I’ve heard a lot of ridiculous statements:
- “I’m sure we’ll find parking.”
- “I’ll just check Facebook for five minutes.”
- “I’ll skip dessert.”
But perhaps the most absurd is the adage: “If you’re a renter, you’re throwing money away.”
Bulls**t.
You’ve heard those statements, right?
- “I’m sick of throwing money away on rent.”
- “Buying is always better than renting.”
- “Your home is your biggest investment.”
I’m going to explain why these clichés are ludicrous. Preposterous. Outlandish. Nonsensical.
(Somebody please take the thesaurus away from me.)
Let’s chat about the “should I rent or buy?” question using logic, math and reason, rather than ill-informed clichés.
Before we jump in, let’s establish a few premises:
- This article is about your primary residence (the place where you sleep).
- This is not an article about real estate investing.
- As with all articles on Afford Anything, these high-level concepts can be applied anywhere. But specifics about laws, taxes, inflation, etc., are geared at a United States audience.
With that said, let’s begin.
“Renting is Throwing Money Away”
Here are three popular arguments defending the “renting is throwing money away” myth.
#1: Rent is an expense. Mortgages build equity.
#2: Rent is forever. Mortgages end.
#3: Renters don’t benefit from rising home values. Homeowners do.
Let’s dismantle these, one-by-one.
Argument #1: “Rent is an expense. Mortgages build equity.”
Here’s the argument, broken down:
- If you rent, 0% of your monthly payments build equity.
- If you own, X% of your monthly payments build equity.
- X > 0
- Equity is an asset.
- Assets are good.
- Therefore, owning is better than renting.
Here’s why this is flawed logic.
What is Home Equity?
First, background information:
“Home equity” is measured as what you own, minus what you owe.
- Home value: $350,000
- You owe: $200,000
- Your equity: $150,000
Here’s the rub: Only a small slice of your mortgage payment builds equity.
Your mortgage consists of four parts:
- Principal (the equity-building piece)
- Interest
- Taxes
- Insurance
These are collectively called PITI, which leads to the geeky joke, “Mortgage? What a pity.” (I probably shouldn’t attempt a stand-up comedy career … )
The “P” is equity; the “ITI” is an expense. In other words, the “ITI” is money that you’re (also) “throwing away.”
How much of your monthly payment is consumed by ITI? Most of it, particularly during the first 15 years of your loan.
Mortgages are amortized, which means the overwhelming majority of your initial payments are applied towards interest rather than principal.
Let’s look at an example of a $250,000 house. Let’s image the following scenario:
- You make a $50,000 down payment.
- You borrow $200,000.
- You hold a 5 percent fixed-rate 30-year mortgage.
- Property taxes cost $3,000 per year.
- Homeowners insurance costs $1,500 per year.
- No mortgage insurance.
Your mortgage payment comes to $1,448.64 per month.
How do these payments break down?
[Thanks to my friend Todd Tresidder at the blog Financial Mentor for this awesome amortization calculator. Yes, I just used the word “awesome” to describe an amortization calculator. #ImNerdyAndIKnowIt ]
During the first year, roughly 83 cents of every dollar goes towards interest, taxes and insurance (ITI) in this example.
You’re not building $1,448 in equity with each payment. You’re building $250 at best.
After 13 payments, you’ll pay almost $15,000 in interest, taxes and insurance. ($14,795.71, to be exact.) And you’ll only hold an extra $2,963 in equity.
Yeowch.
The tipping point, when more money is applied to principal than interest, is based on your interest rate.
During that first 13-19 years of your mortgage, you’re buried deep in the ITI sandbox. You’ll spend the final decade of your mortgage building far more equity than you did during the first two decades.
“What if I get a 15-year mortgage?”
Your first 7 years are going to suck.
Key Takeaway: You’re not building much equity, especially during the first decade-and-a-half. Most of your mortgage payment gets “thrown away” on interest, taxes and insurance.
Now that we’ve established this background, let’s return to the original argument:
- If you rent, 0% of your monthly payments build equity.
- If you own, X% of your monthly payments build equity.
- X > 0
Okay, that logic still seems solid, right? Even if you’re not building much equity, surely some equity is better than none … right?
Riiiighhht?
Not necessarily. Here’s the real question you should ask:
What’s the next best alternative? Is building equity the highest-and-best use of your money? Or could you be doing something better with your limited resources?
Phrased another way: What’s the opportunity cost of this equity-building?
“Uhhh …. Opportunity cost? What do you mean?”
Okay, before we launch into this, here’s one more fact that you need to know:
Home Values Keep Pace with Inflation
Home values historically keep pace with inflation. Nothing more.
When people say, “my home increased in value,” they’re really saying, “yay, inflation rose!”
Don’t take my word for it. Listen to Nobel-Prize winning Yale economist Robert Shiller, who gained public notoriety for predicting the Great Recession.
As early as 2005, Shiller started issuing warnings about an impending drop in real estate prices that could be as severe as 40 percent.
Did he have a crystal ball? Is he magical? How did he anticipate this?
His strategy is ridiculously simple, yet effective. Shiller simply looked at U.S. housing prices dating back to 1890, stripping away inflation. He “benchmarked” the 1890 prices at a value of 100 and tracked relative housing costs through the lens of inflation-adjusted dollars.
Through this, Shiller made a few observations:
- A house in 1897 cost the same as a house in 1997, adjusted for inflation.
- If you benchmark 1890 prices at a value of 100, you’ll notice that U.S. housing prices have stayed within the 100-120 range over the past century.
- In 1950, for example, the index stood at 105; in 1996 the index stood at 106. Real estate didn’t make any gains (other than inflation) during that 46-year timespan.
- Starting in 1997, an unprecedented bubble began forming.
- Every housing ‘peak,’ or bubble, is followed by a tragic, painful, ugly fall.
The New York Times ran this scary chart in 2006 (before the recession), based on data from Shiller’s groundbreaking book Irrational Exuberance. (I’ve added red arrows for emphasis).
Image credit: The New York Times
As you can see, housing prices (adjusted for inflation) typically stay within a narrow range — around 100-120 on that chart.
There have been only two notable exceptions. The first was triggered by the austerity of World War I, ending with post-WWII prosperity. The second was the rampant housing boom that started in 1997. And, well, we know how that story ends.
“But housing is booming now!”
Sure, some people who bought at the bottom of the market in 2009 are now sipping champagne on the French Riviera. (I’m kidding. Kinda.)
Home prices in many parts of the nation have doubled since the 2008-2009 lows. But in that same time period, the total U.S. stock market has nearly tripled.
In March 2009, the Dow Jones (a measure of the largest U.S. stocks) was valued at 6,626. Today its worth 3x more.
Key takeaway: Housing keeps pace with inflation. And when it does produce real gains, it often underperforms the overall U.S. broad market.
- If we cherry-pick dates, we can find a specific sliver of the population that’s enjoyed runaway home values since 2009. Housing underperformed the overall stock market during that same period.
- If we cherry-pick locations, we can find specific towns or cities that enjoyed atypical growth, typically due to external influences like rapid job creation. This falls along a bell curve; we can also find towns and cities with unprecedented levels of decline. (Ahem, Detroit.)
