Rent vs Buy a house

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?

My Recommendation

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!

CONCLUSION

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.

11 thoughts on “Rent vs Buy a house

  1. Hello,

    I am Vancouver Canada and it makes more sense to rent than own generally, as real-estate prices are extremely high compared to the cost of rent. However, fortunes are made (dimes are saved) with real estate due to tax advantages.

    The Unites states does not benefit from Canada’s tax major advantage (primary residence gains are tax free). However owning real estate in the states is still good. Specific mortgages are difficult to give much insight to but would love to see you elaborate on the tax advantages of holding property.

    I am aware of depreciation, refinancing (tax free money), and 1031 exchanges as primary ways to make your $ work hard for you.

    Zachary

    • Hello Zachary,

      In US too – primary residence gains up to $250,000 ($500,000 for a married couple) are tax free.

      You are able to deduct all your costs (brokerage, insurance, repairs, taxes, interest, HOA dues).

      You accurately mention depreciation – In the US you can deduct the entire investment in 27.5 years.

      My article comparing stock market with real estate investment also might interest you: onemoredime.com/2015/11/18/real-estate-versus-stock-market/

      About your comment on fortunes are made (dimes are saved) with real estate due to tax advantages – like I mention in my above mentioned article, real estate offers tremendous tax advantages, but there are several challenges with real estate market.

      Additionally, here I mention how leverage can be used in stock market – leverage enhances returns and has tax advantages as well.

  2. Aren’t you forgetting the money received when you sell a house? So, you pay XX dollars to rent and with the costs, buying could be a little more. But when you move and sell, you will get virtually all of that back. That’s never an option when renting.

    • Actually no, I am not forgetting the ‘money you get back when you sell the house’.

      Are you able to locate a table where I have listed rent expenses in one column and own expenses in another? Rent outflow total to 3,200 and own outflow total to 4,584? The difference between them is 1,384.

      But then I explain how the expense difference is only 647 more (the remaining 737 per month is building your equity in the house – this is the money you get back when you sell the house).

  3. Does your analysis include annual rent increase? Fixed mortgage won’t increase, but my rent in CA could increase as much as 10% per year. You also pay a premium for flexibility.

    • My analysis does not include annual rent increase. The reason being – I am also not including ‘change in market conditions’ even on mortgage. IF you take a fixed rate mortgage today, and the interest rates in future drop, your mortgage will become much more expensive than you originally intended it to be.

      In short, my analysis takes a snapshot of conditions today and not include predictions about future – because then we get into ‘how reliable are the predictions’?

      Having said that, your point about increase in rent and premium for flexibility is valid.

  4. To me this entire argument is flawed for one main reason: The vast majority of people buying a 1/2 million dollar home aren’t renters. You need to be looking at $100-$300k homes, because the likelihood of a home like that being a rental is much greater. Generally speaking, in most parts of the country, you will pay around $700/month total- give or take, in costs for a $100k home. However the rent on that same home will be in the ballpark of $1,000/month.

    Your “About Me” says you are “exposed” to homes all over the country. Is that your way of saying you use Realty Shares or something like that? Because I, on the other hand, actually own 5 homes and 4 of them are rentals. The homes are worth between $90,000 and $850,000 and are in two different states.

    One of them is in Huntsville, AL. The home is 15 years old, is worth $160,000 and my monthly payment is $840. I put down 3.5% when I bought it. That $840 includes principal, interest, taxes and insurance. HOA is $25/month. The rent I collect is $1,300/month. After maintenance I pocket about $4,000/year and never ever have a shortage of reliable tenants. My other 3 rentals each bring about $3,000/year after all costs.

    I’e now owned rentals in a very bad market (2009) and in a good market (today). In both markets it isn’t even worth arguing that buying is better than renting.

    Not one year, ever, on any of my homes have I lost money. One year the entire house flooded, insurance covered it all and I got a complete remodel for free. I’ve always had a waiting list of renters on all of the homes.

    If someone is having to rent out their $500k home then it’s likely for an unexpected scenario, and unexpected scenarios generally mean you lose money.

    If you mean to say you actually own homes all over the country, then why? According to your logic that would be a stupid thing to do.

