Rent vs. own - IO rate?

Yesterday no one answered this question either. You guys talk every day about the rent vs own ratio so you should know how it works, right?

stevejhx, can you help out here?

Rent is the opportunity cost of not sinking your capital into a home. If you buy a $1m home you could also buy $1m of stocks instead (leverage available in futures markets). Renting would allow you to do that. So if I rent a $1m apartment for $2000/month I also get the ability to invest $1m elsewhere since it's not stuck in my home. So you have to compare renting + returns on your alternative investment options to buying.

The answer to your question is tricky because it involves a cost of capital associated with reducing risk to the bank by (a) putting down a 20% down payment; and (b) adding principal each month to further increase the equity. I have an answer for you, but it can be rather long-winded, so perhaps a question to first get an understanding of where you are at. Suppose you are buying a place for $500K and put down $100K. What annual cost do you think should be placed on that $100K when comparing to renting?

mbz & inonada,

Thanks for your input.

Don't agree. Your logic applies to the down payment but not to the monthly payments. Let's say rent is $4,000 and my P&I payment is $4,000 but my I payment is let's say $3,000, that $1,000 is an increase in my equity that you couldn't invest by paying $4,000 in rent.

I think comparing to "returns on your alternative options to buying" is getting at the right idea, but is not fully correct, because the alternatives may have a different risk profile than the capital you are putting up. You need to assign a cost of capital to the money you are putting up (upfront with a down payment and down the road with further principal payments) based on the risk profile of the equity stake in the home itself. Note that the principal payments down the road have a lower risk, in some sense, than the initial down payment since the down payment is taking the hit first (this is the source of difference in the traditional mortgage rate vs. the IO mortgage rate).

Back in the day of no-money-down interest-only mortgages, comparing rent vs. own in a risk-adjusted manner was quite easy. The zero-down interest-only interest rate would be most appropriate because it would bake in most of the price of the risk. (I say "most" rather than "all" because the lender is somewhat protected still by the borrower's desire to maintain a decent credit rating.)

Nowadays that those loans are not available, an IO is the best thing to use for a risk-adjusted comparison (which I think is the "correct" comparison of rent vs. own), but then you have to apply a cost of capital to the down payment. The number you apply here is subject to debate, but unless the cost is appreciably higher than the IO interest rate, you are not thinking about the issue correctly.

ueside: Point taken, but how do you value the downpayment you are putting up or the principal you pay, which is acting as a cushion against losses that the bank would take if you defaulted? This is a crucial question you should answer, because it has something to do with the low interest rate the bank gives you ("low" relative to what it would be w/o a downpayment, not in an absolute sense).

ueside: if your downpayment is $200k and that lets you buy a $1m home then it is no different than using a $200k brokerage account to buy $1m in equities (or bonds, or anything else). If your income was $4000 per month and your rent was $4000 per month (to make this simple) you would then only reinvest the gains on your $1m investment. If you "owned" a home you would have $1000/month to add to your equity each month (income minus interest) but you would not have the gains on a $1m stock portfolio to reinvest.