Rent vs Buy Decision

Many people say “Don’t rent, it’s a huge waste of money!”

But is this really true? Or is this something that people just generally thought was the case?

The concept of analyzing buying vs renting comes down to the idea of recoverable vs non-recoverable costs.

All costs, regardless of whether you are buying a house or renting one, can be put into these two categories.

For example, if you pay property taxes, these costs are “non-recoverable” as they are not something you would eventually get back. Paying down your mortgage (specifically the equity part) is a “recoverable” cost, as you can eventually get it back when you sell. Rent is also “non-recoverable” as it’s something you will never get back.

Now, for this analysis, let’s say you want to buy a house for 5 years and then sell it. Should you rent or buy?

Because housing is so area dependent, let’s look at two very different markets: a $450,000 home, typical of a lot of Midwest metros, and a $1,500,000 home, typical of many California metros.

In the Midwest, that kind of home might rent for around $2,900/month. In California, a comparable property often rents for around $4,500/month or $5,000/month. Expensive markets tend to have much lower rent relative to the purchase price, and that gap is a big part of what drives the outcome below.

Numbers

For both scenarios, we’ll use the same assumptions: 20% down, a 6.5% 30-year fixed mortgage, 4% home appreciation, 4% rent growth, and investing whatever you save each month by renting at an 8% return.

Here’s how to think about it: your recoverable costs are your down payment and the principal you pay down. This is money you eventually get back.

Your non-recoverable costs are interest, property tax, insurance, maintenance, HOA, closing costs (when buying), and PMI, subtracting whatever tax benefits you get from deducting mortgage interest and property tax. Then, when you sell after 5 years, you factor in how much the home appreciated, pay off whatever’s left on the mortgage, cover selling costs (typically around 6% of the sale price). Taxes (when selling) hopefully should be minimal due to the $250k/$500k exclusion.

Here are some of the parametrs I used to run the numbers:

• Down payment: 20%
• Mortgage: 6.5%, 30-year fixed
• Property tax: 1.5% of home value/year in Midwest, 1% in California
• Insurance: 0.3% of home value/year
• Maintenance: 1% of home value/year
• HOA: $0 (assumed single-family, no HOA)
• Closing costs when buying: 2.5% of purchase price
• Home appreciation: 4%/year
• Rent growth: 4%/year
• Selling closing cost: 6% of sale price
• Stock market return: 8%/year (e.g. investing downpayment, or the diff between mortgage vs rent)
• Marginal tax rate used for the mortgage interest + property tax deduction benefit: 24%
• Capital gains: assumed fully excluded (no tax on the sale profit)
• Hold period: 5 years

Midwest ($450,000 home, $2,900 rent): Over 5 years, renting comes out ahead by $30,327 over 5 years.

California ($1,500,000 home, $5,00 rent): Over 5 years, renting comes out ahead by $691,270 over 5 years.

Interestingly, once you do 10 years, buying in Midwest comes out way ahead ($150k net better buying over renting), while renting is still better off in California (~$900k renting over buying)

But here’s a thing – there are a lot of non-quantitative factors that go into this decision. Do you care about the schools as renting may not guarantee the area if forced to move? How much other assets you already have? Do you have kids and want them to be able to customize things you can’t otherwise?

But even from a quantitave factor, what if your selling cost is not 6% but you get a flat fee, or sell privately? What if you are a handy person who can fix stuff at home by yourself? What if that 6.5% rate actually becomes 4% soon?

It’s very difficult to predict, but try running the numbers for youself. See where you will end up.

TLDR:

1. Numbers are extremely locality-dependent
2. The longer you stay in a house, the better the numbers get for buying.
3. What is the housing market pricing? The more expensive a house is compared to rent, the worse the numbers look for buying (e.g. a $1.5M home for $5,000 rent).
4. What are the interest rates? This calculation was run with a 6.5% rate, but cheaper mortgages will proportionally improve the numbers.
5. What are your goals? If you have children in good schools, buying provides non-financial peace of mind.
6. Would you actually invest while renting, or waste that money instead? Discipline is key here.

The main takeaway is that renting is not always a waste of money. You really have to analyze it.

Any thoughts/questions? Feel free to reply back.

See you next Saturday.

MC, CPA