In a recent article I wrote how buying a house could end up throwing away just as much money as renting. That’s because buying a house with a mortgage is exactly like renting, only rather than renting a place to live, you end up renting the money to buy the place.
Quite interestingly, someone rebutted on that argument and suggested that buying is much better if you just pay the whole damn thing off all at once. Yep, back up that dump truck full of cash and buy that thing right out!
It seemed like a very legitimate argument. If you don’t have to borrow any money to buy the house, then there is no interest to pay. With no mortgage that means there’s no money being thrown away. The whole premise of how you throw away money buying was because the interest payments ate up so much of the mortgage payments. Without a mortgage, the argument for owning is much stronger right?
Understanding Cash Flow
First off, if we’re going to talk about cash flow, we have to know what cash flow means otherwise this point makes no sense. This isn’t Fight Club, we’re allowed to talk about cash flow and it’s not a secret.
Cash flow is the very essence that actually makes us feel well off or not. Many people just don’t realize that because they think being well off means making more and having more. Quite the contrary! My favourite way to explain cash flow is with the leaky bucket model. Think of your cash flow as a simple bucket.
The bucket represents your cash flow for the month. The more you fill it, the more you have per month to spend. Most people will fill their bucket with either job income or investment income.
Our bucket springs leaks when we have expenses to pay. These are things that we need to pay for on a monthly basis and that takes away from our bucket.
Our overall cash flow for the month can then be represented by the amount that is left after we subtract the what is leaving our bucket from what is coming in.
If we have any water left over, that means we have positive cash flow. If our bucket is empty that means we are living paycheque to paycheque. If we find ourselves short of water, which means we need to get additional water from somewhere else (like a loan), then we are cash flow negative.
When our bucket is empty or near empty we feel anxious about our money situation. “Where is the next meal coming from?” “Who’s going to pay my rent?” When we lack funds coming into our bucket and it’s slowly leaking, we also have that same feeling of anxiety. That’s because we are always under the fear that our bucket will run out of water (money).
On the contrary, someone who has a bucket that is filling or overflowing doesn’t have that same kind of anxiety. In fact, she may feel “rich”. Even if she weren’t a millionaire, someone who has budgeted well and figured out a way to keep her bucket full will not have to worry whether she can pay her monthly bills or not.
This is why cash flow is important. Our anxiety over money isn’t about making enough or the fact we can’t buy something, but it’s about how much we have left over after all of our expenses.
Now back to the main argument. Remember in my previous article, I wrote about how buying a $575,000 condo with a 20% downpayment is similar to throwing away just as much money as someone renting a similar unit for $2250 a month. So what happens when Bank of Mom decides to help out and pony up the entire $575,000 rather than having a mortgage?
Let’s take a look first at our leaky bucket. If mom is generous to fork over $575,000 for the condo, then maybe she’s willing to fork over $575,000 for investments. Given a very conservative investment portfolio mixed with stocks and bonds, we predict a 5% annual return. That means on average, the investment income would earn $2,395 a month. At the same time we still have our job. Let say we make $4000 a month.
When we rent, we have to pay rent on a monthly basis and that ends up springing a leak in our bucket.
Essentially our rent is eating away at our entire investment income, but the good news is that we still maintain our job income. That means our bucket is filling by roughly $4145 a month.
If we decide to pay off the entire condo of $575,000 then what happens is that we end up turning off one of the flows of our income. Since the entire principal is used to pay off the house, we no longer have the investment income we did in the previous example.
When we buy, we incur other costs that we don’t have when we rent. In the case of the condo, we incur the costs of property tax and maintenance fees. These are monthly expenditures that end up popping holes in our bucket.
With these additional expenditures, we still have positive cash flow at the end of the month, which is great news; however, the amount we have left over after buying is LESS. In fact, rather than having $4145, we only have $3,073. That’s $1,000 less each month in cash flow for buying.
When it comes to cash flow, buying doesn’t necessarily make a better choice, even if you can pay off the entire sum immediately without a mortgage. As this example shows, buying the condo will actually eat away an extra $1,000 in monthly cash flow. Throughout the entire year that equates to $12,000 out of your pockets. Enough for a couple of vacations right?
It’s A Lifestyle Choice
If you’re reading this you might be thinking. Why do I care? If I can afford this condo with cash, why shouldn’t I buy it. You’re absolutely right. It’s hard to put a dollar amount on the pride that one gets from home ownership. It’s impossible to put a value on stability and security. That’s why buying a home is a lifestyle choice. Even when it is affordable.
For some people, losing out on $1,000 a month won’t overcome the peace of mind of owning their own home. In fact, it’s probably more enjoyable to spend the $1,000 on the home than taking a vacation because that is what makes them happy.
That’s where all these arguments of whether home ownership or renting is stupid. There are many people that make home ownership their ultimate life goal. Given the circumstances of being able to pay off the entire home immediately, why wouldn’t you do it? It achieves your life goal!
For others that see a home as just shelter and a place to stay at night, home ownership might not be for you. You may decide to take your extra cash from not owning and spend it on other things. Things that will make you happy other than home ownership.
At the end of the day, the decision of whether to purchase a home shouldn’t be about money and whether it is a good investment. It should be about affordability and whether home ownership is the lifestyle you choose.