 Personal finance practice problem using OneNote. Buy or rent home decision problem number one. Prepare to get financially fit by practicing personal finance. OneNote, you're not required to, but if you have access and would like to follow along, we're in the icon on the left-hand side, the practice problems tab in the 7140 buy or rent decision problem one part one tab. Also take a look at the immersive reader tool. The practice problems will be in the text area as well with the same name, same number, but with transcripts, transcripts that can be translated into multiple languages and either listened to or read in them. Information's on the left-hand side. We're gonna do the calculations in blue on the right-hand side and down below. We're breaking out on a year-by-year basis. The costs and benefits between renting and purchasing, which could be useful if we're going from a rental property and thinking about purchasing something, a similar calculation might be put in play if you were thinking about purchasing rental property because you would think about the kinds of rents that you would be receiving, the income versus the yearly costs that you would have to own the property. Now, when we make a decision that has two paths from a financial perspective, then typically what we want to do is look at the differentials between the two paths so we could break out the flows of income on a year-by-year type of basis and look at the differentials between the two paths. Obviously, we have other factors involved as well, which are less easy to quantify than the financial items, such as we might be moving from a rental property that's smaller to a bigger place. When we own it, we've got the value of us owning the home versus renting the home and the equity in the home so it can get more complex as well, but from a financial perspective, that's what we'll try to do and we'll try to quantify everything as much as possible. The more we can quantify the values that we have the benefits of the two items, the easier we'll be able to look at a comparison from a quantifiable type of standpoint. Now, obviously, when we purchase the home, we'll typically have the cash outflows that will happen upfront, which could include things like the deposit and the closing costs and so on upfront, and then we're gonna have the yearly costs after that point in time. We're gonna be trying to compare the yearly costs at this point in time. So we've got the information on the left-hand side. So for the rent or buy for the rental costs, the renting is pretty easy from a yearly cost perspective. You've got the annual rent, we might have insurance, and we've got the security deposit that we could deal with pretty straightforward. If you're buying, then you've got the mortgage payments. So we could think of the mortgage payments in terms of a cash flow basis. If I'm trying to break things down simply to a cash flow scenario, I could do that. Now, obviously, we might actually have to format or calculate what these mortgage payments would be based on the home. So we'll talk about that in a bit more detail afterwards. We're just gonna assume for starting out that the payments are gonna be for the 10,700. The interest portion is 8,000. That's gonna be, we'll talk more about how to get that number as well because that number will change from year to year. So we'll dive into that in a bit more detail later. We'll assume it to start with. The property taxes are gonna be the 2,100 per year. The down payment closing costs, we're gonna say are the 37,181. The growth in equity, we're gonna say is 2,700. The equity component, that's gonna be the difference between the home value and the loan. So remember, when you purchase the home, you're typically gonna have the home on the books as an asset, and typically most people have to take out a loan. That's a liability. The difference between the two is going to be our equity. Two factors contribute to hopefully an increase in equity. One, paying down the principal of the home, which will change from period to period as we'll see. So we'll see how to get that number. And the other, hopefully the value of the home goes up. The insurance and maintenance are here in the estimated annual appreciation. We're hoping the value of the home goes up. That's what we're assuming the value of the home is gonna go up by. We've got the after-tax interest rates. This is what we're gonna be able to gain or earn on if we have money that we could put into a savings account. And the tax rate we're gonna say is the 28%. We'll try to put in the tax calculations in here as well. So we've got the rental costs fairly straightforward. We're just gonna say we've got the 9,600 of the rent. And then we've got the insurance. If we have to have renter's insurance of the 300, the security deposit, we might try to figure out if, for example, I have that $800 that I had to give to a security deposit, they're supposed to give it back to me. If I had it, then I would be able to invest it. So what am I really losing from a cash flow basis? We're losing that after-tax 6%. So it might not be that significant to put this into consideration, but you can consider the fact, the security deposit, the fact that you can't invest it, but they have to give it to the rental company for them to hold on, means you're losing the interest that you could have got on it, which we're gonna say is 6%. Why is it 6% over here? Because we're figuring that's what we can generate in say the stock market or something like that after taxes, after we pay the taxes, that's what it means after taxes. So that means it's gonna be 800 times 6% or 48. So if we pull out the trustee calculator, I'll do that one more time, 800 times 0.06, that's gonna be the 48 plus the 9,600 plus the 300 that comes to the 9,948. So then if I go to the costs to buy, to buy the yearly home costs, if we were to purchase the home versus the benefits. Now note, when you get to the home side of things, then you're gonna have a cash flow kind of component that we wanna think about, which is important for the cash flow. And then we also have the benefits of the home, which have some non-cash