    Except in rare circumstances, it always pays to own as opposed to rent. Plain and simple. Contrarian arguments make for nice long blog posts, but in reality they just don’t hold up.

    • This post was written from the perspective of a person who is deciding whether buying is right for him or renting is.

      You are talking from an investor/ owner perspective. To address your comments:

      You are right that cap rate is higher in relatively cheaper properties, but the associated problems are also higher – eviction, late payments, tenant turnover, among other things.

      I am not doubting the experience you have had with your multiple properties.

      Now, please look at the post from a person who is looking for a place – whether he should buy or rent? Then the most might not appear as flawed as it did the first time.

  5. “Renting vs Buying a place to live” seems like a never ending debate. I decided to do some research with numbers from my personal experience and some additional from popular sources like Zillow and direct local info. I also posted that in Quora.
    This is a copy from my post there:

    ‘The question will have different answer depending on the time and place, personal values, individual financial skills. For example different countries, different USA states have different property taxes as percentage of the real estate value(e.g. NY avg 3 .01% vs Al avg 0.4%), In many Eastern European countries those taxes are less than 0.2%. Aslo things important to consider:

    -construction type of the real estate(wood, steel, concrete, brick, etc),

    -location(transport hubs, big facilities(infrastructure), hospitals, universities, trade centers, tourist destination, etc),

    -ethnical homogeneity, crime rate, uniform educational system (e.g. Hawaii vs AL).

    I will take for example average family in IL which would accommodate in relatively modest apartment, or condo in Chicago area(third largest metropolitan area in the USA). IL has relatively average percentages for real estate taxes, maintenance, viable locations, etc. E.g. -” New York (3.01 percent), Texas (2.18 percent), Illinois (2.15 percent), Connecticut (2.11 percent) and New Jersey (2.01 percent).”

    Current(2015) average apartment(condo) price in Chicago area a little bit under $200k to around $190k. HOA range $2.5-$4K/yearly that makes average HOA- 1.7%/yearly, average long term real estate tax(as percentage of property value) for the area-2.15%. Maintenance and upgrades- long term maintenance is usually 1%-2% depending on the type of building wooden and steel buildings have higher maintenance since most of the residential building is blend of steel and wood. HOA takes big part of the maintenance. However the apartment itself is responsibility of the owner(kitchen, bath, floor, tiles, selling, walls, painting, etc). I will take the government allowance for depreciation of residential building in the area which is 60 years(39 yrs for commercial,2.52%) that makes 1/60 of property value approximately 1.7%. Also this does not include upgrades, i will assume an average time of keeping the property, and paying for it around 20 years, with upgrades before sale around 8-10 % of its value. This will make an average of 9%/20=0.45% for upgrades. ThenMaintenance&upgrades average 1,7+0.45=2.15%. Insurance(inside the condo only) 0.5%, Usually water&garbage are included in HOA. This is often not the case with utility like gas which will be around $1k/year i.e. 0.5%. Transaction buy /sell cost 1-2% buy, 7-8% sell; 10/20 yrs=0.5%. Other(pest control, door fixings, etc) 0.2%. So far we have fixed long term average yearly cost as percentage of the property value: 2.15(tax)+1.7(HOA)+2.15(main&upgrds)+0.5(ins)+0.5(utility)+0.5(transaction cost)+0.2(other, e/g. pest control)= 7.7%

    These are fixed expenses assuming one pay all in cash for the property(by the way with relatively historicaly low mortgage interest and well performing stock market one has no interest of paying upfront for property unless offered big property discount for cash payment). The usual situation is the min 20% down-payment, we take in account the opportunity cost loss(here i will take the average long term(10yrs&up) yield ofS&P 500 for the last 25 years. with dividend reinvestment which is 9.81%. S&P 500 Index ,current average interest on mortgages around 4.25%(note this is historic low comparing with average last 15 yrs of around 6%)). Then we have down payment opportunity cost loss: 0.2×9.81%= 1.96%, interest+opportunity cost on the principal loss: 0.8x(4.25%+9.81%)/2= 5.63%, Total opportunity cost loss: 7.6%

    (note if property was paid upfront cash then the opportunity loss will jump equal to the S&P 500 performance of 9.81%)

    I will take a Zillow average home price growth for Chicago area of 3.7%.Then, we have income tax incentives as deductible from the income tax assuming 25% tax bracket and one third(1/3=0.33) of the house expenses recognized(mortgage expenses above the standard deduction) under schd. A itemized deduction then 1/4×1/3=1/12; 1/12x (7.7+7.6-3.7)=0.97% apprx 1%. This calculations bring thetotal compound cost of owning average real estate here around 7.7+7.6-3.7-1=10.6%.

