Owning vs renting

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There is no definitive answer for owning vs. renting a home. There can be a financial answer as to whether it is cheaper to buy or rent. However, other considerations such as emotional, environmental, and flexibility can sometimes outweigh decisions that may not be financially justified.

Financial considerations

Home affordability

The first step in the decision-making process is to determine whether or not you can afford to purchase a home.

Issues to consider include your ability to make a down payment (generally between 5% and 20% of the home’s purchase price) and pay closing costs (which may be an additional 5%). These costs are likely to exceed substantially the initial payment and security deposit that would be required if you rent. [1]

The initial purchase is only the first of many expenses incurred in owning a home.

Many financial experts suggest that your monthly mortgage payment not exceed 28% of your gross monthly income and that your total monthly debt payments not exceed 36% of your gross monthly income. If you go beyond these limits, you may run into trouble because, in addition to paying the mortgage each month, you have to factor in home maintenance.[1]Everything, including the kitchen sink, costs money and nothing lasts forever.

Renting may be better from this perspective because it provides a fixed-dollar cost for monthly rent expense. If maintenance issues arise, the landlord pays for the repairs.

Buy / Rent calculator

This New York Times calculator[2] can help you calculate how long you will need to stay in your purchased home for it to be more cost-effective than renting. Please consider increasing the Investment Returns under general settings to 7 or 8%, or to try a range of values. (See Historical and Expected Returns for the justification of why an asset allocation of stocks and bonds should return more than the calculator's default value of 5.5%.)

There are transaction costs associated with buying and selling a home. In particular there are mortgage closing costs when you buy, and a broker fee of about 6% when you sell. Therefore, a house normally must be owned several years before it appreciates enough to offset the transaction costs and make it cheaper than renting.

The Bogleheads' forum has suggested that if you do not know if you will be in a property for more than 5 years, there is no financial advantage to owning a home. Renting is the best choice in this case.[3]

With no other information, that is probably a good rule of thumb. However, stating that it's always better to stay in a house for (pick a number) years instead of renting may not be realistic. The situation varies with the individual. In some cases, the advantage can occur as early as 2 years. In other cases, it could be as late as 15 years, and for some it may never break even.[3]

Owning as an investment

Separate from the value of having a place to live, a home is an asset that increases or decreases in value over time.

The underlying housing equity is a real asset, but it is an incredibly poorly returning one. According to economist Robert Shiller, "the average annual real (net of inflation) increase in home prices was a mere 0.40%"[4].

Of course, any given house might double or triple in value. But it also might lose value even faster. In any event, housing is always an extremely illiquid asset. Unlike stocks or bonds, it can take months to sell a home, and there is a serious risk that if selling during the wrong time, a homeowner can get significantly less than the long term average price.

As an asset class, homes also tend to be highly correlated with economic conditions of their locale. So, if you lose a job because of hard economic times (such as in Detroit), you may find your home equity simultaneously diminished.

Finally, a home is by definition undiversified. An individual home's value may not track the aggregate residential real estate's market value, even if the housing market in general performs well. Although homeowner's insurance, flood insurance and earthquake insurance should protect you from fire, flood, and earthquake, insurance does not provide any guarantee that you will get back the money you paid for your house upon sale.

Comparison of financial benefits

When comparing the financial benefits of owning a home to equivalent investment choices had the money been invested otherwise (equities and fixed income), be sure to include:[3]

  • Purchase price versus current market level
  • Taxes
  • Money used for the down payment

The amount of interest over time from the down payment, e.g. 30 years, is probably the biggest single factor missed when comparing investments.

Forced savings

Part of the mortgage payment is applied to the loan principal and thus can be thought of as "forced savings" that would not occur if the money was spent on rent. For example, with a 5%, 30 year mortgage 22% of the loan payment goes to principal the first year. During the 5th year 29% goes to principal. If the interest rate is 7% the amounts that go to principal in the first and fifth year are 12% and 18% respectively. These percentages are with respect to the loan payment, excluding taxes and insurance and other fees. These extra fees will reduce the percentage of the overall payment that goes towards principal accordingly.

Taxation

There is a large taxation benefit to owning a home versus renting, but it is not the mortgage interest deduction. That deduction is only open to the 30% of taxpayers who itemize their deductions. Plus, the deduction phases out when certain limits are reached.[5]

In any event, mortgage interest is an expense that makes less of the cost of home ownership go toward your equity. The deduction (when you can claim it) lowers that expense, but the expense remains.

The biggest tax advantage of home ownership is the capital gains exemption. The first $250 K of profit ($500 K if you're married) from your primary home sale is exempt from capital gains taxes. If you make $500 K on your home sale, that is $75,000 (at the 15% long term capital gains rate) that you don't have to pay. The value of this exemption depends on your opportunity cost. If you would have invested the excess money for your home into tax-advantaged retirement accounts, the exemption may not mean much. If your choice is between purchasing a primary home and investing in a taxable account, and you plan to sell the asset (house or mutual funds) before you die, then the $75 K is a significant benefit. If you leave the house or the mutual funds to your heirs, the capital gains treatment is the same, in that they get a stepped up basis at your death.

Impact on portfolio (negative bonds)

As a liability, a mortgage note is a negative bond. If you have $300K in bond funds (loaning money), a $300K mortgage note (borrowing money) offsets the bonds in the portfolio.