When we stop cherry-picking and “zoom out” into a multi-decade macro view, we’re left with the uncomfortable truth that U.S. housing prices don’t substantially increase in value. They merely keep pace with inflation, and they significantly underperform the overall U.S. stock market.
Should I Rent or Buy?
“So what? Why are you comparing housing to stocks? You have to live somewhere. You don’t have to buy stocks.”
We’re making this comparison because we’re asking the following question:
Are you better off:
- Tying up your cash into a home
- Finding an alternative investment, coupled with a rent payment?
Any cash that’s tied up in home equity, including the down payment, is locked into a lifetime of just-keeping-pace-with-inflation.
This opportunity cost, combined with the additional overhead of homeownership, can (in many markets) negate any advantage that comes from owning.
“Paula, that sounded like whoomp –whoomp –whoomp. Like Charlie Brown’s teacher. I understood about 0.0000001% of whatever you just said.”
Okay, let’s …
“Seriously, Paula, this is too technical. It’s making my head hurt.”
Alright, let’s walk through an example together.
“Fine. But you’re competing with Miley Cyrus’ latest tweets. And I gotta say, those are WAY more racy.”
Gotcha. Check this out:
Meet Renter Rachel and Owner Owen
Let’s meet Rachel and Owen, two people who are both hardcore savers. They haven’t met, because they’re figments of my imagination.
Obvious disclaimer: This example is for illustrative purposes only. Your personal expenses will be different. Duh.
This example is meant to illustrate that homeownership is not the slam-dunk golden ticket that society likes to believe.
Here’s an illustrative example of one situation in which the buy vs. rent case isn’t so clear-cut.
Please DO NOT pitch a fit in the comments about “waaahhh, my interest rate is lower!” because this tells me you missed the point.
The point = crunch the numbers using the specifics of your personal situation, instead of making a six-figure decision based on an oversimplified cliche.
Intuitively, we all know that if you’re going to live somewhere for one year, renting is better. And if you’re going to live somewhere for 40 years, buying is better.
Somewhere between one year and 40 years is the crossover point, where buying becomes better than renting. It might be 5 years. It might be 10 years. It might be 15 years. It might be 20 years. It might be 25 years.
The question, then, is: Where is that crossover point? How can you solve this puzzle?
The solution comes from running scenarios based on a massive variety of factors, including the price-to-rent ratio in your area (we’ll dive into that concept later in this article), prevailing interest rates, tax brackets, utility costs, HOA fees, alternative investment opportunities and a long list of other factors.
Every human will have unique data points. That’s why every person should crunch the numbers based on their own personal situation.
If you don’t like the numbers in the example below, re-run the scenario using your own numbers. That’s the point.
Don’t buy into oversimplified cliches like “renting is throwing your money away.” Don’t oversimplify a six-figure decision.
Onto the example:
Rachel and Owen separately saved half of their income for the past few years. Now they each hold $102,500 in cash.
- Rachel is a renter. Her rent costs $2,500 per month.
- Owen is an owner. His mortgage costs $2,500 per month.
Rachel paid her landlord a security deposit of $2,500. She invested $100,000 into an Total U.S. Stock Market Index Fund that earns an 8 percent long-term annualized average.
Owen’s mortgage consists of $2,000 for principal and interest and $500 for taxes and insurance. He carries a 30-year fixed-rate mortgage with a 5 percent interest rate, which means his loan balance is $372,500 and the value of the home is $465,000.
“Can Rachel and Owen live in equivalent homes?” — Yes, if the price-to-rent ratio in their area is 15.5.
We’ll deep-dive into the concept of price-to-rent (P/R) ratio later in this article. Stay tuned.
To buy this house, Owen made an initial payment of $102,500, which divides out as $92,500 for the down payment (which is 20 percent of the home value) plus another $10,000 for the buyer’s side of closing costs.
In other words:
- Both started with the same amount of money.
- Rachel used her money to invest in a broad-market index fund.
- Owen used his money to make a 20% down payment on a home.
Rachel and Owen both live in their respective homes for 10 years.
During that time:
- Rachel’s rent rises 2% per year.
- Owen’s home value climbs 2% per year.
- Inflation increases 2% per year.
Are you with me so far? Sweet.
Let’s talk about Owen’s mortgage:
- Owen has a fixed-rate, 30-year mortgage.
- His principal and interest payments stay the same, so he repays his loan with increasingly cheaper dollars over time (as inflation kicks in).
- His property taxes and homeowner’s insurance premiums rise at the rate of inflation, which means his total mortgage payment climbs slightly.
- He sets aside one percent of the home value, or $4,650 per year, to take care of maintenance, repairs and renovations. (He loses much of this value to depreciation of fixtures and mechanicals, which he replaces and upgrades in 10 years before listing the home for sale.)
- He pays $300 per month in HOA dues.
(Note: I ran this scenario through multiple online calculators. Each one gave me a slightly different answer. I’m posting screenshots from the NYTimes calculator. Please allow for slight variations, such as a $2,500 payment vs. a $2,557 payment, based on answers from divergent calculators. These minor differences don’t significantly affect the outcome.)
Still with me? Let’s look at their utilities, maintenance and insurance:
- Owen and Rachel pay equal electricity, gas, cable and internet bills.
- Rachel’s landlord covers water, sewer and trash, while Owen pays $85 per month for these combined services.
- Rachel pays $307 per year in renter’s insurance.
Finally, let’s chat about taxes and fees:
- Owen pays a six percent commission to the real estate agent when he sells his home.
- Owen itemizes his tax deductions and deducts his mortgage interest.
- Both Rachel and Owen pay a 20 percent marginal tax rate.
Any guesses on which person holds the upper hand?
Anyone?
Seriously, take a guess. C’mon now. Close your eyes …
Okay, got it?
Well, the results are in …. Rachel and Owen performed about the same.
They’re neck-and-neck.
“But I thought renting is throwing your money away?”
How is this possible?
Both Rachel and Owen paid opportunity costs.
Rachel lost the opportunity to enjoy equity gains. This is exactly what people talk about when they make the argument that “buying is better than renting because you build equity.”
She missed the opportunity for equity gains from three sources:
(1) Principal contributions
(2) Renovations and upgrades
(3) Market growth
We’ll talk about these later in this article.
Owen, however, paid equal opportunity costs by missing out on the chance to invest $100,000 into an index fund. He tied up cash in a non-performing asset.
I’m going to repeat this one more time for emphasis, because it’s so crucial:
Tying up your cash in a nonperforming or weak-performing asset carries a giant freakin’ opportunity cost.
Can I repeat that again?
Actually, can you tattoo that on your forehead?
Tying up your cash in a nonperforming or weak-performing asset … sucks.
[Quick tangent: Many real estate investors cite this to support “no-money-down,” high-leverage strategies. But this (1) costs higher interest rates, (2) costs mortgage insurance, and (3) creates a frightening risk profile. Anyway, this isn’t an article about real estate investing, and most primary-residence homeowners want to build equity, so I’ll stop this tangent.]
Back to Owen and Rachel:
To be clear, both of them paid an opportunity cost. And in this specific example, with a specific set of assumptions, their overall net result was the same.
“But I’m a Special Snowflake!”
“My situation is different,” you might be thinking. “My HOA is lower. I’m in a higher tax bracket. I can qualify for 4.5 percent interest instead of 5 percent.”