flow items, which includes the equity in the home. And it's important to break those two things out because even though we have more assets, we could look good from the standpoint of assets minus liabilities, meaning we have a lot more assets than liabilities. But if all of our assets are wrapped up in the home and we don't have any money to pay the bills, then we're still in a financial heart, we're still in a problem and we're gonna have to do something about that. So we wanna think about it from the cash flow perspective as well as the net asset perspective. So if we have the annual mortgage, so now we're looking at an annual basis comparing this information. So the mortgage payments we're gonna say is 10,700. We'll talk about how to calculate that more that we've seen in the past. We can try to figure out how much it would cost based on the terms of the loan and so on. And then the property taxes are the 2,100. You can typically get estimates to figure out what you think the property taxes will be in your particular area. Those are gonna be more localized in terms of how much they will be. The insurance and maintenance, we're gonna estimate at the 1,650. So we're gonna take the insurance and maintenance into consideration because when you own the home, notice that when you're renting, we don't have the same kind of maintenance costs up top because clearly those are typically things that are gonna be covered by the rental area. Whereas down here, we've got to deal with the maintenance through a differentiating factor. You might say, well, where's the utilities in there or something like that? Utilities, phone bills, those aren't differentiating factors because we have to pay those up top and we have to pay them whether we own the home or we rent the home. The thing that's gonna differ is things like the maintenance and so on, which we'll have to deal with when you're purchasing the home and can be significant, something we wanna take into consideration. After tax interest lost on the down payment. So now we've got the same kind of thing. We're looking the down payment note is a cash flow item that would happen upfront. So if I was to try to, if I was to another comparison that you can do between these two decisions is to try to think about the cash flows over the life of these two items and try to present value the cash flows. And that means you could think about, obviously you got a big outflow of cash up top for the down payment. That's not really what we're doing here. We're comparing after the purchase has taken place what's gonna be the year by year kind of comparison, benefits and costs between the two. So what we're thinking here is if I had to put that 37, 181 down, what's gonna be the cash flow in a year by year basis? Well, I couldn't put it into a savings account then because I had to put it into the down payment. That means I'm losing whatever I could have made in the savings account or the stock market which we're assuming after taxes is the 6%. So if I had to tie my money up in the down payment and I can't make money on it, that means I'm losing on an annual basis 6% 37, 181 times 0.06 and that's where we get the 2231. And so now we've got the cost to buy which would be the 10, 700 plus the 2100, the 1650 and the 2231. So that's an annual of the 16, 681. Notice this last one, if I had the cash flow for the down payment, this last one isn't really a cash flow item. It's more that I'm losing the cash inflow I would have gotten if I could invest this somewhere where I got a 6% return. So from a cash flow perspective, you might say, well, I've got the 10, 7 plus the 21 1650 and that's basically your cash flow kind of item. So it's important to note from a budgeting perspective, I wanna know what the cash flow is because I wanna determine if I can cover that, if I could pay basically the cash flow. And then from a comparative perspective, I would also wanna take into consider these items with regards to the loss of income from us tying up the money. And that's these two items. Now that's not the end of the story though because we also have the benefits from the purchase of the home. And these are the financial benefits. We could also have the benefits of non-financial benefits I might have purchased a larger home, for example, or a home that has stuff in it that I didn't have when I was renting and so on. So we'd have to factor those in, but we're looking at the financial items here. One, we've got the growth in equity. So there's gonna be that 2,700. Now there's two factors to the growth in equity. One, the equity represents the difference between the home value and the loan value. And the equity can then go up when we pay down the loan, but it's not gonna go up by the payments per se themselves because interest is gonna be involved and it's gonna change from year to year. So it's actually a little bit more complex to figure that number. So we'll talk about it later, but the amount that's paying down the principal will hopefully increase equity. As the loan goes down, the difference between the value of the home and the loan will go up. And that means you have more assets compared to the liabilities equity than going up. Even if the home value stays the same and we're hoping that the home value goes up in value. So this is the estimated annual appreciation. That's the other equity component. We're hoping the home goes up in value. That's the 1,000. This 1,000 is purely speculative. We don't know if the home's going up. We're hoping it goes up. And notice that both of these items, the equity components here, are things that we cannot easily, we can't cash them. So they're great because they make our net assets go up, assets over liabilities. That makes us look better from a financial perspective, but they're not liquid. So we gotta make sure that we still have the cash flow, which is this calculation down here to pay our bills because to tap into this equity, we would have to refinance or sell the home. So we want the equity to go up and we're gonna use that in our comparison calculation. But we also have to be careful with the fact that we can't really get that equity per se. It