[Today’s article is a guest post from our part-time radiologist friend, The Happy Philosopher. Read on as he regales his tale of home ownership during and after residency. Enjoy! -PoF]
Should I Buy a House as a Resident?
When my wife and I started residency we thought no differently. Buying a house for the five years we would be training seemed like a no brainer. It worked out pretty well for us as you will see, but is it really the best financial decision for the majority of new physicians?
I’m going to deconstruct our purchase and subsequent sale of the house we lived in throughout residency, and then take it a step further by following two other imaginary residents that bought the same house after me.
Mr. and Mrs. Happy Philosopher
It was early in my journey and the year was 1999. It was quite a year. I was wondering if Y2K would destroy the world, which tech stocks to put in my IRA and why on earth it took this long for someone to make a movie as cool as The Matrix. My wife and I were bright and bushy tailed interns preparing to do battle with sickness and disease.
We started renting a tiny house close to the hospital where I worked. This was temporary, as after my internship our rental would be far from both our hospitals. We did not even consider renting long term because real estate always went up in value; especially over a five year period (radiology is one of the longer residencies). Just as water is wet and the sun sets in the west, everyone knew this to be true.
We spent every ounce of our free time roaming around town with a realtor for the next several weekends when we had breaks from the hospital. We eventually found the perfect house. Actually it was not perfect, but it was $110,000 which happened to fit nicely into our naturally frugal lifestyle. It had three bedrooms, a basement, a two car garage and big yard – everything two busy residents needed! (Sarcasm intended)
It also had the world’s ugliest and smallest kitchen with industrial grade brown carpeting and wallpaper with apple trees (groovy), but hey, did I mention the price?
We took out a ‘doctor loan’ from a mortgage broker I saw in the newspaper. Looking back it was a slightly shady operation. The fees and interest rates were a little high and opaque in retrospect, but more importantly it was zero money down loan.
We actually refinanced that mortgage into a five-year balloon product (yes, the same ones that caused the world economy to collapse a few years later) as interest rates fell. We knew we would sell the house before the note became due.
As the old saying goes ‘they can’t stop time’. Eventually, our residencies came to an end. We called up another realtor and put the house on the market. This was 2004 and the housing market was HOT.
We had an open house on what was probably the most beautiful day of my five year residency and within a day had three solid offers on the house, two of which wanted to pay us more than we asked for. Final selling price $165,000, a 50% increase in about 4.5 years. Holy &$*T!!! We were kicking ourselves for not buying a MORE expensive house. We could have afforded it and in our conservative stupidity we left money on the table. What idiots we were! Incidentally, even with this modest little house we just made $12,222/yr (55k/4.5 years) of pure profit.
Doing the Real Math
Well, not really. Most people think of it this way. I thought of it this way, but the calculation is more complicated. First we put a lot of time and money into the house.
- We spent countless hours tearing off wallpaper and repainting. (There was wallpaper in EVERY room.)
- We retiled the kitchen and hallways.
- We tore up carpet and refinished the hardwood floors.
- We had to do a complete tear off of the roof and replace most of the underlying rotting plywood (not cheap).
- We bought a new stove, refrigerator, washer and dryer (assuming a rental would come with these).
- Other odds and ends maintenance like AC and garage door repair.
- About $10,700 in realtor fees, title, and transfer fees, etc. when we sold.
- Hours of time (and some money) maintaining a rather sizable lawn.
We made money. In fact, we did great. When we sold we generated a nice nest egg that we used a year later to put a down payment on our next house. But this was not because of great skill on my part. Our timing could not have been any better with respect to buying and selling.
I was lucky.
I didn’t keep complete enough records so I can’t really know what my true cost was, but I think renting and buying would have a similar monthly outlay. At the end of the day I estimate we were 30k richer for our decision.
Pure. Dumb. Luck.
Don’t get me wrong. We put a lot of sweat equity into that house. It was fun and I would do it all over again. I learned a lot about home renovation, but there was an opportunity cost to my time. In residency, free time is a limited, valuable commodity. Owning a house, especially one that needs work, takes a lot of time. Unless you really enjoy this stuff you are much better served letting someone else deal with the headaches.