Yeah. That’s the point.
The myth that “renting is throwing your money away” misses this nuance and detail.
Don’t oversimplify the biggest purchase of your life by claiming that building equity is always superior.
You’re purchasing equity. And every purchase carries a tradeoff. When you buy equity, you necessarily don’t buy something else. Every dollar holds an opportunity cost.
(Oh, don’t make me say it —)
You can afford anything, but not everything.
(There! I said it!)
“But I’m the Special-est Snowflake of All!”
[UPDATE 11/30/2015: I’m getting flack from a lot of Special Snowflakes in the comments. Their arguments are along the lines of: “Waahh! I’m such a special snowflake! Your hypothetical illustration should have precisely reflected MY situation!”
Are you having that same thought? Re-read this Special Snowflake section.
The headline of this article isn’t:
- “Housing might be a good deal if your interest rate is 4 percent instead of 5 percent!”
- “Housing might be a good deal if you live there until you die!”
- “Housing might be a good deal if the P/R ratio in your area is less than 15!”
Stop griping about the fact that your specific life doesn’t match the example. You personally may not have HOA fees, but that’s not true for everyone. Furthermore, it’s irrelevant.
Your Special Snowflake circumstances don’t change the fact that everyone is responsible for analyzing their own variables. Don’t base the biggest purchase of your life on an intellectually lazy cliche.
In this article:
- I give you the exact tools and steps to run these numbers for yourself.
- I give you a framework for understanding the myriad of variables that play into this decision.
- I empower you to conduct your own analysis and make your own decision, based on your own circumstances, rooted in logic and math.
Many people will grasp the lesson. And they’ll be richer for it.
Others, unfortunately, lack the ability to wade out of the details of a hypothetical illustration.
They’re more focused on nit-picking the deviations between themselves and one illustrative example — “waaahhh! my HOA is smaller!” — that they miss the bigger point.
And in doing so, they shortchange themselves from an opportunity to learn.
The next time you get social pressure to “stop throwing money away on rent,” come back to this article. Crunch the numbers, using a calculator that lets you input a wide variety of variables.
Wealthy people think for themselves. Mediocre people cave to social pressure and lazy cliches.
Three FAQ’s About Rachel and Owen
“Why is Owen paying 5 percent interest? Aren’t today’s interest rates around 4.6 percent? That’s a 0.4 percent difference!!”
Let’s learn history, shall we?
From 1971 to 2015, mortgage interest rates (APY) ranged from a low of 4.6 percent to a high of 16.63 percent. During the majority of those years, average mortgage interest rates spanned between 6 to 10 percent.
If you object that Owen’s 5 percent interest rate seems outlandishly high, learn history. Owen’s interest rate reflects a near-record-breaking historical low.
“Why do they both move out in 10 years? They should live their homes until they die!”
From 2001 to 2011, the average American stayed in their homes for only 6 to 9 years. If you object that the Rachel vs. Owen comparison should have assumed they’d live there until they die, look at behavioral data.
“Rachel’s landlord needs to make money. How could he/she possibly earn a profit under this scenario?”
Here are many ways Rachel’s landlord could benefit:
- The landlord could purchase the property at a steep discount, such as through a foreclosure auction, short sale, estate sale, or by “driving for dollars” (making direct contact with the owners of distressed property.) This allows him/her to purchase the property significantly below market value.
- The landlord could be holding the property for the sake of inflation-protected wealth preservation, rather than as a cash flow investment. (Don’t assume all landlords share the goal of cash flow. Some simply want to diversify their assets.)
- The landlord could be making a speculative play on potential appreciation. (I don’t recommend this technique, but many landlords do this.)
- The landlord could have inherited the property.
- The landlord could have purchased the property decades ago, paid off the mortgage, and now enjoys the cash flow. They don’t want to sell/trade into a different property due to the hassle involved, so they let this property ride.
Okay, tangent finished. Back to our regularly-scheduled article, already in progress …
Argument #2: Rent is Forever. Mortgages End.
Don’t worry. This next section won’t be as math-y.
Let’s revisit the beginning of this article. There are three arguments that justify the “renting is throwing your money away” myth:
#1: Rent is an expense. Mortgages build equity.
#2: Rent is forever. Mortgages end.
#3: Renters don’t benefit from rising home values. Homeowners do.
We’ve dismantled the first argument. Let’s deep-dive into the second: “You’ll pay rent forever. Your mortgage will eventually end.”
Here’s the breakdown:
- If you rent, you’ll always make rent payments.
- If you own, you’ll pay off your mortgage within 15-30 years.
- Fewer payments are better than more payments.
- Therefore, owning is better than renting.
Flawed logic strikes again.
This reasoning presupposes that your mortgage is your only payment. That’s plain wrong.
After you purchase 100% home equity, you own your home “free-and-clear.” This does not mean that you’ll never spend another dime on your home again. It merely means that you no longer need to make principal and interest payments, which are known as “P&I.”
However, P&I are only one of many home-related expenses. Your other costs include:
- Maintenance
- Repairs
- Renovations / Depreciation
- Property taxes
- Homeowner’s insurance
- Utility bills
- Municipal usage fees (water, sewer, trash)
- Homeowner association dues (if applicable)
- Transaction fees, commissions and closing costs
- Opportunity costs
How much can this cost? Depending on where you live, those expenses could cost equal to or more than rent on a comparable property.
Here’s an example for a $300,000 single-family home owned for 10 years:
- Maintenance: $50/month
- Repairs / Renovations: $250/month (1 percent of property value per year; includes major capital expenditures)
- Property taxes: $300/month (1.3 percent of property value per year)
- Homeowner’s insurance: $125/month (0.5 percent of property value per year)
- Utility bills: $50/month (beyond what a landlord covers in a comparable rental)
- Municipal usage fees: $75/month
- HOA dues: $250/month
- Transaction fees: $166/month (combined total of $20,000 out-of-pocket closing costs from both buying and selling with a 120-month holding period)
- Opportunity costs: $315/month (investment of a $60,000 down payment at a growth rate of 5 percent after inflation compounding annually; subtract the initial contribution and divide over 120 months, calculated via investor.gov)
Total cost: $1,581 per month.
In this example, owning a $300,000 home “free-and-clear” for 10 years costs $1,581 per month without a mortgage.
Key takeaway: Your principal and interest payments are not the total picture. Not by a long shot.
[Quick tangent: Unfortunately, many investors don’t do their homework. They jump blindly into the waters, assuming “if the rent covers the mortgage, I’m cool.” Then they lose their shirt.]
Humans have many cognitive biases in our understanding of money. One of these biases is that we emphasize cash flow rather than the whole picture.
- When money leaves our bank account (e.g., paying bills), we feel the pain. It hurts! It hurts!
- When expenses are “invisible” (e.g., opportunity cost), we ignore it. You don’t miss what you never had.
- When expenses are lump-sum (e.g., replacing the roof, windows, siding, floors, garage door, etc.), we convince ourselves that our monthly costs are absent of those figures. “My costs are only $600 per month. Oh, and once every 20 years, I pay an extra $55,000.”
In the example above, you won’t literally watch $1,581 depart your bank account every month. At least $731 of that figure comes in the form of intangibles or lump-sums, which means you’ll only see around $850 per month leave your checking account.