    Average rent per sq ft according zillow is around $1.29 that makes around $16k/ year for rent on $195k property value that makes around 8.1%. including most utility but electricity and internet/cabel. Here we received our result comparing owning vs renting: -10.6 vs -8.1%. It seems that the average buyer in the area losses money on his/hers investment with average long term return of minus 2.5%( -2.5% ) . In our case, property value of $195k, means $400 monthly loss.

    This brings the question how the landlords make money if the average retail owner actually losses money and why they do invest in rel estate, instead the stock market for ex?

    The answer is economy of scale.

    Similar to utility where most of us don’t have interest to get our own water, heat, electricity, intranet, etc. At least for most of us doesn’t make sense to deal with these things. it gets times cheaper when these things are done in the numbers of million than single units. The same here, landlords with thousands of managed apartments get half of the total of compound price(around 6-7%) of a retail individual investor.they save from to name just few: property taxes, interest, maintenance, etc because of the size of the deals they do-economy of scale. They often get leveraged positions(30%) with huge low interest loans where they get 2% difference with leverage of 3-5 times this gives them relatively secure yield of 6-10%/yr. which is lucrative in turmoil in other markets(e.g. stock, commodity, treasury notes, etc).

    So at least, in the case of Chicago area(and probably most other areas in the USA since the difference of -2.5% couldn’t be compensated with even the lowest property tax in Alabama) the average home owner is losing money. Here, I didn’t even included significant long term risks as potential cost, cost as:Neighborhood change over time(e.g. crime rate change, school change, shopping places change), job relocation, real tax increase, natural disasters, etc. and many complications that could follow from that. For ex job relocation leads to long commute times and indirectly makes the owner to use convenience stores for grocery shopping where most products are more expensive. This indirect cost is in addition to the increase travel cost as gas, car repair, etc.

    However, for many buying a home still makes sense if they lack financial discipline, their home acts like forced long term commitment saving account with negative rate. In our case 20 years and (-2.5% yield). They don’t get good value of their “investment” but at least they have something saved.

    Many people are tempted to spend all they have for food, ,restaurants, drugs, cars, trips, furniture, entertainment, electronics, etc. All these don’t keep their value in a long run.However, this is arguable depending on the point of view/ individual value system. Memories could be the most valuable thing, though the same goes for the sense of community, and personalized own home place.’

    • GREAT analysis, thank you for sharing Stan, very detailed and factual.

      I particularly like the way you have ‘normalized’ the HOA as a % of the property price. ‘HOA is about 1.7% of property price annually’ – that is a very smart way. In many of my Excel Spreadsheets, I was ‘normalizing’ many other variables like taxes, insurance etc; but HOA was a standalone number – now on I will use the 1.7% as proxy (if I do not have a more accurate idea about the property).

      You are also right about the spending habits – sometimes it is just about at least being able to save the equity you are building in the house (otherwise people will spend every thing): same logic applies to credit cards. Technically the more you have the better it is, unless of course the more credit you have the more you are likely to spend.

      • Thank you for your reply Bob.
        I see specialization, concentration of knowledge and personal resources/capital as key in personal well being/happiness. However person should be open to different type of knowledge. Applying ‘economy of scale’ concept as part of ‘ transformation of quantity into quality’ is important. It is easier for a person to create wealth when he/she are knowledgeable about how the system works and are aware of the trends. So knowledge and skills should be priority over ‘raw’ capital. Many times it makes more financial sense to ‘rent’ over ‘owning’ a service, or object. Depending on the person needs/consumption.

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