“As long as you’re renting, you’re throwing money out of the window” – That’s the advice you will hear from many well-meaning friends, relatives and acquaintances. These wannabe experts will explain to you that having a mortgage is much better because “at least the house will be yours at the end”.
On the surface, it may look like they are right, but most likely they are wrong. They probably haven’t done the maths and are just naively repeating what the system wants us to believe.
Most people are impulsive in home purchasing – they want a place of their own – and they don’t spend enough time considering the mortgage consequences of that action. Often people buy a house as soon as they have saved enough for a minimum down payment. Others use rules of thumb like “with a 50% down payment, a mortgage is cheaper than renting”.
The problem is that there are no rules of thumb that can apply equally to all situations. And, unfortunately, few actually compare mathematically the cost of renting versus buying in order to make an informed decision. That means a lot of bad decisions are made.
Buying Versus Renting
The best way to understand the financial difference between buying and renting is to run the figures! Let’s imagine a professional Monkey couple, trying to make up their mind about what to do.
They have steady incomes and some savings ($97,500 in our scenario). The question is, will they be better off as homeowner or as tenant?
The Monkey couple has fallen in love with a 2-bedroom house in inner Sydney. It is priced at $650,000. They will make a down payment of 15% ($97,500) and borrow the remaining $552,500.
Assuming a payback schedule with constant installments over 30 years and a mortgage rate of 7%, they will already be making monthly payments of $3,676.
It is thus unlikely that our average-income Monkeys will be able to shorten the mortgage term to increase their installments.
The Monkey couple is happy living in a 2-bedroom rental apartment. They are paying $430 per week in rent and saving as much as they can (the savings rate is 5% per year). They don’t want to worry about a mortgage or home repairs.
So? Who fares better? Homeowner Monkeys or Rental Monkeys?
In order to make a realistic comparison, we’ll need to look 30 years into the future. That means using future values, and assuming a yearly inflation rate of 1.5%.
Using the formulas for compound interest, annuities, and mortgage costs from previous posts, we’ll be able to see if our couple would be better off having bought the house with a mortgage or having rented throughout.
Buying a house implies many hidden costs that most people don’t tend to consider. They only focus on the market value of the house, discarding any recurring taxes, fees and other payments that come with being a homeowner.
|Total||$1,016,002||($1,279,333)||Net Worth = -$263,331
|House||$1,016,002||Even though I don't believe in automatic real estate price growth, I will assume the price of this $650,000 home follows the 1.5% inflation rate.
|Mortgage Cost||($770,787)||This is the total cost of the mortgage for interest paid over 30 years on a principal of $552,500, assuming constant installments and a mortgage rate of 7%.
|Mortgage Insurance||($8,636)||Following market practice, we will assume its cost to be 1% of the mortgage principal, hence $5,525 compounded at the inflation rate over 30 years.
|Inspection Fees||($1,563)||We assume $1,000 are spent on various building and pest control inspections prior to the purchase. This amount is the inflation adjusted future value.
|Renovation Work||($31,262)||Realistically, when you buy a new home, you will perform some immediate renovation (kitchen, bathrooms, painting, flooring, etc...). We assume a reasonable spending of $20,000 up front.
|Government Fees||($39,149)||This includes mortgage registration fees, transfer fees and stamp duty. This amount is the future value of $25,046, compounded at the inflation rate for 30 years. (Source: NSW Stamp Duty Calculator from RAMS)
|Council Rates / Strata fees||($150,155)||We will assume $1,000 per quarter are paid towards those fees, amount which increases with inflation.
|Property Tax / Land Tax||($120,120)||For 2013, the land tax in NSW for a $650,000 property amounts to $4,004. This amount will be assumed to stay constant over time as the government already readjusts the property valuation with inflation. (Source: NSW Land Tax Calculator)
|Water Bills||($45,046)||This is one of the few utilities renters do not pay and is only born by owners. For this property, we will assume $300 a quarter is necessary, which we adjust with the inflation rate.
|Home Maintenance||($75,077)||There are several rules of thumb to estimate yearly repair costs for regular wear and tear. There is the 1% price rule, the 1% square foot rule, etc... Let us just assume $2,000 per year is spent in repairs, adjusted with inflation.
|Home Insurance||($37,539)||This insurance covers the building itself, not the contents. Given the value of the property, it would roughly cost $1000 a year to insure it, which we adjust with inflation.
When renting, all maintenance costs are already included in the rental price. As a tenant, you don’t need to worry about anything apart from insuring your belongings. Everything else is the responsibility of the landlord.
|Total||$1,944,043||($839,365)||Net Worth = +$1,104,678
|Downpayment||$435,605||Given that Rental Monkeys didn't put their savings towards the downpayment ($97,500), it will generate interest for the next 30 years.
|Regular Savings||$1,508,438||Rental Monkeys are able to save the difference between the mortgage installment and the rent i.e. $1,812 per month. To keep calculation simple, we assume their salaries increase with inflation such that it counterbalances the inflation-adjusted rent, keeping their level of savings unchanged. Using the constant annuity formula, we get the future value of their savings account.
|Rent||($839,365)||We assume a weekly rent of $430 to start with, amount which is adjusted yearly by inflation.
After 30 years, Homeowner Monkeys have a house which is now worth $1,016,002 (assuming there was no market crash…).
Factoring in purchasing and maintenance costs, they have spent a total of $1,279,333. If they would resell the property at that point in time, they would have lost $263,331 (not taking into account real estate agent commissions and fees derived from the sale).
Rental Monkeys have no property but have been busy saving instead. They now have $1,104,678 in their bank account. That means they could buy Homeowner Monkeys’ house, pay the inspection fees, renovation work, government fees and still have $16,072 left in the bank! Hence, in this case, renting was the better financial decision.
The main goal of this post is to stimulate you to think. There is no one best answer that fits all scenarios; you need to compare buying to renting based on market conditions. The critical factors to take into account are:
- The interest rates, both for mortgage and savings (the higher, the better to rent!)
- The term of the mortgage (the shorter, the better!)
- The amount of principal borrowed (the smaller, the better!)
The long and short of this post is that the statement “buying is always better” is wrong. It is a myth that keeps us locked into a life of salaried work to repay our debt.
However, there are also cases when buying will be a better financial decision than renting. It’s possible but a lot of parameters will have to be in your favour: lots of savings, small mortgage, high salary, short mortgage term, etc…
If you think you are in the right position, don’t just rely on your gut feeling – Make sure you can prove it mathematically!