Should You Buy or Rent a Home?

June 11, 2015

Summer is often a popular time for people to buy a home. In fact, I was recently talking to an employee who wanted to buy a place but she noted that the mortgage payment would be more than the rent for similar priced homes in the area she was looking at. However, after looking at the tax breaks and possible home appreciation, we discovered that owning would actually be cheaper for her.

In one sense, that initial cash flow number is important because you don’t want your housing costs to be too high relative to your income and other expenses or you can find yourself having trouble making the payments. Lenders typically don’t want your debt payments (including your mortgage) to exceed 28% of your income but what’s affordable for you depends on what your other expenses are too. For example, someone who spends a lot traveling and eating out probably can’t afford to spend as much on housing as someone who spends less even if they have the same income and debts.

Just comparing the difference in cash flow doesn’t reflect all the costs between owning and renting a place though. For example, I was recently looking at a condo for sale in San Diego for $450k. With a 20% down payment, a 30-yr fixed 4.125% mortgage rate, property taxes of $4,559 per year, and HOA dues of $398 per month, it would cost about $2,523 per month to own. That’s a little more than the $2,300 it would cost to rent. However, there are several advantages that owning has:

1) Part of your payment is paying down your mortgage and building equity. That shouldn’t be considered a cost at all because that money is increasing your net worth by paying down your debt. That’s why people say that paying rent instead is like throwing money away.

2) The rest of your mortgage payment is mostly interest and property taxes that may be tax-deductible. You can see how much those tax-deductible expenses can reduce your tax liability here. If I were to buy the property, I would save about $400 per month in taxes since almost all the initial payments are interest and property taxes that would be fully tax deductible for me.

3) Real estate tends to appreciate over time. Put aside the extreme gains during the housing bubble and the extreme losses after the bubble popped and we can see that real estate has historically appreciated slightly more than inflation in the long run. If the condo’s value grows with the Fed’s 2% target inflation rate, that would be $9k per year on average or $750 per month.

But renting has a couple of hidden advantages as well:

1) You could invest your down payment and any monthly cash flow savings. In my example, the $400 per month I would save in taxes wipes out the cash flow advantage of renting but if I were to invest the $90k down payment aggressively and earn a 7% average annualized return, that would be $6,300 per year or $525 per month in additional investment earnings. (If it’s invested in a taxable account, the earnings would be reduced to $446 per month after capital gains taxes.)

2) Renters pay less in maintenance costs and insurance. Homeowners tend to spend 1-4% of their property’s value on maintenance and repair costs (this is a good way to estimate the cost for a specific home) and .25% on homeowner’s insurance costs. Since the condo is relatively new and some of the maintenance costs would be covered by the HOA, let’s use 1%. That would mean an average of $375 per month in maintenance costs plus $80 per month in additional insurance (above my current renter’s insurance premium).

Putting this all together, it would cost me about $1,823 to own this condo and $1,870 to rent it or about the same either way. (Interestingly enough, one of the biggest but often ignored factors is how much I would earn after taxes by investing my down payment. For example, if I was investing it tax-free in a Roth 401(K) or Roth IRA, renting would actually be cheaper.)

Finally, there’s one other thing to keep in mind. Even if renting looked like a better deal right now, rents are likely to go up over time at least with inflation while the principal and interest on your mortgage can be fixed for 30 or even 40 years. That combined with the appreciation of real estate with inflation is why the higher future inflation is, the more beneficial owning would be.

Too complicated? You can plug your numbers into this NY Times Buy vs Rent calculator to do all the math for you and see how long it would take for owning to be financially better than renting. (Just remember that with any calculator: garbage in, garbage out.)

Generally, the better your investment opportunities, the better off you are renting. The more you can reduce maintenance costs by doing repairs yourself or shopping around, the more advantageous owning a home will be. If the financial considerations are pretty close, you can also do what most people probably do and just make the decision an emotional one. Do you want the flexibility and lack of maintenance hassles involved with renting or the security of owning your own castle?