The other day I wrote an article and mentioned the challenges Millennials are having purchasing a home. I received so many comments and direct emails in support of renting vs buying that I decided to analyze the question in today’s post.
The most expensive single asset for most people is their home. For many, not only is their home the largest asset they own, but as recent studies show, the average American looking to retire has less than $200,000 in net worth almost all of which consists of equity in their primary residence. So the average American is relying heavily on home equity to fund their retirement.
For many, the question of renting vs buying is based on whether you can afford to buy. But another question is whether it is better financially renting vs buying. As we know, just because you can afford something doesn’t mean you should buy it. And a house is no different. In fact, it’s probably even more important with a house considering the significant costs involved.
It’s useful to look at a comparison between buying a home and renting a comparable one. For purposes of the comparison, let’s assume a house with a value of $500,000 as compared with renting a comparable house over a 10 year period.
To determine the breakeven for renting vs buying let’s look at the true costs of home ownership.
Cost of Home Ownership
Buyer transaction costs. Including real estate costs, title costs, appraisal, inspection, and closing fees, expect to pay 3% of the value at closing when you buy, which in our example equals $15,000, or $1,500 per year over the 10 year time horizon.
Seller transaction costs. At the end of the 10 year term, assume you will sell the house and this time pay approximately 5% in transaction fees – the seller often pays a larger portion. Assuming 1% annual appreciation, the value will have increased to $552,000, and 5% in fees will equal $27,500, or $2,750 per year.
Interest expense. Assuming you put 20% down, that leaves $400,000 financed through a mortgage. Using a 4% interest rate, you’ll spend about $20,000 per year in interest. At a 25% tax bracket, you’ll save $5,000 of that, netting $15,000 in annual interest expense.
Property taxes. Assuming a 1% tax rate, you’ll pay $5,000 per year in taxes.
Property insurance. Assuming 0.25% of the value, you’ll pay $1,250 per year in property insurance.
Maintenance. In order to keep the value of your home from dropping, you’ll need to spend money to fix broken items, to maintain the structural items, and update from time-to-time, All together, expect to spend 1% of the value on maintenance, upkeep, and renovation. In this case, that equals $5,000 per year.
Opportunity cost. Don’t forget that you will need to invest 20%, or $100,000, as a down payment. If you assume you could generate at least 2% per year in investment returns with this money, that’s another $2,000 per year to be added to the cost.
The above totals $32,500 per year.
But the big financial reason to buy rather than rent is the appreciation of hour house. As we mentioned above, assuming 1% annual inflation, your house will increase $52,000 over the ten-year period, or $5,200 per year.
This brings your net cost to buy down to $27,300 per year.
Cost to Rent
In addition to your monthly rent, you’ll also need to factor in an upfront security deposit equal to between one and two month’s rent as well as renter’s insurance.
And there are two other considerations to take into account when deciding between renting vs buying.
The first is rent escalation. If the property rental rates are increasing at a rate comparable to the increase in home prices, in the above example, rent will increase by 1% per year over the ten-year analysis period.
The other big consideration is flexibility. When you own your home, you can do with it what you want (within reason and within the constraints of any city, county, state, or homeowners’ restrictions). If you want to change something, you can do it. If you want to add a pool, or another room, or change the color, you can do it.
Maintenance – The Downside to Owning
Apart from the financial costs described above, the downside of owning is that you must handle the maintenance, upkeep, and renovations yourself. Some people don’t mind doing this work themselves, and may actually enjoy it. Others cannot stand it and would rather outsource thereby costing more money.
Which is the Better Option – Renting vs Buying?
In the end, the financial decision as to whether it’s better to buy rather than rent, comes down to rental rates as a percentage of purchase price for homes in your area. In the example above, in order for renting to be financially better than buying, rent expense needs to be less than $2,275 per month. Another way to look at it, if annual rent expense is less than 5.5% of the home value, you’re better off renting than buying.
This is pretty simplified, but in general, what are rental rates (as a % of purchase price) for houses in your area? Is this the primary reason why you are choosing to rent? Or is it something else? Flexibility perhaps?
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Hi there FS, I’m in position of being both an owner and a renter. I own three houses but rent an apartment to live in. The reason? My houses are all located in Auckland, NZ, which is a market that has seen huge capital gains in property over the last 10 or so years. But, I live in Brisbane, Australia, which has has a stagnant property market for 10 years. In fact, some months growth is actually negative.
