Today I discuss one of the long standing personal finance questions: Buying a home vs renting a home?
Personally I’ve been a renter for the past 12 years, but that has been more for reasons of flexibility than financial sense. After all, I’ve moved 12 times since 1990. Two of them were purchases and both times the decision to purchase was more family related than financially motivated.
Now that we are living in Thailand the question has pretty much been laid to rest for the time being, thanks to the laws here. Foreigners are not allowed to own land, so I see little point in buying. Sure we can buy condos, but when you can rent a condo for a fraction of the purchase price why bother. Plus I worry about the possibility of the laws changing, since Thailand has been tightening their visa policies for years.
However this isn’t about me. I decided to take a look at the financial wisdom of buying a home versus renting for one of my friends. He lives in one of the more expensive property markets in the U.S. and as I was thinking about buying vs renting I wondered how it would apply to him. I’m sure he has already run the numbers, but let’s have some fun and run them together here.
So let’s get started shall we.
Simple Buying vs Renting a Home
As I said, this is one of the more expensive areas of the U.S. and home prices are quite high. My friend is young with a growing family and is looking for a 3 bedroom house or condo so he and his family have plenty of room to grow. Currently the average list price of 3 bedroom places in this town is $786,386. Because we want to be sure to avoid PMI we will need to assume a 20% down payment or $157,277. Using those numbers (and ignoring closing costs) my friend would have a monthly mortgage payment of $2970.91 assuming he can get the average mortgage rate of 3.91% showing today on Bankrate.com.
Since this is a comparison we now turn to the renting side of the equation. In the same area 3 bedroom homes are currently renting for an average of $3200 per month. Well, that locks it for buying versus renting doesn’t it? My friend will save $229.09 per month by purchasing and paying a mortgage.
That would indeed be true if that were the whole picture, but sadly it isn’t. I have lots more numbers to throw at you and this is where the equation becomes quite fuzzy. It is also why this particular question is difficult if not impossible to answer in purely financial terms.
Buying vs Renting Isn’t That Simple
Sure the mortgage costs are much lower than the rental costs, but there are other expenses of home ownership that we haven’t included in our equation. Such as property taxes. In the area I am using for this example the property tax rate is $ 42.94 per $1000 of assessed value. Yikes! I thought that had to be wrong and I actually went to the city tax office website where they let you see what property taxes were paid on properties in the area for the past several years. After several queries I determined that this rate is in fact accurate. That means on my friends $786,386 home he will be paying $33750/yr or $2812.57/mo in property taxes alone. This combined with his mortgage payments comes out to $5783.48 per month. Not looking so great for buying now is it? This new monthly payment means the renter will come out ahead each month to the tune of $2583.48. Not exactly chump change.
With what we have so far we can tell that over 30 years the home buyer will pay $2,082,052.80 while the renter will only pay $1,152,000 for a savings in the renters favor of $1,087,330 (includes the initial down payment).
I’m not done yet though. Even though I’m a renter myself I’m not going to let renting win that easily. There’s another piece of the puzzle we haven’t included and that is inflation.
Inflation IS a Big Factor
Over the course of 30 years both the property taxes and the price the renter pays will increase. By how much you might ask. That’s the problem, we don’t have a crystal ball and can’t tell for sure. The best we can do is use averages to project future price. So, I am going to assume a 3% rise per year in property taxes as this is in line with CPI over the past 50 years. I am also going to assume a 5% per year rise in the rental price. I arrived at this because my friend lives in a rent controlled city where landlords are not allowed to raise rental prices by more than the CPI figure plus a factor for increased taxes.
Typically when people look at a mortgage payment they make the assumption that over time they will be paying less in today’s dollars because the mortgage is a fixed amount. That is true, but it doesn’t account for rising property taxes. If taxes remained static my friend would still be paying $5783.48 on his mortgage in 30 years. This would be awesome because at 5% increase per year the renter will be paying $13171.63 in the 30th year. That’s a whopping difference of $7388.15 per month!
Sadly though property taxes do rise and if we factor in a 3% rise per year we find that in fact our home buyer is paying $13425.23 in mortgage costs and taxes by year 30.
So far, over all 30 years the renter ends up paying less than the buyer. Granted it is a falling difference, in year 1 the difference is $3101.76 per year, but by year 30 the difference is just $3043.19 per year.
What About Investments?
With these figures in mind we can also get an idea of the relative worth of the investment in the home versus the investment return of the savings from renting. Assuming an increase in home values of 3% per year my friend would have an asset valued at $1,908,765.23 once the mortgage is fully paid. On the other hand, if the renter started by investing the $157,277 down payment and invested all of the savings over the 30 years at a conservative 4.5% he or she would end up with a nest egg of $2,171,416. Not too different from the value of my friends home.
Now, both retired and ready to enjoy their retirement is when it gets interesting for my friend and his renting counterpart.
Buying vs Renting in the Retirement Years
Because the mortgage is now paid off in year 31 my friend’s payments drop to $10,767.95 while the renters payment increase the standard 5% to $13,830.21. Over $3000 in difference, although you could say it will take some time to catch up to the difference of $702,203 paid over the past 30 years by the home buyer. Plus the money saved by renting is throwing off a nice $97,713 per year in payments at 4.5%.
Wait one second though, that money is not even enough to pay the rent payments which would total $165,963 in the 31st year. Granted it is also not enough to pay my friends taxes at that point, so it looks as if both the renter and buyer should have been saving aggressively during the past 30 years if they expect to stay where they are.
Things get even worse though. Assuming both live for an additional 30 years after they retire we would see the property taxes rise to $24,636.29 per month while the cost to our renter would rise to $54,216.22 per month! Because of the vast and growing gap in monthly payments the home buyer enjoys a difference of $4,532,872 over the next 30 years, far outstripping not only the first 30 year period savings ($702,203) of the renter, but also the growth from investment of that savings ($2,171,416).
We Have a Clear Winner
I think at this point it is fairly safe to say that in the long run, that is a period in excess of 40 years, the home buyer comes out far ahead of the renter. And the increased savings and security come at exactly the time you would expect to need it; during retirement when your income is somewhat fixed.
I know some of you may complain that I didn’t take into account the cost of maintenance to the house, the tax consequences of buying vs renting and cost of insuring either a home or rental property. That’s true, but I felt there was already enough ambiguity in my calculations without adding more.
I did want to include a link to a buy vs rent calculator, but after looking at 10 different calculators I gave up. Some were good, but every single one neglected to account for increasing property taxes even though they accounted for increasing rent payments. Interestingly one of the worst calculators I looked at was the one on the Ginnie Mae site.
The truth is there are other important factors that lead people to buy rather than rent. One of the most powerful is the fact that as a buyer you feel as if you have a home. It is yours to do with as you like and no one can dictate to you about changes, and more importantly no one can evict you. You make it yours and fill it with memories and the love of your family.
And as we all know from the 1939 classic The Wizard of Oz:
Oh, but anyway, Toto, we’re home. Home! And this is my room, and you’re all here. And I’m not gonna leave here ever, ever again, because I love you all, and…there’s no place like home!