When that happens, it’s easy to fall into the cognitive trap of assuming that cash flow is the whole story. “My expenses are only $850 per month!” But it’s not.
Cash flow is a chapter in the novel. An important one. But as the Chief Human Responsible for Your Money, your job is to read and understand the whole book.
Zoom out and look at the big picture; make decisions accordingly.
In fact, if there’s one broad lesson from this entire article, it’s this: zoom out.
If you zoom out and look at the larger picture –inflation, investment gains, opportunity costs, legacy-building – you’ll start making smarter choices.
Back to the debunking the “rent is forever; your mortgage is not” argument:
Yes, your P&I payments will disappear after 15-30 years. But you’ll always pay for maintenance, taxes, insurance, renovations, care and operations of that house.
You’ll never be finished with home payments. Regardless of whether you rent or own, you’ll spend your life paying for housing in one form or another.
Death and taxes. And housing. And socks. These are life’s few certainties.
You’ll still need socks.
The question, then, isn’t: “How can I escape this perpetual payment?”
The question is: “Which of these two perpetual payments is more desirable? Would I rather pay rent in perpetuity? Or would I rather pay homeownership costs forever?”
Before you can answer that question, you’ll need to see which of those two numbers is bigger. And depending on where you live – Detroit or San Francisco? — the answer could go either way.
The myth that “renting is throwing money away” ignores the simple fact that the cost of rent, relative to the price of the property, occupies a HUGE range nationwide.
In some parts of the country, you can rent a $300,000 house for substantially less than $1,581 per month. Heck, the landlord will even throw in a free TV and send you a $25 Starbucks gift card.
In other parts of the country, you can’t dream of touching a property like this for less than $3,000+ per month in rent.
And this leads us to today’s actionable lesson: Check the price-to-rent ratio.
Don’t be a zombie who listens to oversimplified clichés. Spend 30 seconds doing a little bit of math.
“Meth?”
No, math.
The formula for calculating price-to-rent is (predictably) the price divided by annual rent.
Price: $300,000
Rent: $1,500 per month = $18,000 per year
Price-to-Rent Ratio = $300,000/$18,000 = 16.6
Cool. So what does that number mean?
Here are a few rules of thumb:
- If the P/R ratio is greater than 20, hesitate before buying the house.
- If the P/R ratio is greater than 25, don’t buy the house unless you have strong non-financial reasons.
- If the P/R ratio is greater than 30, run screaming in the other direction.
A house with a P/R ratio of 25 would equal a $300,000 house that rents for $1,000 per month. Or a $100,000 house that rents for $333 per month. Yeowch. That’s painful.
[To put this into perspective, my bare-minimum-criteria for any rental property that I purchase is a P/R ratio of 8.33.]
In the Rachel vs. Owen example, their homes carry a P/R ratio of 15.5.
Fun facts about P/R ratios you can use to impress your friends:
- The average is 11.95 nationwide.
- The median is 11.27 nationwide.
- Nationwide, P/R ratios range from a low of 2.84 (awesome for owners) to a jaw-dropping high of 46.38 (fantastic for renters).
- The highest P/R ratios (best spots to be a renter) are in southern California and the northeastern states, particularly in major cities with concentrated business clusters such as San Francisco, Seattle, and New York.
- The lowest P/R ratios (best spots to be an owner) are in the land-locked states. Many of the larger non-coastal cities, like Chicago, Atlanta, Miami, Phoenix and Las Vegas, hold P/R ratios favorable to owners.
When you’re calculating P/R ratio, follow these steps:
- Use the “total acquisition cost” – including purchase price, closing costs, and (if needed) upfront repairs to make the space minimally viable (e.g. if you bought a fixer-upper).
- Run three calculations: best-case, worst-case and mid-case.
For example:
Purchase price: $440,000
Upfront repairs: $10,000
Closing: $5,000
Total Acquisition Cost: $455,000
- Worst-Case Rent: $1,800 /mo = $21,600/year
- Mid-Case Rent: $2,000 /mo = $24,000/year
- Best-Case Rent: $2,200 /mo = $26,400/year
- Worst-Case P/R ratio: 21.06
- Mid-Case P/R ratio: 18.95
- Best-Case P/R ratio: 17.23
In this example, we have a property that would obviously make a terrible real estate investment. A quick glance at the numbers makes that abundantly clear.
But it’s a viable candidate for a primary residence, given that the P/R ratio still points in favor of owning. It dances on the edge of the razor blade, but the balance tips in favor of ‘buy.’
So anyway –
Now that I’ve given you some homework, let’s circle back to the justification that launched this conversation:
“You’ll pay rent forever. Your mortgage will eventually end.”
That’s false. Nothing ends.
You’ll be making house payments until the day you die.
(Sorry. But it’s true.)
(Hey, I’m available for parties!)
Here’s the smarter question that you should ask yourself: Will it be cheaper in the long-term to maintain a home or keep paying rent?
The answer is influenced by:
- Where you live
- What “income bracket” of housing you prefer
- The length of time you’ll hold onto the home
- The ancillary costs of homeownership
To find your answer, check out the price-to-rent ratio, and weigh those four other factors I’ve listed above.
Argument #3: “Renters don’t benefit from rising home values. Owners do.”
At this point, we’ve tackled two of the three misguided justifications for the cliché that “renting is throwing your money away.”
#1: Rent is an expense. Mortgages build equity. – Debunked!
#2: Rent is forever. Mortgages end. – Busted!
Let’s tackle the final rationalization: “Renters don’t benefit from rising home values. Owners do.”
Here’s the argument, broken down:
- Home values rise over time.
- Rising values result in equity gains.
- Homeowners benefit from equity gains.
- Renters don’t.
- In fact, renters are penalized, because equity gains correlate with rising rents.
- Therefore, owning is better than renting.
Let’s dissect this argument. We’ll start with a deep-dive into the concept of equity.
“Mommy, where does equity come from?”
Equity is created in three ways:
#1: Principal Reductions.
Imagine that you sell junk on Craigslist. You earn an extra $500. You use this to make an extra mortgage payment. Congratulations – you now have an extra $500 worth of home equity.
This is called “principal reduction.” You’re trading cash for equity.
Every dollar that you spend on principal reduction carries an opportunity cost.
We talked about this at length earlier, so let’s move on to two other types of equity gains.
#2: Forced Appreciation.
Imagine that you get a $10,000 bonus at work. Hooray!
You use this money to upgrade your kitchen. You’re an excellent manager, and you oversee a hyper-profitable renovation.
Your home is now worth $20,000 more, even though you only made a $10,000 investment. You’ve doubled your money.
Half this added value came from trading-cash-for-equity. But the other $10,000 came from forced appreciation, which is the result of knowledgeable, skilled management.
Forced appreciation comes from choosing the right property and managing it correctly. This is a real estate investor’s bread-and-butter.
Talented investors don’t sit around, hoping that the market might rise in value. They take matters into their own hands. They spend $X to remodel a home, create a value that’s greater than $X, and pocket the spread — either through higher rental income or via sales.
Here’s the question: Do you have what it takes to force appreciation?
“Yeah, of course. I oversaw a bathroom remodel last year.”
Well — that’s not exactly the same thing.
Smart investors don’t spend money based on personal desires – “I’ve always loved this deep-blue granite!” They make informed, rational decisions based on profit and loss. (Remember this story?)
