12 factors that go in the decision Rent vs Buy a house – you can also download the Excel with a real example, change the numbers per your situation.
36 million people move every year, assuming these 36 million people represent 20 million households, 20 million households face the following question every year: Rent or Buy?
In most cases, people say ‘Let us start by renting and then see if we like the place enough to buy’. Although that is a very valid way to think about things, read on to find a holistic scientific method of determining what makes more sense financially?
12 Facts to consider
A. Renting is a smaller decision as compared to buying
B. Renting gives you more flexibility
C. Buying has big one – time costs (closing costs)
D. Buying also has big one – time costs when you sell (closing costs)
E. Renting gives you a right to live (use the property) for a predetermined period of time; while buying gives you a right in the property indefinitely till the time you choose to transfer your right
F. You can be asked to leave at the end of the lease if you are renting. You can decide to stay forever if you buy the place
G. Renting is easier – you just pay the monthly rent; you do not have to worry about property taxes, mortgage payments, insurance, and property maintenance
i. Although property maintenance sounds simple, in reality it can be quite an effort (specially if Home Owners Association is particular)
H. Rent is a pure expense, you pay money and you used all of it to ‘rent’ a place. While when you buy a residence, you are paying to live in the house PLUS you are building equity in the house. You will buy the house completely after 30 years of mortgage.
You can read here to see if 30 year mortgage makes sense for you or 15 years?
I. You do not get any tax deduction on the rent paid BUT you do get mortgage interest deduction on the mortgage interest paid.
Two things to note:
i. Self employed people can claim home office deduction even for rental properties
ii. Mortgage interest deduction phases out at higher income levels (a mistake that I have personally made)
J. When you buy the house you have more of a feeling of ‘home’. My girlfriend finds this feeling important so I am obliged to list it in the list.
K. Affordability: Total Cost of Ownership (TCO) is invariably higher than renting (because you are also building equity in the house), so one thing to keep in mind is whether you can afford to buy? Sometimes my friends get fooled into believing that mortgage payments are lesser than monthly rent payments – true but do not forget the 20% down payment that you have to make and the additional costs that go into TCO.
Before getting too mathematical
Before we go more mathematical, let us understand what all of the above intuitively means. There are one time costs associated with buying a home.
Since we know that the one time cost will get spread over the amount of time you live in the house, the one time cost per month goes down with increased time spent in the home.
So intuitively we know that buying makes sense if you end up living in the house over a longer period of time.
Financial factors vs Non-financial factors.
If you go through the above list again, you will see that many factors are financial and some factors are not-financial. For example, having a place to call home is a non-financial factor. How do you take those into account?
Do a financial analysis, keep your financial goals in mind, and then evaluate: Am I willing to pay $xxx extra in order to avail myself of the y and z non-financial benefits.
A direct fall through from our discussion above is the list of financial factors that should go into making the ‘Rent vs Buy’ decision.
Now let us walk through of an example:
A house is available for rent as well as buy – Rent is $3,200 a month and it is selling for $500,000.
If you buy, then you will have to pay Homeowner’s Insurance, Property Taxes, HOA dues, Appliance insurance, Repairs (e.g. roof), swimming pool maintenance, landscaping, pest control, and other costs too.
Some additional costs that you will have irrespective of whether you rent or buy: Electricity, water, garbage disposal, internet, phone, Cable TV (we are not including these in our discussion today but you should definitely include this in your budgetary decision: how much to spend on housing? I cannot emphasize more – Total Cost of Ownership TCO matters more than any other cost in isolation)
Let us assume bank gives you 100% mortgage (no money down so that we can compare Apples to Apples). There are 100% LTV (Loan To Value) loans in the market but they mostly come with PMI (Private Mortgage Insurance). It is not uncommon for PMI to be about 1%. Hence interest rates of 4 – 5% for Excellent credit are not unusual (I am myself paying 4.6% for my 2014 mortgage).
In our example, we are assuming the marginal tax rate to be 25% (This is important because this determines the tax shield).
We are assuming the loan term to be 30 years.
‘Stay’ is the period for which you intend to stay in the house. I am taking 5 years as the example – you can change it in the Excel. (All the things that are in Blue can be changed – actually everything can be changed but change only the values in Blue, all others are calculated values).
Buying costs are closing costs typically paid by the buyer (they vary state to state and can be anywhere from 2% to 5%), we are taking 3% as the benchmark for this rent vs buy analysis.
