Rent or buy? We’re about to choose a new home in a new location. So the question of renting vs. buying has come to the foreground for us again.
Whether you’re newlyweds starting out, a middle-age couple downsizing, or seniors contemplating retirement communities, you too will likely need to evaluate the economics of renting vs. buying at some point.
For decades, conventional wisdom ruled that buying was the smart choice. After all, when you rented you were just “throwing money away,” while when you bought you were “building equity.” But that traditional personal finance fiction was laid bare during the Great Recession, and is now dying a slow death.
Owning a home does not somehow make it free to live in. When you look at the numbers, which I will do shortly, you can see that notion is completely false. Home ownership has clear, quantifiable, ongoing costs, just like renting. For different people in different times and places, one approach or the other can make more sense.
So there is no longer a universal answer to the rent vs. buy question: you simply have to run the numbers.
But if you are after a precise answer, the rent vs. buy analysis can be quite complex. Mortgage costs and tax implications can be complicated. Other variables, such as interest rates or how long you will own a home, are essentially unpredictable.
But, as I’ve pointed out before, in the retirement calculator articles, if we treat this rent vs. buy calculation as just a “model” of the future, we can gain a useful understanding of the issues without pursuing the fiction of a precise numeric answer.
So what follows is my own simple approach to the rent vs. buy decision….
The first thing to observe is that we actually know how much renting costs: It’s just your monthly rent payment, a single monthly number that replaces all the traditional expenses of property ownership — no additional calculation required.
The problem lies in determining the cost of home ownership. With that, there are many variables, all working over different time frames. There is no simple monthly cost for owning a property, though there might be homeowner’s association dues on top of many other expenses. There is a “sticker price” for a home. But that number bears very little relation to the actual cost we’ll experience living in a purchased home. So what we need is an effective monthly cost of home ownership, that we can compare to the cost of renting.
And that’s what we’ll try to calculate here. To make the number easily scalable to different situations, we’ll look for the “equivalent” monthly cost for each $100,000 of home value. So we can scale the monthly cost number up to different size houses using simple multiplication.
I’ll work through a hypothetical example based on national averages and my own experience, that you could then modify for your situation if desired. More important than my actual calculations — which will vary depending on individuals and economic circumstances — is the process. If you understand the basic issues, and how to compute the components of a monthly ownership cost, then you can duplicate the calculation in your own specific circumstances and decide whether renting or buying is most advantageous for you.
A Rule of Thumb
A while back I was talking to a nearby friend with years of experience owning and managing rental properties. I asked him what was his rule of thumb for identifying a property that could be purchased and rented out profitably? He said he looked for at least $1,000/month in rent for every $100,000 in purchase cost.
So that means a monthly rent equal to 1% of the purchase cost of the home. And that is another way of saying that the ongoing cost of owning a home in our market at the time, along with some profit for the landlord, was approximately $1,000/month for each $100,000 of capital expense.
Where exactly does that $1,000/month number come from? Does it apply in your situation and your market? Let’s dig in and look at the components of home ownership cost as converted to a monthly expense….
The first issue you’ll hit when analyzing the rent vs. buy decision is the time period for the calculation. That’s because the transaction costs for buying and selling a home are so large that you can’t ignore them. But you don’t have to swallow them all at once. You can amortize them in some form over the length of time you’ll be in the home.
Yet, without a reasonably accurate estimate of the time period you can’t accurately amortize costs.
Your life is unpredictable — unknown career or health issues can easily impact your time in a given location. Even if you think you know your time frame for acquiring and living in a house, the time required to sell it is nearly always an unknown. Houses are famously hard to sell on a schedule. We were incredibly fortunate to sell our house in 24 hours. But we have friends who’ve needed years.
For the sake of our hypothetical analysis here, let’s say you’ll be in the house for 10 years.
Closing and selling costs are some of the most daunting expenses in home ownership. Various government entities, plus a host of professionals — realtors, lawyers, appraisers, surveyors, bankers, etc. — will be standing in line to get paid whenever you buy or sell.
How much does that all cost? For our purposes here I’m not going to try to sum up title fees, points, origination fees, loan fees, document fees, commissions, taxes, inspections and so on. Instead, we’ll rely on some broad percentages for our rough estimate.
Real estate supersite Zillow reports that home buyers typically pay between 2% and 5% of the purchase price of the home in closing costs. Because my own experience buying and selling a couple of houses has shown the costs to be punishing, and because I think it pays to be conservative when it comes to such a large transaction, I’m going to estimate transaction costs for buying a house on the high side of Zillow’s range — at 5% of the sale price of the home.
The picture from the seller’s side is even worse. Selling a house is especially punishing, because you get to pay realtor commission (6% in many cases), plus staging costs, plus some closing-related costs.
