THE SCENARIO If I were to win, earn, or inherit $200,000 (after taxes) all at once, I could do quite a bit with that money. I could buy several cars, upgrade my living situation, or take a mind-blowing vacation. However, if I wanted to use that money to set myself up for a comfortable retirement, I could do so in several different ways. Let's compare two of them. Option 1: Buying stocks I could invest the money into the S&P 500 index (this approach is recommended pretty commonly by financial advisors, so it must have some merit), and it might make an average annual return of 7.5%. Option 2: Buying rental property I could buy a rental house, and it might net me $400 per month in rental income (after depreciation, property taxes, maintenance, management, and other expenses) and appreciate at a rate of 3% per year (assume it can be sold with no costs and no taxes at the end). While I'm renting the house for those 25 years, I'll take the $400 per month in net rent and invest that in the S&P 500 where it would make the 7.5% annual return. The question: At the end of 25 years, which of these approaches will leave me with a larger lump sum of money?
THE SOLUTION This one has several parts, which are all pretty straightforward.
- Determine the value of my simple S&P 500 purchase after it grows for 25 years
- Determine the value of the rental property paired with the over-time S&P 500 purchase
- Determine the value of the rental house after its appreciation
- Determine the value of the S&P 500 investment that's being contributed to over time
- Add them together
- Compare the two results
After 25 years, my stock account will be worth $1,296,576.09.Step 2.1: The house's appreciation N: 300 (The investment will last for 25 years, which is 300 months) I/YR: 3 (We're assuming that the house will appreciate 3% per year) PV: -200,000 (At the beginning, the house is worth $200,000) PMT: 0 (The house's value doesn't have any monthly contributions or withdrawals) FV: (This is what I'm trying to find)
After 25 years, the house will be worth $423,003.91.Step 2.2: The over-time S&P 500 investment N: 300 (The investment will last for 25 years, which is 300 months) I/YR: 7.5 (We're assuming that the index fund will yield 7.5% per year) PV: 0 (Since I'm investing net rents, I have nothing at the beginning) PMT: -400 (I'm investing the $400 per month in net rent from the rental house) FV: (This is what I'm trying to find)
The stock account with over-time purchases will have $350,904.35 in it at the end.Step 2.3: The house's total Adding up the house's value with the over-time stock account value, the buy-a-house approach will give me $423,003.91 + $350,904.35 = $773,908.26 after 25 years. Step 3: Comparing the two If I bought the stocks with the whole lump sum up front, at the end I'd have $1,296,576.09. On the other hand, the house approach yields me only $773,908.26.
So the stocks-only approach would leave me with $1,296,576.09 - $773,908.26 = $522,667.83 more than the house-and-stocks approach.
What do you think? Did you expect this answer? Does it make sense to you? Did I miss anything? Let us know in the comments!