Since it is likely that rents will increase within a 30-year span and the interest paid on the mortgage loan is tax deductible, the purchase option may be less expensive.
What makes the mortgage loan appear expensive when expressed in this way is ignoring the time value of money. Money received in the future must be discounted when compared to money received today. When dis¬counted, we may speak of the money’s present value, meaning the amount of money that would have to be invested today to equal the amount in the future. Although the example mortgage loan would require almost $320,000 in future payments, a lender would only pay $100,000 for the loan to get a 10% return. The loan’s present value is $100,000.
There are several keys to understanding the time value of money: Money today is worth more than money received in the future. If you have the money in hand, you can invest it and have more of it in the future. On the other hand, you may need to spend the money now. If you didn’t have it, you would have to borrow it and pay back more in the future. In addition, whenever you invest money, there is a chance that you won’t get it back, that you won’t get back as much as you expected, or that inflation will decrease its value in the future. The further into the future you receive the money, the less valuable it is. At 10% interest, a $100 payment a year from now has a present value of almost $9 1 , but the same payment two years from today has less than $83 of present value.
The amount by which money decreases in value in the future depends on the discount rate. This is equivalent to an interest rate. If the rate is high, the present value of future money is low (however, it should always have some positive value). If the rate is low, the present value is high (but never more than the amount in hand today). Discount rates differ from time to time and from person to person. If alternative investment opportunities are good, the rate will be relatively high. If the person lending the money has no immediate need for it, the rate will be lower. Risk also increases the rate. If the chance of repayment is low, the lender will demand a higher interest rate.
The effect of compound interest increases the return from an investment. Compounding means that interest is paid on interest that was earned and left on deposit. When the interest is earned and is reinvested, it earns interest along with the original principal. In effect, the interest earned becomes principal.
Consider the magic of compound interest: if you can earn 10% interest, compounded annually, $1000 deposited now will grow to more than $13.7 million in just 100 years! A key to real estate finance is recognition that inflation erodes the value of money. If your interest rate is 10% and the inflation rate is 4%, your real cost of money is only 6%. The loan costs even less if you take advantage of the tax deductibility of mortgage interest. Another advantage to keep in mind is that the value of a property may keep pace with or out pace inflation, while the true value of the amount you owe tends to erode. The opposite is true in a deflationary environment. To read more free articles on refinance and financing your home, please visit www.SmartRefinance.net
Jack Fredman Ph. D CPA Real Estate Consultant and Appraiser Dallas Texas