Investors don’t say things like:
- “I love these maple cabinets!”
- “This hardwood would look great with our furniture.”
- “Let’s wallpaper the living room’s accent wall!”
Homeowners, by contrast, often make renovation decisions based on their personal tastes. This is a far less profitable strategy.
Forcing appreciation is a skill – just as playing guitar, dribbling a basketball and speaking Spanish are skills.
Key takeaway: You can create equity through forced appreciation. But don’t assume you’ll hit a home run on your first swing. You’ll need skill and strategy first.
#3: Market Gains.
Market-based equity gains come from growth in the overall housing market.
Let’s say that you buy a house in January for $100,000. By December, that house is worth $102,000. Congratulations – you’ve gained $2,000 in equity.
Sounds amazing, right? Who doesn’t love something-for-nothing?
But here’s the tough truth about market gains: You’re outta control.
The housing market might rise, might fall, or might stagnate. It might do a combination of all three.
If home values climb, they may rise at a long-term annualized rate of 2 percent, 3 percent, 4 percent. Or maybe 10 percent. Who knows? There’s nothing you can do to affect these results.
Sure, you can purchase a home in a neighborhood that shows signs of appreciation: lots of new construction, permits and jobs are usually a good sign. Unless, of course, it’s 2007 and supply has drastically outpaced demand. Then you’re screwed.
You can’t control market gains. You have no influence over timing, scale, or direction.
“Buy-and-pray” is not a wealth strategy.
Key takeaway: Hope is not a plan. And it shouldn’t drive a six-figure decision.
Back to the original argument: “Renters don’t benefit from rising home values. Owners do.”
Rising home values come from three sources:
- Principal reductions
- Forced appreciation
- Market gains
What’s the cost of these?
- One requires opportunity cost.
- One requires skill.
- One is outside of your control and historically keeps pace with inflation.
I’d hardly call this a “benefit.”
“But renters get nothing at all. At least owners are getting some equity.”
Let’s return to that conversation about opportunity costs. Renters are:
- Not tying up cash in a downpayment
- Not tying up cash in renovations, repairs and maintenance
- Potentially paying lower monthly costs
By doing so, renters enjoy:
- Greater flexibility
- Lower overhead
- Fewer responsibilities
- Opportunity to pursue higher returns elsewhere
So … yeah. Plenty of benefits on both sides.
Is Renting Better Than Buying?
What conclusions can we reach at the end of all of this?
Should you keep renting? Is renting better than buying? Or should you purchase a home? Is buying the better choice?
Your answer is going to depend on a massive number of factors, including:
- The local price-to-rent ratio.
- How long you’ll live there.
- Your alternative investment options.
- Your assumptions about inflation and investment gains.
- Maintenance, repair, insurance, property tax and capital expense costs.
- The rate at which rents rise.
- Et cetera, etc., etc.
You get the picture.
My goal is to impress upon you — once and for all — that this myth that “renting is throwing money away” is wrongheaded.
In fact, it’s dangerous.
It oversimplifies a life-changing, six-figure decision.
It’s probably caused thousands (or millions) of people to buy houses they later regret.
And it needs to stop.
The next time you hear a friend or family member repeat one of these cliches — “I’m tired of throwing money away on rent” — send them this article.
And the next time you catch yourself thinking the same thing (because we’re social creatures who internalize pop-mythology), come back and re-read this.
There’s no such thing as “throwing money away on rent” — not any more than you’re also throwing money away on cleaning gutters, paying property taxes, and for that matter, buying socks.
If you’re a homeowner (like me) and you enjoy it, good for you.
And if you’re a renter, stop feeling guilty.
Next time, we’ll focus on a different ridiculous statement:
“I’ll skip dessert.”
Yeah, right. I’m going to prove that one wrong right now.
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Great detailed post and the biggest takeaway of all is that “it all depends.” One way is not automatically better than another way, just like renting is not always throwing away money (or as you say, they’re both throwing away money!). I think people who believe one set rule for anyone and any situation is just being lazy.
And we are all special snowflakes! 🙂
I totally agree that it really depends! One of the reasons we love buying houses (aka soon to be rentals) is that our mortgage is less than our rent. So we get to save money while we live in the house and turn it into retirement baskets when we leave. As always every area is different. So its important to know your area.
The American dream of home “ownership” is nothing but a joke! The average American has 62+% of their net worth tied up in their home, but how much income does that investment earn? Nothing! or better yet, negative nothing! Property tax, insurance, upkeep, HOA dues, etc. on a paid off home can take a massive bite out of your Social Security check!
Me? I’m either going to purchase a home for cheap (all cash) during the next crash, or just keep saving my money and renting! As I save money on rent, my cell phone ($20 per month from Boost), my car insurance ($25 per month from Insurance Panda), etc., I’ll be able to invest more into index funds with my freed up capital… something home-owners can never do!
Depends on how you use it. Elizabeth owns them and converts them to money making machines. I utilize my equity into HELOCs and use those to buy rentals thus making my “dead equity” alive.
Wouldn’t call it a joke because for most without the knowledge its all they could do.
Jim,
I agree. This was a detailed article and it really does depend. I like the point about opportunity cost.
The sentence that really got my attention, though, is: ‘A house in 1897 cost the same as a house in 1997, adjusted for inflation.’
That is so surprising to me. I would expect that housing costs would decline due to advances in construction methods, material procurement methods, and so forth. Then, on the otherhand, maybe the added comforts of home have more than outpaced the advances in building technology such that if we were comparing apples to apples, home to home, a 1997 cabin would be be much cheaper than its 1897 counterpart!
Unfortunately, point one is talking to average people who spend 30 years paying for something. If you pay for a house instead of renting to own from the bank for 30 years, a home can be a great investment on money you were going to spend MOST of anyway. If you don’t buy a house but instead let the bank buy it, then of course your not getting a good deal.
Ok, very interesting article and all, but i do have one major question that is really bothering me. All of this is true, for the U.S. realestate market, but what about other markets?
As an example, where i live, the AVERAGE/GOOD P/R = 25 , what should you do in this case? Being a home owner for renting purposes doesnt really give you an equity i think, and pretty nice for renters tough…
@Zach – you may be right since I don’t know your specific situation. However, you seem to have completely missed the concept of opportunity cost when it comes to paying all cash. For example, buying all cash for $160k vs putting $160k in VTSAX for 30 years is the better comparison (with adjustments for rent/buy expenses, etc of course). The former may grow 3-5% per year based on area and historical averages, the latter may increase 10-11%/yr based on historical averages (FYI, over the last 100 years – 2 world wars, Great Depression/Recession, high and low inflation, etc), the S&P gave actual total returns over 10%/year so this is a very fair return to use) and dividends reinvested. Only by favoring in something like this to your personal situation can you take opportunity cost into account. And given that you use a time frame of 30 years, historical averages are fair compared to cherry-picking shorter time frames with either higher or lower returns.
Jim Wang! From http://www.bargaineering.com!!! HUGE fan of your articles on that site.
Amazing article, Paula. I will definitely send it to others that need a reality check, and also re-read it before I decide to purchase. Informative and FUNNY!
Subbed!!!!
I own rental property and recently sold the only house I ever bought for myself to live in. One of the happiest days. No more work or negative neighbors.