In today’s real estate market, the expense to make all necessary repairs and then dress up a house to be competitive in the market can be substantial. For our recent house sale we spent over $4,000 in immediate staging costs. However we spent much more than that on repairs and improvements with an eye to selling, in the years leading up to the sale. So, for the seller, I’m going to estimate transaction costs at 10% of the sale price.
That means for each $100,000 in house cost for our hypothetical example, you are going to spend $15,000 in transaction costs as a buyer then seller. Divide that by the 120 months in our assumed 10-year holding period and you get an ownership expense of about $125/month due to transaction costs.
Note: to keep the math simple in our example, I’m going to ignore time value of money considerations. (The fact that future dollars are worth less than today’s dollars.) This may or may not be appropriate in your own situation, depending on the time frame and interest rates.
Even for somebody like me who believes in self-insuring, when you own a very large asset like a house, insurance is almost mandatory. Banks will require it for those who take out mortgages. And for most everyone else, the prospect of a 6-digit loss is unthinkable.
So how much should we budget for property insurance?
According to one source the national average premium for homeowner’s insurance is running at around $1,200 now. Given a national median home price right now in the low $200,000’s, that means annual cost for property insurance is approximately one half of one percent of the property value. (If you want to be more accurate, you might subtract the cost of renter’s insurance here, since most homeowner’s policies are also insuring personal property.)
Doing the math, per $100,000 in housing cost, you can expect to pay about $42/month for property insurance, on average.
The most painful aspect of home ownership might be that the buck stops with you. Whether it’s mundane repairs like replacing door locks, fixing toilet leaks, and touch-up painting, or big-ticket items like new roofs, furnaces, or driveways — it all comes out of your pocket. What does this cost homeowners, on average?
A popular rule of thumb for annual maintenance is 1%. But that may be too low. U.S. News and World Report says that homeowner’s spend from 1% to 4% of a home’s value each year on maintenance and repairs.
Looking back at my home maintenance records for our Tennessee home, extending over more than a decade, I see many months where we were shelling out hundreds of dollars, and more than a few where the cost ran into the thousands. On average our cost was about $400/month, which was about 2% of the property value annually.
So let’s stick with a 2% number. That means for each $100,000 in housing value, you’ll incur about $167/month in maintenance costs.
Next we come to property taxes. This is probably the expense category with the largest variation across the country. A study from the National Association of Home Builders shows property tax rates varying by a factor of three between the low-cost southern states and the high-priced northeast.
Ultimately, property taxes are a function of your state and local government. In relatively low-priced Tennessee, our property taxes came to about 1% of the market value of our home annually . (Keep in mind that property taxes are actually computed based on an “assessment ratio” and/or “assessed value” which may not bear much relation to the market value of your home.)
Our experience was on the low end of tax rates nationally, but let’s assume you’re retiring in a low-cost area and use it for our hypothetical calculation. Thus, 1% of $100,000 monthly means about an $83/month expense for property tax.
Speaking of taxes, is the news all bad? No. There is, after all, the mortgage interest deduction — probably the most highly-touted of all tax breaks. It’s often at the center of arguments about why home ownership is a “good” financial decision. After all, you get a tax break. How could you go wrong?
For starters, those with the requisite income, who loathe debt in any form, may pay off their mortgages quickly enough that the mortgage interest deduction is not a major factor in their finances. Even for those who aren’t able to achieve early financial independence, many enter retirement without a mortgage or substantial interest deduction. And the increase in the standard deduction that took effect with the Tax Cuts and Jobs Act in 2017 cut the number of people who will benefit from the deduction approximately in half.
Nevertheless, a number of retirees will carry a mortgage and get a deduction on their taxes. And, whereas we’ve been computing the costs of home ownership so far, this will actually be a credit. To compute it you’ll need to know your marginal tax rate and multiply that by the amount of the interest deduction, to get your tax savings. Since that tax rate is a function of your income, I’m going to leave this calculation as an exercise for the reader instead of attempting to generate a one-size fits all number.
Are there other benefits to home ownership aside from a possible tax reduction? How about the expected growth in home property value?
There were times, and there will always be places, where killings can be made in real estate. Many of us have seen older parents do well. And we’ve all heard stories about somebody flipping a house and making tens of thousands of dollars in a matter of months.
But that’s rare, especially these days. Now there are more and more voices suggesting that, even over long time spans, the best you should expect from real estate is to keep up with inflation.
In many cases, a home is not a great investment. That was our experience over 17 years in Tennessee — in a real estate market that was largely spared the Great Recession. Despite apparently selling our home for much more than we paid for it, once all the capital improvements were accounted for, it barely kept up with inflation.