From time to time I wondered what happened to that little house. Did it sell again? What’s it worth now?I thought it would be a fun little thought experiment to follow three more cohorts of imaginary residents that all bought this house from one another, as I now have over 12 years of historical price estimates since we sold. How would they have done financially?
I’m going to assume each couple does a 4 year residency (yeah I know there are single residents, but I can’t really figure out why a single person would buy a three bedroom house in residency).
Resident couple #1:
Its 2004 and everything is booming. What better time to buy a house and catch the wave. Heck, the way the market is going they may be priced out forever. Our resident power couple buys my house for $165,000, snatching it from other greedy home buyers looking to buy this goldmine.
They had to pay more than they wanted, but feel incredibly lucky as the other two houses they bid on were lost to others in spite of them offering full asking price. They were getting desperate as their residency director frowned upon homelessness.
Nothing major goes wrong with the place, just the routine maintenance. They get job offers in another state shortly before finishing residency and they put it on the market in 2008.
2008 is a different animal than 2004. The paper value of the house has fallen quite a bit from its peak of $205,000, but they still think they can break even or make a little money. In spite of a very soft regional housing market, the neighborhood is still desirable as it is close to the hospital and overall a nice place to live. The house sits on the market for a few months but finally sells for $173,000.
Countless hours were spent over the phone with the realtor and various contractors to fix a few issues that came up in the inspection. They soon realized trying to sell a house from another state while starting high stress jobs was suboptimal. Many nights they had dreams they were renting instead and just handed the landlord the keys moments before they boarded a plane to their new city.
Overall they lost about $5,000 after selling costs were factored in. They feel fortunate as they got ready to close on their $970,000 McMansion that was selling for 1.2 million a year ago. This time they are going to make a killing!
Resident couple #2:
Our next couple is feeling great. Housing prices have come down significantly from the peak, and they had their pick of the litter. $173,000 is a great price for this house and in 4 years should provide a nice little chunk of money to get started in life.
(Cue dark ominous tones)
First though, some renovations are in order. The kitchen is decent but doesn’t even have a dishwasher? Who were these people that lived here before us? Barbarians!? And while they were at it, they decided to finish the basement and update the bathrooms which required liberation from the horrendous pink circa 1950’s ceramic tile.
Our couple recently received a sizable inheritance of $40,000 and they poured this into the house. Every spare weekend and vacation was spent on the house that first year, and the hard work paid off. The place looked fantastic.
They had to forgo some trips they wanted to go on, and they didn’t quite have as much money as they wanted when the baby came along and their dog needed an expensive surgery. Oh well, that’s what credit cards are for. They were genuinely happy, and would make it up when they sold the house.
Fast forward to the end of residency. It’s 2012. Although housing is starting to plateau from its free fall, the housing market is absolutely terrible. No one is buying, and those that are want deals. After lowering the price a few thousand dollars several times our couple finally gets a lowball offer.
They thought about renting it out, but being a landlord sounds like a nightmare to them, and who knows how much more the house will continue to fall in value. After much negotiation they sell it for $155,000, requiring $25,000 out of pocket after realtor fees and lost equity. They borrow this money from their parents and vow to pay it back quickly with their signing bonuses and new found high-income.
They decide to rent a modest two bedroom condo in their new city and are quite angry at all the ‘renting is just throwing away money’ articles they read over the past 10 years. They are even angrier 4 years later in 2016 when they realize had they just invested the original $40,000 in an S&P 500 index fund and rented instead they would have doubled their money even after adjusting for inflation.
Resident couple #3:
Our last couple moves into their beautifully renovated house in 2012. They researched price to rent ratios in the city before deciding to buy. Even if the house did not appreciate in value they calculated it would be more expensive to rent in almost all scenarios. They needed the extra space as they had two kids, a dog, a cat and an iguana named Fred.