To me the only real disadvantage of renting in my market is the potential of disruption. Via sale, nightmare neighbors or insane rent increase. To mitigate I verify the likelihood of those up front.
You make an interesting point, with ownership you get stability. If you are forced to move, you’ll see it coming. If you rent, it can be sprung on you.
I think it’s true that these bad rental experiences (crappy landlord or house sold) drive many towards buying. Then they borrow these myths Paula debunked to rationalize the decision.
Eliminating uncertainty may be a viable reason to own, but as this article shows, you need to measure what that certainty truly costs. There may be cheaper ways to get certainty than buying (like paying a premium rent, paying some of landlords expenses, etc).
I love the balanced prentation and thoroughness of this article, Paula! I will be sharing it widely.
Potential disruption from renting can also be a good thing. Life moves so fast that my family might miss out if we feel too rooted and pass up opportunities.
I value flexibility, less chores and money much higher than tradition, fixed mortgages and the prospects of residential appreciation (especially when rates return to normal). But to Paula’s point it depends on the individual.
If I can’t paint the walls I guess I could always dry my tears with excess cash and free time 🙂
Love this, well said. Disruption while renting was a big concern during the real estate crash of 2007 as many were collecting rent but letting mortgages go into foreclosure, however in a stable market this is less likely.
But there’s also an opportunity cost to that stability. Renters are in an easier position to move in response to an employment opportunity.
My wife and I are considering doing something somewhat similar to what you mentioned. We currently own our home in the suburbs, but are considering renting out our home and renting a condo in the city for a few years before we have kids (really just to enjoy the city lifestyle and be closer to both our offices). Once we do have kids, however, we would want a bigger place since we will likely need to downsize when we move.
Based on my research, the rent we could get for our home would just cover our mortgage, and the condo we would rent in the city would be ~$300-500/mo. higher. Maintenance on the exterior of the property is covered by the HOA, but I would factor in ~$100/mo. in maintenance to cover incidentals while we’re away.
In my mind, effectively the “net rent” would be the $300-500/mo. rent increase + $100 maintenance costs + some assumption for vacancy, since we would still enjoy the tax benefits and appreciation of our current home, but our mortgage would be covered by the rent paid by the tenant. There may be some other small incremental expenses, such as the difference in cost between landlord insurance and homeowner’s insurance, but based on your experience, is this a reasonable way to approach this analysis?
Any insight would be appreciated!
Just a warning, if your incoming rent from your current property would just barely cover the mortgage, you might be better off just selling the property. You will eventually have to repair something, or cover mortgage a month or so here and there between renters. Also eventually something like a bathroom, kitchen, or roof will need re-doing or some other 5-figure expense.
based on very little info, my gut might suggest that the house prices in your area are just too high to really be investment worthy. I live in a similar neighborhood, most homeowners have owned for 20+ years before the prices got out of control, and just held onto the places so theres not much inventory for sale (theres a ton of rentals available, hence the low rent prices), but still a high demand of people that want to live in the town driving residential sale prices up.
just my 2 cents
I have been a “appreciation forcer” (in Paula’s words) for 25 years and am thinking of selling my primary house, while keeping my three rental units, just so I can relax and travel more. I see horrific bubbles in my area that I also saw before the crash.
I definitely agree that renting or buying can be a profitable path. It all depends on the details and your goals, which few people fully analyze or think through. The one thing I would add on the buying side though is that if you can get 1.) a below-market-value house and 2.) force additional value through renovation, it really supercharges the return on your invested capital. If you can get those two things AND 3.) actually really like the house (i.e., it is something special not easily available through renting), buying is tough to beat in my opinion. Granted, it is tough to get all three. If I couldn’t have all three, I would rent for all the reasons you mention.
I would go one step further and say always have an exit plan. While my husband is active duty so we move more than most. This generation finds ourself moving alot with up or to a different area. We personally never buy a house we are in love with . We buy a house that meets your 1 and 2, with a different 3, a great rental. This way we have a great rental for when we move on.
I think renting vs buying is a personal decision…pros and cons of both. But I think your first point is slightly misleading. You have owner owen in a 465,000 house (2500 per month), while Renter Rachel is probably closer to a 250k – 300k house (2500 per month). So, there is a large discrepancy on the quality and features of the home..number of bedrooms, etc. A better comparison might be similar values in overall home values. The second misleading portion of it is to say in 10 years, the market will return 8%. While it ebbs and flows, I think the 8% was over a longer period of time. It could be better, or worse over that time.
In your second argument, I would equate the same “extra expenses” as added to the rent. Unless the landlord is constantly going to lose money, which I doubt will always be the case.
I think you can find certain situations that you can find it cheaper to rent, but most are not good stable areas. And I would doubt they will be that cheap over the long term or the value of the home will be there.
I still find the article very interesting, and it makes people think in another manner…but I am not sure it is not slanted a big to the renter side.
Hi Test —
Check your assumptions! You’re assuming that the entire U.S. holds the same price-to-rent ratio. That’s false. In downtown Las Vegas, for example, a 2-3 bedroom high-rise luxury condo costs around $465,000 and would rent for around $2,500 per month. [The price would range from $2200 – $2800 per month depending on time of year, length of lease term, number of parking spots, and whether it’s two or three bedrooms.]
That’s why I emphasize calculating the price-to-rent ratio (P/R ratio). A blanket statement that “everywhere in America, a $2500/mo rental will get you a $250k-$300k house” is misleading. Actually, it’s just plain wrong.
Sure, renting vs. buying is a personal choice. But you need to understand the math behind your decision (in addition to emotional/personal factors). And wild mathematical assumptions about P/R ratios that aren’t grounded in actual, verifiable facts can lead people into making six-figure mistakes.
Remember: Don’t let speculation drive a six-figure decision!
I was told a long time ago that purchasing a home is an investment. Boy am I glad I listened to them, NOT! Do the math or don’t do the math. I believe Robert Kiyosaki (multi-millionaire)is right. If it’s an asset it puts money in your pocket each month. If it takes money out of your pocket, it’s a liability. That is not to say you should live on the street, but I recently explained our very situation to my 16 year old daughter. My wife and I bought our home 18 years ago, paid it off early and it is worth almost twice what we paid for it. Most people would think we made a wise investment, until I show you the true numbers. To break even, I will need to sell my home for more than $150k than it is currently worth. Conversely, if we lived in the high end apartments right down the street, not only are they bigger than my home, it would have cost us about $10,000 less in the same time. The bottom line is that Paula is getting you to think rationally. Make decisions based on facts and numbers, not total assumptions. Owning a home can be rewarding, but unless you figure out a way for someone else to pay for it, it will never be a good investment.
I’m glad you took a REAL look at the numbers, adjusted for inflation, to understand your relative performance. This is a critical step that most people never take!
+1 and thank you for your comment. “Make decisions based on facts and numbers, not total assumptions.” Heck yes! 🙂
My assumption didn’t compare a house, with a high-rise condo. I would have compared a house with a house. I agree with you that it (P/R ratio) is different in different areas, but disagree on it is just plain wrong. It is a good rule of thumb. Perfect, by no means.
I would ask you that since you have rentals, does your pass the 1% test? Or would you rent in your location, a 465k house for 2500 per month?
