Buying vs Renting a Home - Difference and Comparison

Does it make financial sense?

For most people, buying a home is partly an investment decision. Money spent on rent is often considered money down the drain - never to be seen again. But this is not the full picture. The rent vs. buy decision needs to account for several variables:

While each of these factors can be a complicated parameter in itself, you can make some realistic assumptions to start your analysis. As you become comfortable with the decision model, you can tweak it to add more parameters or handle more complexity.

Mortgage interest

Depending upon your credit history and employment/income situation, the interest rate that you get will wary. You can also decide if you want to take a fixed rate loan or a variable rate loan. For the rent vs. buy analysis, assume a fixed rate. Let's say your loan amount is $300,000 and interest rate is 3% (fixed) over 30 years. This equates to $1,265 in monthly payments. Over the course of 30 years, you will pay $455,332 to your lender — $300,000 of that will go towards your principal loan amount and $155,332 will be paid as interest.

The interesting thing about mortgage payments is that even though the monthly payments do not change over 30 years (for fixed-rate mortgages), the amount of that fixed monthly payment that goes towards interest versus the amount that reduces the outstanding principal varies every month. Simply put, in the first few years of your mortgage, a bulk of your payments will go towards interest and you will be barely chipping away at the principal. In the last few years, most of your payments will be towards the principal.

In our example of $743 in monthly payments over 30 years, the average interest payment is $1,071 per month in the first year and only $20 per month in the last year of your mortgage.

Why is this important?

In the first few years of your mortgage, your outstanding loan amount barely goes down. So if you are planning to live in the house for only a couple of years, your equity (value of the house minus the loan amount outstanding) is not very high. It also makes ARMs — adjustable rate mortgages — more attractive. ARMs typically have lower interest rates for the first five or seven years of the life of the loan. Since the initial years are where the principal outstanding is the highest, having a low interest rate in that period really helps. Many people sell the home before their interest rate adjusts.

Opportunity cost of downpayment

A larger downpayment (20% or more of the home value) usually lowers the interest rate that you will have to pay. Let's say you shell out $40,000 as downpayment when you are buying your home. This $40,000 is like an investment that you make in an asset (your house), hoping that the asset will appreciate. If you were to invest $40,000 in an online savings account, you could earn 1% interest (risk-free) every year. If you invest in equities and are lucky, the returns could be even higher.

In short, you forego the opportunity to invest this amount in other assets that can provide returns. Assume that you have other investment opportunities that you know will give you a certain (X) return on investment. This "X" plays an important role in the rent vs. buy financial model.

Taxes

What you pay

When you buy a home, you will pay property taxes. Depending upon where you live, the property tax can be around 0.5 to 1% of the value of your home.

What you save

The property taxes that you pay, as well as the interest payments that you make in the year, are both tax deductible. The catch here is that you can claim these tax deductions only if you itemize your deductions and not take the standard deduction.

How much you save

In a very basic simulation of the math, let us assume that:

• Annual Property tax = $2,000 (A)
• Interest payments made in the year = $12,000 (B)
• Standard deduction available = $8,000 (C)
• Your tax bracket - 28%
• Your income - $85,000

If you buy a home and itemize your deduction, your taxable income will reduce by $14,000 (A+B). If you rent, your taxable income will reduce by $8,000 (C). So the "net effect" of buying a home on taxable income is $6,000 (A+B-C). And the net tax saving per year is 28% of $6,000 i.e. $1,680.

For a fixed rate mortgage, the interest payments that you make will be the highest in the first year and will reduce in subsequent years as your outstanding principal gradually decreases.

Rent increase with inflation

In building a financial model to compare renting and buying a home, we can assume fixed monthly payments with a fixed rate mortgage. But in the rent scenario, it is expected that rent will rise over the course of the next 20-30 years. The yearly increase in the rent can be assumed to be 2-3% - in sync with the rate of inflation.

You should compare the cash flow for buy (monthly installment, home owner's dues, insurance etc.) vs. rent. Also, be sure to note the opportunity cost of investing the difference (Rent - Monthly installment or vice versa, depending on which is greater).

Appreciation in the value of the house

Over a long term (20-30 years), house values can be assumed to appreciate at the rate of around 5% every year. Depending upon where you live, and whether you're dealing with a single family home, townhouse, or condo, that percentage may vary. This number has a substantial impact on the outcome of the rent vs. buy financial model.

Transactional costs when buying

There are sundry transactional costs that you will incur when buying a home. Home inspection, attorney fees, mortgage closing, agent's fee, taxes, filing fees etc. Treat this amount as you would treat the downpayment (in terms of cost of missing the opportunity to invest this money elsewhere).

Broker commissions when selling

Typically, the seller pays commission to both the buyer's and the seller's agents. With 3% each, this commission typically works out to 6% of the value of the house. As you can guess, this has a significant impact on the financial model. You can choose to work without agents and assume 3% or less commission costs in your model.

Time and effort

Looking for your dream house can be taxing and can take a lot of time and effort.

When you rent, the landlord is responsible for fixing most things that commonly go wrong in the house (plumbing etc.). But when you buy a home, you are responsible for all maintenance.

People also may need to make several touch-ups and spend time and effort when trying to sell their house.

Rent Ratios

One way to figure out whether to buy or rent is to look at the rent ratio: the purchase price of a typical house divided by the annual rent of a similar house. When the rent ratio is above 20, it means you should consider renting. Between 15 and 20, lean towards renting unless you find a home you really like and plan to stay in it for a long time. If the rent ratio is below 15, it makes more sense to buy.

Rent ratios for major metropolitan areas in the U.S. are available on the New York Times website.

References

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