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?