If you want to see a huge assumption….assume that your rent will stay 2500 per month in a 465k house for 10 years.
#1: Nobody assumes that rent stays the same over 10 years. Re-read the article. Rent inflation is included in the Rachel vs. Owen example. As you’ll notice, Rachel’s rent rises annually at the rate of inflation.
#2: P/R ratios occupy a range from 2.8 — 46.3 nationwide. Your statement that “$X rent will only give you #Y level of quality everywhere in America” overlooks this incredible nationwide range.
— An area with P/R’s of 5 will allow you to buy a much better house than you could rent at the same monthly price.
— An area with P/R’s of 35 will allow you to rent a much nicer home than you could buy for the same monthly price.
In some areas, $2,500 per month will allow you to rent a home that costs $500,000+.
In other areas, $2,500 per month will rent you a $175,000 home.
#3: Yes, all of my rental properties meet the One Percent Rule. Go back and read all of those articles.
#4: Why are you assuming a single-family house? We’re talking about homes that people live in. You can buy OR rent condos, townhouses, and single-family residences. The type of structure doesn’t make a difference. The numbers are what matter.
As I said, the factors that matter include:
— The local price-to-rent ratio.
— How long you’ll live there.
— Your alternative investment options.
— Your assumptions about inflation and investment gains.
— Maintenance, repair, insurance, property tax and capital expense costs.
— The rate at which rents rise.
— Et cetera, etc., etc.
Do the math. Plug different variables into these spaces to see whether renting or buying is better for your special-snowflake-situation. Don’t defend tired, lazy, trite cliches like “renting is throwing your money away.”
1. Your 500k for 2500 a month is probably not a 10 yr rental. It might be intro, or will be sold if it is truly worth 500k. What would a rate of return be? 2 percent? You might be able to find a special case, but I think it would be rare…not the norm.
2. I understand the ratio.
3. Of course yours do. I would think most would as that is why people own them. So, saying someone would knowingly lose money for ten years is rough to believe.
4. When, in the original article, you referred to them buying or renting a house…but your response compared the houses to a condo. I believe there is a huge difference between the two. It does when you can’t find a 465k house that rents for 2500. But you compare it to a condo that does. They are two completely separate types of market.
Also, funny in #3 Market Gains. You could substitute each housing market with stock market….and all would still apply.
Buy and pray is not a wealth strategy….true in houses and stocks.
But when someone says that about stocks…doom and gloom.
If you understand P/R ratio, as you claim to, then let me ask you a question:
In what situation would a $465,000 home rent for $2,500 per month? The answer … are you ready?? … is in a local market that holds a P/R ratio of 15.5. Ta-da!!!!
Here’s the math: $465,000/$30,000 = 15.5
Rachel and Owen live in a local market where many homes hold a P/R ratio around 15 – 16.
Your argument in points #1, #2 and #4 all relate to the same basic argument: You assume that Rachel can’t live in a rental property that holds a P/R ratio of 15.5. You don’t have any data to back this up, other than “I think.” You assume that just because YOU wouldn’t own a rental property with these returns, nobody else would, either. Newsflash: Not every investor thinks like you.
Then you bring housing vs. condos into this?? Who cares? You’re distracting from the topic. Fine, have it your way. Screw the condo. Rachel and Owen both live in single-family houses. And they’re in a market with a P/R ratio of 15.5 — just like millions of other Americans. End of story.
If you want to keep arguing trivialities, here are two recommendations: (1) start your own blog, and (2) put your name on your ideas. Stand behind your own opinions, like a real (wo)man.
I completely devoured this article, lol, and was following this post in particular with great interest because 1, I don’t know how to argue very well, and I am very curious how critisism is handled by a poster, and 2, it made me laugh. 🙂 I love your replies to Test, and I was glad to see that your reasoning (aka, logic) was rock solid.
I am a homeowner, and in my situation, my home costs less per month (out of Pocket at one time) than mortgage, but when I factor in all the other costs…not so much. However, if I ever sell this place, or if I move and decide to rent it out, I will do that with much more knowledge and understanding of how property investment really works.
Thank you so much for posting this article, it was very eye-opening!!
ps I agree, Test, it would be very nice to own your statements as confidently as you write them. 😉
Paula is completely right. I am currently renting 2200 square foot $320,000 house in a very nice town in Massachusetts for $1900. There are also $400,000 houses in town renting for less than $2500 a month. My landlord lived in the house then moved out of town and decided to rent instead of selling for whatever reason. Perhaps he moved away for work and wants to move back to the neighborhood in a few years, who knows. The point is situations vary and not all landlords are investors.
According to MIT’s Lynn Fisher and Penn State’s Edward Coulson (http://www.econ.psu.edu/~ecoulson/coulsonfishereisub.pdf), if people perceive that they cannot move, they earn less income over time. Those who make more? Renters and those who have sufficient equity in their homes so that a move is not a financially negative decision for them.
(written from my apartment…with no socks on)
Wow. That is an AWESOME statistic. Thank you, Jason!!
(I’m not wearing any socks right now, either. 🙂 )
Or crazy people like myself who husband is active duty military so we buy every house with the eye that it will be a rental. We move every 1-3 years so we are moving around even as home owners. The great thing is we get to take advantage of the low personal property financing (5% down) and interest rates!
Wow, I love this. I’m a renter and haven’t come across such an in-depth article lately about renting vs buying.
Thank you for debunking the “Renting is Throwing Money Away” myth! This will be my go-to article for showing people that renting isn’t a waste of money, especially when done responsibly (just like home-ownership).
Thank you Elizabeth! That’s exactly my goal (writing the go-to article that debunks that myth). I’m really happy to hear that you loved it. 🙂
What about capital gains taxes? If you own your own house and you sell it, you don’t owe uncle Sam anything. That is a significant savings compared to selling stocks (renter scenario).
If your stocks are held in a Roth-structured account (e.g. Roth IRA or Roth 401k), you also won’t pay capital gains taxes.
That is true. However, you are essentially tying up the funds for quite a bit of time till you retire. Hypothetically, a regular 25 year old making a decision to rent or buy will only be able to contribute approximately 23K a year into a 401K and roth combined and won’t be able to access the earnings till 65. That’s 40 years away. The same 25 year old, buying well (under market value) and looking at it as an investment (making good improvements) will outperform a renter putting in 23K a year in non taxable accounts. If we assume that they are contributing to a 401K anyways while living in a house, I’m hypothesizing that the homeowner will out perform. Plus homeowners can house hack – Buy a house under market value, conduct improvements and sell their house every 5 years without paying any taxes.
Hi SO —
A few points:
(1) You’re free to withdraw contributions from a Roth IRA without any penalties or taxes. That money is available to you, anytime that you want it. (I’d personally recommend keeping it in the Roth IRA, but that’s your choice. You’re free to access it without penalties.)
(2) “Market value” is, by definition, the median price people pay for homes. “Buying under market value” is a specialized skill that only a minority fraction of buyers can achieve (by definition).
Successful investors can buy under market. The average person cannot. If they could, then it wouldn’t be “market value” anymore. The price anchor of “market value” is whatever price the average person is paying for a comparable home in a given geographic area at any particular point in time.
(3) The capital gains on a house, historically, equal the rate of inflation. That’s a significantly lower rate of return than what a person could achieve in the market.
