rent vs buy

photo: renjith krishnan/freedigitalphotos.net

You just arrived in a new city after a promotion, job change or a change in family circumstances. Or you just sold your house because the real estate market is heating up again and someone said you can have people bidding against each other. Now you’re faced with the age-old question: do you rent or buy your next home?

There are two kinds of considerations, hard money logic, and the fuzzy factors, difficult to quantify.

Intangibles

These are the things that are not about money, but are still important.

Home Ownership

To some people, it’s important just to have a feeling of home ownership, that this roof and these walls are mine, and nobody can take it away from me. Well, nobody except the bank who owns more of it than I do. 🙂

Personalizing

When you rent, you usually are not allowed to repaint the place in colors you like. You can’t add on a deck and convert the basement into a study or guest room. And you can’t redo the landscaping. when you own, you have much more freedom to add your personal touch. For example, here are before and after shots of the same  location, less than three years apart:

Before and After

Some people are indifferent to the details in the space in which they live. Others, though, care greatly, and spend time and money to personalize their homes. For such people, buying is the only option they’ll go for, except of course if they can’t afford to buy.

While you can put plants and pictures in a rental home, you can’t add a deck and an awning.

 Security

A landlord can kick you out whenever the lease expires, for pretty much any reason. When you buy, you have the security that as long as you make the mortgage payments, nobody can kick you out. And if you’re fortunate enough to not have a mortgage, even that tiny threat goes away.

Numbers

In addition to the fuzzy considerations, there are some numbers to consider. Most of us have heard two arguments in particular:

  • When you rent, you just throw all that money away.
  • Your home is one of the best investments you’ll ever make.

Are those arguments really true?

“Throwing Your Money Away”

What’s unspoken here is that when you buy you’re not throwing any money away. That’s simply not true. As all homeowners know, there are plenty of things you “throw money away” on when you own your own home. The biggest of course is the mortgage interest. That’s just gone forever. What about the tax break? Well, in order to get a tax break of $20, you have to spend around $100 (depending of course on your tax bracket). That means you’re still “throwing away” $80, or 80% of what you pay in interest.

But that’s just the beginning. Then you have property taxes, homeowners insurance to protect the bank (Grant loves that one), and the never-ending repairs and things you buy simply because you can. The movie The Money Pit was made about home ownership, not renting. That’s not a coincidence.

The only part of the cash you spend when you own a home that’s not “throwing away your money” is the principal on the mortgage you pay. And again, as any homeowner knows, for the first ten or so years, that’s almost nothing.

Therefore, just repeating the hackneyed phrase that you “throw all that money away” is misleading. You can throw as much away, or even more, owning your own home. Therefore, it’s entirely possible that if you rent your entire life, you can end up better off.

But, as you’ll see shortly, that only happens if you do certain things right.

Your Home Is Your Best Investment

For this argument to be true, it would have to have had a better performance than any other investment available to ordinary individuals. Your home would fail this test, because there are investments out there which have for decades performed better than a home as an investment.

This chart shows that if you invested, say, $250,000 (the price of a middle-of-the-road house) in a simple S&P 500 stock index fund, your return over the past twenty-odd years would have been significantly better.

Home price vs SP 500

Average home price vs. the S&P 500 index

Of course, very few people have $250,000 to buy a house for cash. They only put down, say 20%, or $50,000. Now it gets a little more complicated.

Comparison

Let’s take the two arguments above and put together a spreadsheet showing how all the factors compare when put together.

When you do that, one number emerges as the critical number, and that’s the ratio between the monthly rent for a given house, and the purchase price of that same house. And the tipping point turns out to be close to 0.44%. That simply means a house selling for $250,000 will rent for $1,100 per month. If the rent is higher, the ratio is higher.

Let’s see how that plays out. Let’s start with the breakeven scenario, i.e. the choice between $1,100 a month in rent and buying the same house for $250,000.

rent or buy

Rent or Buy: breakeven at $1,100 and $250,000

What this chart tells you is that after 20 years, it’s a wash. Choose what you like.

However, in today’s market, rents are higher relatively. In our neighborhood, a $250,000 house can rent for $1,600 a month. Let’s be a little more conservative and say $1,500. That computes out to 0.6% rent/purchase.

rent or buy 0.6

Rent or Buy with $1,500 rent for a $250,000 house

Not surprisingly, it’s better to buy a $250,000 house than to rent it for $1,500 a month.

But what happens if you can rent the same house for, say, $1,000 a month?

Rent or Buy

Rent or Buy for $1,000 rent on a $250,000 house

Now renting (the orange line) is the better option.

Summary

It’s clear, then, that there are times when renting is better, and other times when purchasing is better. The determining factor is that ratio between rent and the purchase price.

One final note: in order for a renter to do as well as a buyer, he or she will need to have the same down payment and invest that down payment in a stock index fund. There is a certain element of forced savings buying a home imposes on you. If you’re able to adhere to that same discipline as a renter, you will reap similar investment rewards.

If, however, you don’t invest the down payment and the difference between the money spent on rent and what you would have spent if you bought, then you’ll be significantly worse off, regardless of the ratio. But that won’t be because of the way the numbers work out, it will be because you elect not to invest.

Not investing, that is a bad decision… very bad. If you don’t trust yourself, then the answer is simple: buy.

 

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