could be locked up if the economy is doing good. We could refinance possibly. We could do it that way, but just notice not as easy to get the cash. So tax savings on the interest. So we said the interest is gonna be this 8,000 up top. This is another number that we might get from the amortization table. It will change from year to year, but we're gonna use that number for the purposes of the example. We've got the rate at the 28%. This is a little bit deceiving. So this is something that you also wanna take in a lot, look at a lot more closely because if you talk to people that say, you're gonna get, like if I take this calculation, I'm gonna get a tax savings of the 8,000 for the interest. That's gonna lower my taxes. It's an itemized deduction on the schedule A times 0.28. And that would mean savings of the 2,240. That's true, but you have to also consider that before you did this, were you itemizing or were you taking the standard deduction? And the standard deduction, most people are taking the standard deduction if they do not own a home. And therefore, and the home is usually the thing that kicks people over to itemizing. And that's because of the big guys here on the itemized, which is the interest on the home as well as the property taxes. So you have to really do a projection because any gap between the standard deduction and the itemized deduction isn't really a benefit to you until you get over that. In other words, if it was taken, if I wasn't itemizing, I was still like 4,000 away from itemizing, then really I only got a $4,000 benefit because if I was to take the standard deduction, I would have still gotten the other 4,000 because the standard deduction would have been higher than my itemized deductions. So it's a little bit more confusing than this. And the only way to really wrap your head around it is to use tax software, do a projection in tax software and talk to your accountant about it. Also note that the interest will not be the same each year. It will go down each year. Also note tax laws could change. So if the tax law changes, like the rates could change and or the deductibility of how much interest could possibly change and the changing of the itemized and the standard deductions could change. So all that stuff makes the tax calculation a little bit more complex than you might first think. Then we got the savings on the property taxes, same kind of thing here. The property taxes depend on your local area, how much the property taxes will be. We have the same tax rate. These are also itemized deductions. So everything I just said with the interest applies here too. And how much taxes are they gonna put a tax on the cap on a cap on how much taxes you can deduct? What's the standard deduction versus the itemized? So you wanna do an actual tax projection on those ones. So in other words, if I got 2100 and I was at the tax rate of the 0.28, also note that this is the marginal rate that you would typically be using because we have a progressive tax system. So that means you're actually getting taxed on multiple rates but you would think that the change would happen at your highest rate would be the marginal rate. So the best way to do these is actually to do a tax projection in tax software. So this tax savings are gonna be the 588 there. So the benefits we're gonna say then we're gonna hope the equity goes up because we're paying down the loan balance of the 2007 plus we got the 1000 that we're hoping the home value goes up. Plus we're gonna save on taxes 2240 plus we're gonna save on taxes 588 for the property taxes. That's gonna be the 6528. So the 6528. And so if I take that on the benefit side minus the 16681, that's gonna be the 10153. And then on the equity side of things like if I take off the equity. So in other words, this is kind of like the total benefit the 10153, but on a cash flow side of things, you've got these two equity items over here and you might also take into consideration the amounts here that aren't really cash flow items. But at the least you'd say, okay, there's the 10153. If I then take that and I say if I take the 10153 minus like the equity components, which is the 2700 minus the 1000, which is the 37. Let's do that one more time. I'm gonna take the 101353 one more time. We're gonna take the 10153 plus the 2700 plus the 1000 that gets us to the cash flow of the 13853. So if I compare these two, I can start to say, okay, well, if I was renting up here on a year by year basis, I got to the costs of on a yearly basis of the six of the 9948. Whereas down here, I've got to the 10153. So you got some comparative numbers there that you can take a look at to help you with your decision-making process. But then you might also kind of break it down to more of a cash flow basis to think about your cash flow item. So we're thinking about one, our full, our kind of like our balance sheet information in terms of our total benefits and costs. And then we might break it down to our cash flow information. So up here, clearly this is basically a cash flow type of item, the 9948. Whereas down here, this 10153 is taking into consideration equity benefits of the 2700 and the 1000, assuming the home goes up in value and because we're getting a benefit in terms of our net assets going up when we pay down the loan principle. So those are not cash benefits. So if I add those back, then we've got the cash here at the 13853. So that's the kind of comparison that you might wanna look at basically on a year by year basis. And then also look at that kind of cash flow that's going up front, which would include of course the deposit. Now, once you have this information, you might also think, okay, how did I get to this 10,000s? All the yellow items, the annual mortgage payment, the interest portion of the 8,000 and the growth in the equity. How did I get to those items? Well, you're gonna basically get to that with the loan calculation, which might be the first thing that you'll take a look at. We'll back into it here because we've seen the loan calculation a couple of different times. But let's say that we had the loan of the 148.723, the mortgage payments at the 8.92 