Astute readers will have noticed (and I often point it out in case you missed it), that when we are comparing two or more similar Scenarios to each other that we do not compare the amount saved to month 1. Instead, we compare month 2 to month 2. But, why? That’s a very good question.
The short answer is: your expenses when buying a property for the first month are very different than subsequent months, making comparison in month 1 less than ideal.
Now for the long answer in story form.
Imagine for a moment that you’re trying to compare two Scenarios. In one Scenario, you are a home owner and live in a property that you buy in the first month of your model. In the second Scenario, you are a renter who begins renting in month 1.
At first glance, you might think to yourself if my rent is equal to the sum of all the expenses of owning a home, that the amount that I save in the first month would be identical. Turns out, that’s not quite how it works. Why? Mortgages are paid in arrears. That’s why.
When you buy a Property and get a new mortgage on it you actually do not make a payment the first month you own it. You need to live in the Property for a month to let the interest on the amount you borrowed accumulate for the month so you can make the principle and, more to the point for this example, the interest payment on the loan. In other words, after living in the Property for a month, you’re making a payment for the interest that accumulated over the previous month; you are not pre-paying interest for the upcoming month when you make a mortgage payment on the first of the month.
So, when you buy a Property, you actually need to wait a month to have a payment that is due. If you think you’re pulling a fast one over on the lender; you’re not. You’ll catch up when you sell the Property. If you sell the property on November 30th, you’ll need to make a December 1st payment even though you never lived in the property for December. That’s because the December 1st payment is actually for interest that you accumulated in November.
Getting back to our primary question though: so, why do we compare the amount saved in month 2? It’s because you actually don’t have a mortgage payment in month 1 if you buy a Property in that month.
If you’re renting a Property to live in, the expenses for renting are typically represented in the personal expenses part of the Paychecks and Personal Expenses Rule and will show up in month 1. But if you buy a Property in month 1 your mortgage payment will not show up until month 2. So, the amount you saved in month 1 will look much larger for the first month if you’re a home owner than if you’re renting. If we tried to “match” the personal expenses of two Scenarios in the first month, it would not work.
Instead, what we’ve opted to do in most cases is to compare the savings rate for the second month where rent and the owner-occupant mortgage payment are both being accounted for.
Here are a couple of examples where you can see it for yourself.
Below is a chart showing the first three months of the total amount saved for two Scenarios: one where we are modeling a renter and the second where we are modeling a homeowner.
As you can see, the renter (shown in dark blue) is saving about $1,100 of their paycheck in month 1. The new homeowner gets to skip the first month of making a mortgage payment and is actually able to save $2,492.02. However, in month 2, they both are saving the exact save amount: $1,102.71.
Here’s another way to look at it with the same example. In this chart, I am showing the first three months. This time I am showing the total personal expenses including the cost of real estate.
In the chart above you can see that the expenses for the first month are lower for the homeowner, but they become the same in month 2.
We also see this phenomenon reflected in cash flow when buying a new rental property. Since there is no mortgage payment due in the first month you buy a property, the cash flow on the property in the first month is much better. Here’s a chart showing us buying a rental in month 18 and seeing a temporary 1 month bump in cash flow due to the lack of a mortgage payment that first month of ownership. After month 1, the cash flow normalizes.
So, I hope you can now see why—when we are trying to compare two or more Scenarios—we try to compare the total amount saved in month 2 (not month 1).
If you need further clarification on this, please do leave your questions below and I will try to explain it better.