So, while it may shock some, I’m going to ignore the potential for any real growth in the value of your home. In general, I just don’t think you can count on it anymore. As for keeping up with inflation, so will most of the other costs we’ve been computing. Yes the value of your home will probably increase at the inflation rate, but so will your maintenance, insurance, and other expenses. It’s a wash.
The most common argument against renting, one that I’ve read in print and heard in person more times than I can remember, is that renting is somehow “throwing away money.” On the surface it may appear that way. Although we’ve already detailed a number of ongoing costs of home ownership, the one cost you don’t have is the rent itself. That rent seems to add up to astronomical numbers over time for the renter, while the homeowner is spared writing those monthly checks.
But this is largely an illusion. Why? Because that common argument neglects the opportunity cost of tying up equity or capital in a home purchase. It works like this: If you put $100,000 in a home, then that money is not invested somewhere else, growing and earning income. And that missed growth and income is a cost just as real as any other. It’s money you are not earning because you chose to buy a home instead of making some other investment, in stocks and bonds for example.
If you choose to take out a mortgage and borrow the capital for your home, then this cost is more readily apparent: It’s the interest you pay on the home loan. And that is a cost of home ownership like all the others.
The tricky thing about computing opportunity cost is choosing an interest rate. As a general rule, mortgage interest rates are below what you could earn on your money in the stock market. Mortgages are a more reliable financial vehicle, while stocks are more volatile and less predictable over short time spans. That means stocks will pay more in the long run. On the other hand, large mortgages usually incur an additional expense in the form of PMI (Private Mortgage Insurance) at first, increasing their cost and apparent rate. Just getting approved for a mortgage at a competitive rate can be more complicated for a retiree with assets but no income.
Where would your money be invested if not in a mortgage, and what would it earn? For our purposes, I’m going to pick an arbitrary 5% rate of return to compute the opportunity cost of owning a home. That’s more than current mortgage interest rates, but less than most conservative projections for stock returns going forward. Though arguably this should be a real rate of return (after inflation), in which case it could be high.
On $100,000 of home value, a 5% foregone return equates to a cost of about $417/month.
And that is the missing link between renting and buying. Generally speaking, this is the single largest cost of home ownership, yet it is invisible, poorly understood, and largely ignored by the majority of people!
The Bottom Line
Ok, so we’ve explored most of the obvious and not-so-obvious costs of home ownership. As we went along, we made some simple calculations using assumptions based on my personal experience and national averages, to come up with monthly equivalents of all these home ownership costs. So now let’s add them up:
The bottom line for our hypothetical example is that home ownership actually costs about $834/month per $100,000. So, for example, if you’re looking at living in a house valued at $300,000, you could assume that would cost you about 3 x $834 or about $2500/month to own. If you can rent it for less than that — which indeed you can in some U.S. markets right now — then renting is actually the better value.
Interestingly, that $834 value is also in line with the 1% rule of thumb stated above for landlords, because if you’re looking at home ownership as a rental property business, you want to make some profit on top of what the property is costing you. Charging $1000/month in rent would give you that profit margin. (If you’re a landlord reading this, I’d be interested to hear about your real world experience.)
Just remember that the numbers I’ve used in this post are hypothetical and may not apply to your situation, especially if you live or retire in a more expensive region of the country. Instead, take the structure I’ve outlined above and come up with your own “monthly cost of ownership.”
Finally, if you are interested in this topic but don’t want to crunch the numbers yourself, check out the Rent vs. Buy Calculator over at FinancialMentor.
Before we end, it would be remiss not to discuss some of the non-financial factors in the rent vs. buy decision. Most of us sense that this isn’t a purely financial matter. Owning a home is very satisfying to some people. There are emotional benefits. But, there can be similar benefits to renting also.
When you own a house you have more control over your environment. You can modify things to suit yourself. You don’t need permission. You also don’t have to worry about whether the lease will be renewed or you’ll have to relocate. On the other hand, you are not in control of your monthly budget: A large home repair expense could materialize at any time. On the plus side, a home is a relatively safe place to park your money: Houses are hard to steal, courts don’t like to seize them, and insurance is typically easy and cheap to obtain.
By contrast, when you rent, you have more control over your expenses. Monthly rent is predictable and you don’t have to worry about paying for unexpected repairs. On the other hand, unless you are able to sign a very long lease, there are no guarantees against having to move on relatively short notice. And you have only limited control over your environment. You aren’t free to make changes to suit yourself. Yet, in one respect, you have more flexibility and control when renting: You can leave a place within 12 months, if it doesn’t suit you. There are no transaction costs.
In the end, emotion will continue to drive many rent vs. buy decisions. It’s not a purely financial determination. Just don’t act on your heart, before your head has run all the numbers!