This morning your parents kicked you out of the family home (you're 42, after all). You're having a bad day until you get a phone call telling you your Aunt Selma died and left you $200,000 cash. Your day brightens considerably.Should you plunk that cash into a new home, or rent a home and invest it elsewhere? Do you go for Home Equity (HE), or an Alternative Investment (AI)?You pop open Excel and compare HE to AI and determine which provides the highest return. HE gives you two advantages over AI. First, you can sell you home tax free up to $250K/$500K single/married (your investment tax rate is 20%). Second, you get to live in your home, so there's no rent to pay. How to account for these? For the first, you decide to use after tax investment dollars when comparing AI to HE. For the second, you must determine the Equity Discount (ED)- the difference between what a homeowner pays to live in a home he owns and what he would pay to rent or live in a home with a mortgage. You determine the ED in your area is 60%- on other words, if you had to pay $1000 per month in total costs to rent or own with a mortgage, you'd only pay $400 if you owned the home outright. This $400 would go to property taxes, maintenance, and insurance. Finally, you realize you need a Gross Rent Multiplier, or GRM. The GRM determines the how much house you can get for your rental dollar. In your area, you determine the GRM is 12. The means the landlord will rent you a home for 1/12th the value of the property annually. With this information, you know your $200,000 home will rent for $1,389 per month, or $16,667 per year. (The GRM is 12, and 200,000/12 = $16,667). If you buy the home, it will cost you $556 per month or $6,667 per year in expenses (the ED = 60%, $1,389*.6=$556).You expect inflation to be 3% per year, and you estimate your home will appreciate at the same rate (meaning it will not appreciate in real terms).Assuming no transaction costs, your AI would have to return 10% per year to equal a home appreciating at only 3%. The math works like this: 10% after 20% taxes = 8%. Then you reduce by inflation/home appreciation (3%) to arrive at 5%. 5% of your $200,000 investment is $10,000, the same as the annual difference in cost between renting and owning ($16,667-$6,667=$10,000).Obviously the results can change dramatically depending on your assumptions, but it is a pretty strong argument for home ownership. Any comments or corrections are welcome.Nick
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