The house's fair market value (FMV) is an undiversified and illiquid asset that counteracts the negative effect of the mortgage note. The net asset value (FMV less mortgage note) can become liquid and subsequently diversified when the asset is sold in a competitive market[6]. Implicit rent, which is the amount a homeowner would pay to rent, or would earn from renting the house in a competitive market, is also considered a real (positive) bond. The implicit rent is only like a bond in that you can think of it paying a "coupon", but that coupon is a housing voucher good for a month's implicit rent at a single address.[7]

Inflation and deflation

In a high inflation environment, homeowning has two advantages: the value of the home generally stays consistent with inflation, while the cost of a fixed mortgage shrinks dramatically. Thus, the 1970's were a great time to own a home. Going forward, it is possible but unlikely that the US will again experience such high inflation. In addition, there are investment securities such as TIPS that more directly let you preserve your wealth in an inflationary environment. If deflation occurred, the fixed mortgage would become more onerous over time, though you could keep refinancing every few years.

Asset protection

Main article: Asset protection

One advantage of home ownership over owning mutual funds is that in many states, one's primary home is protected against creditors in nearly all circumstances. This could come in to play in bankruptcy or if there were a large lawsuit judgment against you. Florida's homestead exemption [8] has no limit to the value of the house that is protected.

Environment

Your lifestyle influences where you live.

  • The city life or the suburbs
  • Distance from work
  • Availability and cost of public versus private transportation
    • Parking may be a significant cost in the city
  • Proximity to shopping, destination spots, health care
    • Living near health care providers can be a significant influence for some
  • Privacy: living as far as possible from others versus right next to your neighbors

If you can only afford properties (or rentals) in environments that do not fit your preferences, you need to reconsider your options. For example, if you love the city but cannot afford to own, then consider renting.[9]

Location is also important. If you like the area, or if you want to be near friends and family, then you might want to choose accordingly.[3]

Psychology

Many people get a psychological benefit from owning a home. They like feeling that a piece of property is theirs, and that they can settle in and relax there. Homeowners have the maximum say over who can enter their home. Many homeowners get satisfaction from home improvements projects they fund or do themselves.

Like renters, ownership is dependent on making monthly payments. Homeowners should remember that even after the mortgage is paid off, insurance and taxes must still be paid.

Flexibility

Relocation

The biggest advantage of renting is the flexibility to relocate relatively easily. The situation in which you bought your home can change.

For example, the perfect house you bought a few years ago may now be a grueling cross-town commute from the great new job you were recruited to. The second kid may mean that you need more room. Having the kids leave home means that you're paying for far more space than you need or want. That leaves some homebuyers in a situation where, due to frequent moves, they are always worse off owning than they would be renting.

On the other hand, with the flexibility of renting comes also some instability. The landlord can always raise the rent or ask you to move before you are ready to do so. If you own a house and make the payments, you can stay as long as you desire.[9]

Property improvements

An owner obviously has far more flexibility to make improvements to a home than a renter.

Homeowners who choose to live in areas run by a homeowner association [10] are under significant restrictions, known as Covenants, Conditions, and Restrictions (CC&Rs), on the ability to change their home. For example, many CC&Rs restrict the color you can paint your house, the kinds of plantings you can make, and what you can keep in your front driveway.

Although counter-intuitive, many people make improvements to their rental properties. For example, if you're going to be in a rental for a year or more, you may decide to repaint a room or change a fixture. If you have a reasonable relationship with your landlord, she may approve you doing this work. If not, you will have return it to original condition even if the costs exceed your deposit. Some leases explicitly forbid any changes (like painting and fixtures) at all, so read your lease and talk to your landlord. Some renter's have put as much as $100,000 into improving their rental[11], but that is not a recommendation to do so yourself!

Amenities versus customization

Renting can offer a substantially greater number and variety of amenities than buying. For example, upscale apartment buildings can offer a swimming pool, tennis court, and on-site gym. The monthly rent is comparatively lower than a mortgage for a property with the same attributes.

However, there are affordable homes with private outdoor spaces that you can customize to your liking. There aren’t many apartment buildings that come with acres of property that will let you do your own landscaping, keep horses, or grow a garden.[9]

Maintenance versus available time

Buying a house gives you the opportunity to choose a unique and distinct architectural style and to personalize it. But this freedom comes with the responsibility of keeping up with maintenance and repairs. If you don’t enjoy cutting the grass or fixing a leaky faucet, you will have to hire someone to do this for you.

Although renting gives you no control over exterior aesthetics, you don’t have to worry about dealing with wear and tear on your residence. Renting still gives you plenty of opportunity to choose furnishings and decorate your interior environment in a manner that suits your style. And, as a renter, all you have to do when something goes wrong is notify your landlord.[9]

Rental variety

There is a common misconception that only apartments are available for rent. Although most rentals are apartments, homes in every category from 400 sq ft shacks to 15,000 sq ft mansions are available for rent.

Another misconception is that one buys to be located in a good school district. There are expensive and inexpensive rental properties available in every school district in the nation.

If you are concerned about having to move after a year, most landlords would be thrilled to sign 2 or 3 year leases. But this is normally unnecessary. Many landlords are grateful to have a renter who reliably pays their rent, and will happily keep you as a tenant for a decade or more.

See also

References

  1. 1.0 1.1 To Rent or Buy? The Financial Issues
  2. Enable browser cookies to view
  3. 3.0 3.1 3.2 3.3 better to rent or buy??
  4. "Just how overvalued are home prices?" (pdf), Ronald A. Wright, August 2008
  5. The deduction also applies to a second home. See IRS Publication 936, Home Mortgage Interest Deduction.
  6. "Consumer Price Indexes for Rent and Rental Equivalence", Bureau of Labor Statistics, 2007-02-09
  7. Mortgage as a "reverse bond" in Allocation Planning Forum discussion, which includes comparison of bond vs. mortgage "liquidity"
  8. Florida's homestead exemption
  9. 9.0 9.1 9.2 9.3 To Rent or Buy? There's More To It Than Money
  10. homeowner association
  11. Sinking Your Money Into a Rental, Vivian S. Toy, New York Times, 2007-04-15

External links

Bogleheads forum discussions