Their parents lived in the city and they knew they would like to stay here long term if they could. The house was located close to several possible places of employment, and immediately after buying they started networking with physicians in their community for potential jobs after they finished residency and fellowship. They had to replace the water heater and a few minor things, but no major renovations or other big costs.
In 2016, they decided to stay in the house in spite of the fact that they could afford a much larger place with their income. The house was close to their work and they loved the neighbors. They had no desire to uproot the kids and felt they could always do an addition on the house should they decide they needed more room. The house was valued at $166,000, so they would probably just about break even if they sold.
What really happened to the house?
I know what you are thinking. Anyone can just make up stories and cherry-pick dates and circumstances to tell whatever story they want. You are correct. So I’ll tell you what really happened.
I was sitting in a theatre waiting for the musical to start. I’m not normally a musical guy, but my wife really wanted to go. It was Mary Poppins I believe, and actually quite enjoyable. For some reason, at that exact moment I wondered what happened to our house from residency.
I hadn’t thought about that house for years. Why it popped into my head on that day is still a mystery to me. To this day I still don’t know why. I jumped on Zillow and looked it up.
I was surprised to see that the house just sold (this was 2014) and there were tons of pictures. Most of the renovations I talked about above did happen. The kitchen was completely remodeled with beautiful new countertops and cabinets. There were intricate ceramic tile backsplashes and all new appliances. The lighting was updated and a new dishwasher installed. Every room was repainted and the basement was now completely refinished. There were new windows and water heater.
I would be shocked if they got all of this done for $40,000. I’m probably massively underestimating the true cost unless they did everything themselves.
Sale price in 2014: $144,000.
Purchase price in 2004: $165,000.
Realtor fees assuming 6%: $8640.
Approximate mortgage balance: $130,000.
Net ‘profit’ after 10 years: $5,360.
In reality there was no profit. These people lost money. A lot of money. Those renovations cost a boat load. The repairs and maintenance are excluded. The true cost of the house is not just the mortgage; it is also the other expenses that seem to come at you at the most inopportune time. They are asymmetric and easy to forget about.
Not only did they pour a ton of equity in an asset that they never saw a return on, there was massive opportunity cost as that money could have presumably been invested elsewhere.
The S&P 500 had roughly an inflation adjusted return of 5.7% per year from mid-2004 to mid-2014. Historically these are below average returns.
Note that their financial opportunity cost would be much greater if they put 20% down as is traditional. This would be additional money tied up in a depreciating asset. They would have lower monthly payments and maybe a lower interest rate, but there is still a cost to be had.
Financially this decision cost them tens of thousands of dollars, maybe 6 figures when all is said and done. The projections and math get a little squishy when making assumptions and not having all the hard data.
Renting would probably have been much cheaper for them as I estimate the price-to-rent ratio was probably about 20-25 when they bought.
The price-to-rent ratio is simply the purchase price/annual rent. The higher the ratio the worse it is for buyers, and better it is for renters. Land lords use this as a rule of thumb to decide if a property is worth buying from an investment standpoint. If you want The Happy Philosopher rule of thumb, if the P/R is under 10 buy, P/R over 25 rent. If it is between 10 and 25 you need to do math.
I can’t know for certain what my ratio was, but I’m guessing it would have been somewhere between 10 to 15. This is buy territory. Buying kind of made sense for us, and as you can see it worked out.
I hate it, too.
[PoF: What?!? Math rocks!]
But before you plunk down 6 or even 7 figures on a questionable highly leveraged asset that you will be relentlessly taxed on, will require costly insurance and continuous maintenance and produce no cash flow, you probably owe it to yourself to spend some time learning math! Financial education is mandatory around here. If you have not done so please read this article from Afford Anything. It is an excellent framework for the rent vs. buy decision.