So, as inconvenient as it is to own property overseas, the cap gains on these make it worthwhile holding on to for now which I am doing. However, the cost of renting here in Brisbane is about half the cost of buying the equivalent property since we don’t have to pay insurance, maintenance, body corporate (home association) fees or water.
The key benefits, to me, of owning rather than renting is that you have the security of knowing that you can’t be evicted, and that you have the opportunity to add value and personalise the property.
When I look at purchasing a property, whether as a rental or to live in, I always look at how I can add value to it, whether a paint job, landscaping, or some renovation work. This is often the only way you will capitalise on a property, when you sell, especially when owning in a stagnant market.
I have to admit, I never look at a property from an emotional point of view. To me it’s 4 walls and a roof that I can live in (or rent out) that has a current value and I want to know how I can increase that to sell for a profit in the future.
Perhaps a little hard-nosed for some but it has provided me with my financial independence which I am now enjoying the fruits of.
However, done right, property buying/selling can make a significant difference to your retirement portfolio worth.
Sounds like a solid strategy. Do you have a property management company taking care of the houses? How much does that impact your profits?
Good question FS and one anybody considering buying a rental property should consider if they don’t want to deal directly with tenants or if they are not local as in my case.
In NZ, rental properties need to have someone managing them so if the owner is not going to do this, they must appoint someone who the tenants can contact. It doesn’t have to be a management company but this is often the easiest option which is what I do.
Management fees range from around 5% up to 7.5% of the rent but can be higher for premium properties. Three monthly inspection fees are on top of that again. Yes, this does impact my return but a) I don’t have a lot of choice, and b) the capital gains still make the properties worth hanging on to.
Your breakdown for home ownership looks accurate and I think a lot of people ignore some of the costs.
I prefer to own, and treat any home purchase as an investment on top of a place to live – MN real estate has been insane the last year, a lot of people are priced out of the market
It’s great if you can be detached and treat your primary residence as an investment. Not everyone can do that.
There are many markets at historic highs right now. It’s one of the reasons I am struggling with where to put idle cash.
That’s a nice breakdown you did!
I’m very happy with my house and neighborhood, but I was happy living in an apartment as well (I’m pretty easy). It’s a pretty big investment to buy a house to live in. And unfortunately, you don’t get any cash flow out of it like you do with a rental property. I also miss not mowing, snow-blowing, and doing home repairs!
On the other side of the coin, it’s much easier to entertain company with a house. I’ll also have it paid off in a handful of years which will make it a lot cheaper every month to own at that point.
Good and bad!
— Jim
I have tried to think back to when we bought our first house. At the time, I wasn’t thinking much about the financial impact beyond how much I could afford.
Now that I am looking at early retirement as a viable lifestyle choice, the analysis might look a little different.
When we bought our home, we did so assuming we would never sell it. Not because we want to live in it forever (though we could, it is lovely) but because we live in a college town and know that unless something terrible happens to the university, we will always be able to rent it for more than the mortgage. And rents will typically be higher in 10 years than they are now, while our mortgage payment will stay the same. Our mortgage is less than what we were paying in rent, so even with the hassles of repairs it’s more than worth it for us to own.
Also, if we didn’t own our house we probably would not be able to rent our basement out on Airbnb-we’ve only being doing this since November, but we have made at least the mortgage + property tax payment every month, and more in May because of graduation.
That’s a great setup. And I agree, there will probably always be demand for your rental due to the nearby college campus.
Don’t be a fool… You do not need 20% Down to buy a home.
True. There are programs that allow you to buy with 5% or even 3.5% down. But it will typically cost you more – PMI, higher rate. It’s also risky. You can easily find yourself underwater if housing prices decline even a small amount.
But as long as you are aware and you’re comfortable with the extra cost and increased risk, it may be worth it.
The 20% down payment is a truly huge some for many folks. In the US, the FHA loans can be really helpful in this regard. Most homes in my area go for $250K. The need for a DP prevents many of us from moving away from renting.
ZJ:
I agree. Especially in an expensive market, 20% is tough. What is the down payment requirement for FHA? Isn’t it 5%?
I’d rather buy a multi-family home, live in one of the units, and rent out the rest. Divert the rent to the mortgage payments and even if you are taking losses each month, you’re still coming out far ahead of “buyers” and “renters” alike.
Sincerely,
ARB–Angry Retail Banker
ARB,
With the tax advantages as well as essentially living rent free, living in your rental makes sense.