and the periods are gonna be a 30 year loan. The rate is at the 6%. If we made then our loan amortization table, which we can do here, or you can do it with an online calculator tool such as this, just type into the browser, the loan calculator. Although I think it's easier and better to do in Excel because you could tie everything out a little bit more easily that way. Now note that we're kind of backing into this loan amount so that we could tie into the numbers that we had up top. So we said, for example, that the annual mortgage was the 10,007. So if I take the 8.92 times 12, we get about that 10,007. So in practice, you might actually first think about how much home you're purchasing, for example, and then the loan amount. So we kind of backed into the loan amount in this way to kind of tie into our data up top. And then we took our loan amount and we assumed that there's a 20% down payment. So if there's a 20% down payment, that means that we purchased, we purchased, or we're gonna finance 80%, one minus 20%. So we would have then, I can then get to my home cost 148.723 divided by the 80%, which would give us the 185.903 about for the home value. So in other words, in practice, you would probably run it this way. You would be looking at the home cost, the 185.903, and say, okay, I'm gonna assume a 20% down. So 185.903, I'm gonna have to put 20% down. There's the 0.2 for the 20%. There's the 37.181, which we kind of put in our data up top, the 37.181 here about. And then we're gonna say that means that if I had a house of 185.903 minus the 37.181, that would give us the 148.723 that we're going to finance. And so then I can build my amortization table. So now I'm gonna assume this data up top to build the amortization table, which looks something like this. It's a little overwhelming to look at, but we can see that we now have the interest and the loan decrease. Those are gonna help us to get these balances, the interest here and the equity. Now that's useful because it helps us to calculate our tax calculation for the interest and our equity calculation up top. The problem is that it's not even from year to year. So if I'm trying to look at cash flows over each year after this point in time, then it's gonna be difficult to do that comparison because those two numbers change. As you can see here, we've seen in prior presentations that interest and the loan decrease are changing. So it's nice to be able to break this out into a year by year breakout, which we can do in Excel using formulas or using a pivot table, which we do in Excel. We do this problem in Excel if you wanna check it out. And that's something you can't do as easily here. And then we can try to use this number to try to populate our data. So this might be the first thing we do to help figure out the annual mortgage payments, the interest portion and the growth in equity. So the annual mortgage payments pretty straightforward. It's gonna be the 10-7 and that doesn't change. So that's fairly easy to do. The interest, I'd have to calculate or add up the interest for the 12 months each time, which is gonna differ from year to year. Year one is different than year two and it's substantially different than year 30. So that means I'd have to say, okay, if I'm gonna try to average this so I can get a calculation on average from year to year, I gotta use something I used. That's why we used 8,000. So it might take like an average of some of these, of some of these years or something that would be around year seven. You might try to pick the one in the middle like in year 15. But most people start off using the first year, which is really only gonna be your benefit. That's like best case scenario because it's going downhill from there. If you're owning the home for 30 years, you might choose somewhere in the middle of this whole thing. If you're choosing, if you're only gonna own the home for a few years and you think you're gonna sell it after 10 years or something, you might try to take the middle number between one and 10 and there's formulas in Excel to help you do that so that you could automate this whole thing. Meaning I could pull this data from this table and try to pick the one in the middle so this will populate automatically and we could tie everything together if we so choose. And then the growth in equity is the same thing. This equity balance here, this represents how much on a year by year basis of this payment is going to the decrease in principle. That's important because the amount that decreases the principle is increasing our equity. Meaning the equity is the difference between the loan balance and the value of the home. If the value of the home stays the same and we pay down the loan, that's gonna increase our equity which increases our balance sheet. So this number, notice it changes though from year to year. So if I'm gonna pull this number over here, we got 2007 which is somewhere around here for year eight but you'd have to use some kind of, you could use some kind of median calculation or average calculation or something like that pulling from something like this year by year table. It's more difficult to get from the amortization table which it would be very difficult to try to determine which equity number would be appropriate depending on how long you're gonna be holding this. That's why it's a lot easier to do this in Excel, put together some table like this and we can start to draw the data from say the table which would be the better way to go. We could also do these tables with formulas or a pivot table which is nice. So that's just one kind of comparison method that you might take a look at. And so when you're thinking about a decision like these or any financial decisions you might try to break everything out to cash flows and try to compare the differences in the cash flows between the two items. You might try to present value those and then in this what we're talking about here is basically looking at the year by year cost to see if we can break out or think about the cash flows and benefits from a financial perspective from one decision compared to another decision after the initial purchase.