Renting is simple. You cannot compare the monthly cost of renting with the monthly cost of a mortgage. Buying will always artificially look better as it excludes all the maintenance, repair and other expenses. This is a more accurate picture.
|Costs of Renting||Costs of Buying|
|Closing costs, realtor fees, title, tax and transfer fees|
|Repairs and maintenance|
There are non-financial benefits of both renting and buying. These are more difficult to value and are probably the main reasons why people make the decisions they do. It’s not right or wrong, but these decisions have a financial cost, and when we make emotional decisions without considering the financial and opportunity cost we may and up regretting our decisions. Here is how I would approach the rent vs. buy decision.
|Flexibility. Move when lease expires. Upsize or downsize easily.||Stability. No landlord to evict you or raise your rent.|
|Known costs. Maintenance and upkeep responsibility of landlord.||Unknown costs. Major repairs or housing crash can be financially destructive.|
|No upside appreciation.||Can make good money in a hot housing market (or lose it in a bad market).|
|Much less time managing property.||You are now the property manager.|
|Limited ability to alter property/renovate.||Great flexibility in renovation/remodeling.|
|No tax advantage.||Possible tax advantage.|
Using an investment analogy, renting is like owning a bond until maturity. Your return is known. Owning a house is like owning a volatile stock that you buy from an expensive broker. You may make a lot of money, but you may also lose a lot if you need to sell when the market is down, and chances are you are going to pay a high commission for the privilege.
There are many online rent vs. buy calculators that will help you decide, and if you are buying a house without consulting one or more of these you are doing yourself a great financial disservice.
Buying a house in a market with an above average price-to-rent ratio for a time period of 3-5 years is a risky and speculative leveraged bet on further appreciation of residential real estate. In many markets it is impossible to break even in less than 5 years. Most residents do not need to be taking more financial risks. More importantly, you probably have better things to do with your free time than dealing with the headaches of home ownership.
There are three kinds of residents I know that purchased houses.
- Those that bought in a reasonable market at the right time and got lucky (me).
- Those that made a poor financial decision, but think they did well because they suck at math.
- Those that bought in an unreasonable market or at the wrong time and got screwed. They either took a big loss or became unintentional and unprofitable landlords.
In aggregate we don’t accumulate wealth by purchasing residential real estate and holding it for less than 5 years. Historically it appreciates at the level of inflation, which means at the end of the day you may break even. Some people win (San Francisco) and others lose (Detroit), but unless you are extremely lucky or skilled you are going to probably lose financially by buying a house and selling it 4 years later.
|Lean Towards Renting||Lean Towards Buying|
|Short residency (4 years or less)||Long residency (5 years or more)|
|Price/rent ratio >15||Price/rent ratio <15|
|Few attachments to city||Strong attachments to city (family, kids)|
|Didn’t know screw drivers come in different varieties||Like to work on home projects and maintenance|
|Hate the idea of being a landlord||Wouldn’t mind being a landlord some day|
|Freedom is being able to spend your free time any way you want||Freedom is the ability to change your living environment any way you want|
|Wouldn’t be caught dead in a house like this once I start making real money||Planning on living in the house after residency as an attending|
|Would be embarrassed if seen using a lawnmower||Enjoy yard work and landscaping|
|Wouldn’t phase me if I had to move||I don’t want to move in residency at all costs|
Buying a house in residency is probably not the worst financial decision you can make. Certainly going into consumer debt or living beyond your means is more disastrous as it establishes terrible financial habits. Some will decide to purchase a house anyways. If you have strong non-financial reasons to buy a house I’m not going to try and stop you, but don’t walk blindly into residency and buy a house because everyone else is doing it.
If you buy, this is how I would approach it, knowing what I know now.
Do the math and if it makes more sense to buy in your market and you accept both the risks and time commitment to owning, go for it. Pretend you are a landlord buying a property you will be renting to yourself.
Run the numbers and try not to allow emotions trump logic. If the numbers don’t work seriously consider renting. If you still insist on buying, just realize there will probably be a financial cost associated. Be sure the noneconomic reasons are worth it.
[PoF: Thanks for the detailed and thoughtful post, Happy Philosopher. Readers, did you buy a home straight out of med school / grad school / when you landed your first job? How did it work out financially? Be honest!]