calculations.