Selling costs are the costs you will pay when you sell the house – the largest costs are realtor costs, they are usually 5 – 6%. We are taking 6% in this rent vs buy analysis.
In addition to the realtor costs, there are other costs that the buyer might be required to pay at closing, we are ignoring those for the time being in this analysis.
We are also not considering costs that are needed to get the house ‘in shape’ to be sold. For example, some make over like painting is expected when you sell a house. Usually those costs are about 1% of the house value but they are ignored in this rent vs buy analysis.
These are the numbers.
When you rent, you pay the rent – $3,200 and nothing else.
When you buy, you pay the morgtage, taxes, insurance, closing costs (buying), closing costs (Selling), HOA dues, Other landlord expenses, and you get a mortgage deduction for the mortgage interest paid.
In our example, total owning expenses equal $4,584. Hence the difference between rent and buy is $4,584 – $3,200 = $1,384.
All of your rent is an expense BUT all of your mortgage payments are not expense. you are building some equity also in the house.
Whenever you make mortgage payments, a part of it is interest payment and a part of it is principal repayment. Outstanding principal goes down with every mortgage payment.
Mortgage payments in this scenario are 2,533 a month. We are talking about 5 years example, so over a 60 month period, total mortgage payments equal $152,006.
Out of $152,006; $44,210 are principal repayments (I used Excel formula CUMPRINC to calculate that). Hence average principal payment per month = $737.
So you are building $737 equity per month. Hence the true differential (rent vs buy) becomes $1,384 – $737 = $647.
By buying you are spending $647 more.
In most cases when people buy, they end up paying a premium to own. They pay this premium in anticipation that the real estate prices will rise faster than they have historically AND/ OR they like the feeling of ‘owning a home’.
In my case, this ‘premium to own’ is $647 a month.
Now this analysis will change if you think the property values are going to appreciate drastically in future (say the house is worth twice of what it is worth today – then although you pay $44,210 in principal payments, the house is worth a million dollars in 5 years). I strongly suggest people not to think of residence as an investment that will have lot of capital appreciation.
The analysis will also change if you stay for more than 5 years or less than 5 years (specially because one time costs will get allocated over a different period of time).
Needless to say, the analysis results will change if any of the numbers is different – like the interest rate, loan term, insurance, taxes, HOA dues etc. That is the reason I am providing the Excel sheet. It has the model built in – change the numbers and you will see the results.
One specific scenario analysis that I did is the following:
Remember the $647 from our discussion above? That is the intersection of $500,000 price and $3,200 rent in the table. What if the price was $500,000 and the rent was $4,000? then you will end up saving $153 every month while buying.
What if the price was $350,000 but the rent was $3,200? Then you are $432 better every month by buying. So on and so forth, I am sure you get the point.
Once again, this table is just indicative given the HOA dues/ maintenance expenses, marginal tax rate that I have taken in our specific examples. Your mileage will vary!
To Conclude, I see a lot of talk about people trying to save on their Starbucks coffee expenses and the like. All of those talks are very meaningful but consider the magnitude.
Apart from marriage (and perhaps education), mortgage is the single largest expense you will incur in your life.
Many people will tell you that you will be able to refinance the mortgage at any time – True, but there are costs associated. Do you know how much? A house that is about $500,000 can easily have $5,000 – $6,500 in costs when you refinance.
So it is important that you get it right the first time.
Also keep in mind that the mortgage companies spend a lot of marketing dollars to get your attention but you want to explore all your options (and this usually should include the local credit unions too).
Bankers intentionally or otherwise will make this decision difficult for you – Mortgage is a complex subject to understand if you weigh in all the financial implications; on top of that they will add ‘points’ and ‘credits’ to make it even more complex.
Still, I cannot stress enough that every hour you spend on mortgage choices analysis will pay off. I do not have the time today but recently (Feb 2016), I requested quotes for refinancing from three major banks I know are the best in the industry.
I realized that the financial difference between the best and worse option is $73,446. Yes, you read it correctly, the financial difference between the best and worse is almost seventy five thousand dollars.
(Although my case is a little too complex – because I am talking about an Interest Only ARM and hence it will take an entire new post to share the details, but it suffices to say that I saved Seventy Thousand Dollars – though it took me several days of effort to get quotes, create models in Excel, then counter etc, but it is time well spent).
You can download the Excel here and play with the numbers 30 year vs 15 year_Rent vs Buy
I am here to answer any questions - remember this will save you perhaps more money than all other financial decisions you will make in coming 5 years.