We are currently in the 9th year of a bull market in stocks, with popular stock market indexes reaching new all-time highs seemingly every day. We all know that the next recession is just a matter of when, not if. If your trying to save for your kids’ college which is 18 years away (or less), that is simply not a long enough time horizon to recover from potential 40% losses in a stock portfolio. There could even be two recessions in the next 18 years. I am not bashing stocks. I think they are great for long term investing. But when saving for such a large expense in a relatively short amount of time, I believe that real estate is a better alternative to stocks.
Rental property offers predictable growth. A lot of people put money in to a 529 college savings plan when their child is born and then probably add what they can once a year. That, combined with the uncertainty of stock market returns, makes planning difficult. A mortgage forces you to save. By using a fixed rate mortgage, you know exactly when the debt will be fully amortized by making just the minimum monthly payment. Rental income is also much more stable than fluctuations in the stock market. Rents tend to go up or remain flat, but they rarely go down.
The World’s Simplest College Cost Calculator estimates that I will need to save $215,000 to pay for 100% of my newborn son’s college expenses. They assume that I will need to earn 6% per year on monthly contributions of $465, for 21 years, to meet that goal.
What if I bought a house instead?
Price of home: $400,000, detached, single family home in the DC area
Down Payment = 25% = $100,000
Interest rate = 3.75%, 30 year fixed rate mortgage
Monthly Payment = $1,800 including principal, interest, taxes, and insurance
Monthly Rent = $2,500
I am budgeting the full $700 per month difference toward management, vacancy, repairs, and capital expenditures which I consider to be a conservative estimate.
From a monthly cash flow standpoint, you are breaking even. At the end of year 18 you owe $161,000 on the 30 year mortgage. Even if the home did not appreciate at all, you have $239,000 in equity in the home. The more likely scenario is that rent and home values keep pace with inflation. If we assume inflation of 2% per year, then the home is worth $573,000 at the end of year 18, and you have $412,000 in equity.
By using leverage, you turned your $100,000 initial investment in to $412,000 in 18 years. That’s an annual return of 7.9%, not counting any increases in the amount of rent you are receiving over time. Instead of selling the property to pay for college, which would incur transaction costs and taxes, you can use a cash out refinance of up to 80% of the value of the home to pay for college, and your tenants continue to service the debt.
If your child gets a scholarship or decides to not go to college, you don’t incur any of the taxes or penalties that you would with 529 college saving plans. Speaking of taxes – yes, 529 college savings plans do offer tax free growth, but so does rental property in the form of depreciation. Straight-line depreciation of the $400,000 over 27.5 years is $14,500 per year of the net income on your rental property that you can shelter from taxes. That is almost all the net income in our example.
The returns between real estate and stocks are similar over the long run, but the amount of risk you take on matters. I believe there is much more risk in depending on average annual returns of 6% on stocks over a period of only 18 years.
What do you think? Feel free to offer feedback or call me out on any of my assumptions. If you agree with me, that buying a rental property is a better way to save for college, give me a call so we can get started!