Even if you invested money in a taxable brokerage account (non-IRA and non-401k), you’d still be likely to get higher returns, even after taking the tax hit. A house produces historic returns that equal inflation (3 percent). If you’re very skilled, you may get inflation plus some forced appreciation. If you’re lucky, you might get more, but that’s luck, not investing.
The overall market produces historic returns that range from 7 to 9 percent over a long-term annualized average. Even after subtracting for taxes, stocks still beat housing from a market-based-gains perspective.
Investment properties are a wildly different topic than personal residences. Personal residences are not an investment.
Your max contribution to a roth ira is 6500 (over 50) and 24k for a roth 401k. So, how do you get the other 69,500 into it in the first year?
Over 3+ years? So the full 100k is only working 6+ years? At the mythical 8%?
Wow, you’re attached to the idea that housing-is-always-better-than-renting-for-everyone-everywhere-all-the-time.
Alright, let’s analyze your argument.
You’re concerned about capital gains. As we’ve already established, the capital gains on housing historically equals the rate of inflation.
As a primary-residence homeowner, you can expect market gains of 3 percent per year, over a long-term annualized average.
Here’s the question. Would you rather:
— Earn returns of 3 percent per year, tax-free?
— Earn returns of 8 percent per year, taxable?
OBVIOUSLY, 8 percent taxable returns is better than 3 percent tax-free returns.
“But I object to 8 percent — even though I’m not providing any data to substantiate my objection!”
Okay. Here’s the data: Between 1926 (just before the Great Depression) to 2006, the U.S. stock market returned 10 percent overall. Source: Stocks for the Long Run by Wharton professor Jeremy Siegel.
The after-inflation total market return is 6.8 percent, which means the total U.S. stock market performed 6.8 percent BETTER than housing over the span of the last century.
If you disagree with Dr. Siegel’s analysis, or if you think that we should look at a shorter timespan, let’s take a look at the S&P 500 over the past 40 years. From 1975 to 2014, the average annual return on both the S&P 500 and the Dow Jones was 8.88 percent. (The NASDAQ, during that same timespan, produced returns of 11.48 percent.)
So I guess you’re objecting that the 8 percent figure is too low?
But fine. Let’s play your game. Let’s assume that America loses power in the 21st century. China and India overtake us as the world’s next superpowers, and our economy slows to only 6 percent annualized growth.
Would you rather:
— Earn 3 percent tax-free returns?
— Earn 6 percent taxable returns?
The current capital gains tax rate is only 15% for people in the federal 25%, 28%, 33% or 35% top marginal tax bracket. Basic fourth-grade math tells us that 15% of 6 equals 0.9. After subtracting 0.9 from your 6 percent taxable returns, you’re left with total after-tax returns of 5.1 percent. This is significantly higher than the 3 percent returns you’re getting from housing.
IN FACT, let’s assume that the U.S. economy only produces 5 percent returns! Guess what? You’re still better off investing in index funds!
Any tax-free capital gains that you shelter through Roth-based accounts is a bonus. It’s extra icing on the cake.
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Moral of the story: Look at P/R ratios and a multitude of other factors (all of which I list in the article) when you’re deciding whether renting or buying is better in your neighborhood. Don’t obsess over capital gains tax rates, based on the unsubstantiated objection that “paying taxes makes it a worse deal.” Do the math!!
I am not set on buying is better for everyone. They are many cases in which it makes very little sense. Most are personal, or not average situations.
You recommended the Roth option. I think it is a very good option, but in your hypothetical, it doesn’t work. It cannot be done. So, you refute that with a great long term market analysis, that mentions nothing about 10 year returns.
2008, 09, 10, 11 10 year stock returns were negative, negative, 1 and 2 percent.
If you would have used a 30 year renter and 30 year mortgage with 30 years in the market…your 8 percent returns look more likely.
apples to apple comparison.
Btw. Most of your other articles are great, that is why I read them…this one is a seems to be a stretch.
“You recommended the Roth option. I think it is a very good option, but in your hypothetical, it doesn’t work. It cannot be done.”
Really? In my hypothetical, do I talk about capital gains taxes at all? Nope.
You asked about tax-saving strategies. So I recommend a route that would help you achieve this goal. You know, for the purpose of being HELPFUL, rather than the purpose of mindlessly quibbling.
You’re missing the point of this article. The social pressure that’s placed upon renters to “stop throwing money away” isn’t grounded in math or logic. I use a hypothetical to illustrate a specific situation in which the better option isn’t clear-cut.
Then I make the point that every renter needs to run an analysis based on his/her own specific situation, which includes local P/R ratio, alternative investment options, length of time that he/she will live in the house, and more.
Yet instead of saying, “Yes, people should do math,” you waste your time nit-picking at the hypothetical.
I’ve now counted a total of 6 comments that you’ve left on this article; possibly more. Here’s an idea: Why don’t you start your own blog?
And put your name on it. Stand behind your own opinions.
@Test – you really dislike using 8% as the long term average return on the stock market. I actually agree, but because it is too low, if you reinvest dividends. Which is a very safe assumption to make given the clear reasons to do so and how tax efficient it is (assuming “worst case” scenario that none of it is inside a Roth or Traditional IRA). Just looking at the S&P over the last 100 years, the actual/historical return was 10.381%/year annualized. Over the last 40 years it was 11.679%. Of course, over shorter periods of time and/or cherry-picked dates this could be higher or lower. But for the life of me I don’t understand why people struggle to believe the stock market could ever provide average long term gains of 8% when historical and freely available data shows that it far exceeds this with no need for stock picking or luck.
Run the numbers (I have but not including them here and showing work for brevity) on selling at the end of 30 years and paying capital gains on the stock portfolio vs capital gains (including 250k/500k exemption) on the
property (In my area the P/R is about 19). The stock portfolio will completely swamp the returns of the property portfolio. Or I can just live off of the dividends and all capital gains/tax basis will disappear when I die and it is passed in a stepped up tax basis to my heirs… tax-deferred magically becomes tax-never-paid. Of course, look at your assumptions. If the P/R is favorable enough, maybe buying in your situation will make sense even with using real world historical results. But if it isn’t favorable enough, the advantage of the long term larger growth in the stock market based on actual historical data results in a portfolio that is multiple times larger.
https://dqydj.com/sp-500-return-calculator/
Paula I really liked this article. Thanks for all the figures. I have long known the principle but I never saw the figures to back it up. Good work. I really appreciate it.
rlean
Thanks Arlean! 🙂
Interesting article Paula, very eye opening!
Like you, I love investing in rental properties, but I have a hard time paying for the home I actually live in. Like you said: “Either way you’re going to throw money away”.
Unfortunately that is SO true!
+1 to that! 🙂
Totally agree!! Thats why we are looking for a four plex at our next duty station. Hopefully through the sweat equity of managing 3 other people, we get to live rent free minus the 3.5% downpayment.
I would just like to say THANK YOU for this article. This could not have come at a better time for me as I am a renter who, until 20 min ago, was fully invested in buying my first place based on the exact assumptions you’ve just debunked!! I’m not saying I won’t eventually buy, but that I now have the ability to make a SIGNIFICANTLY more informed decision about whether to proceed. The price-to-rent ratio is one of the first things I’ll consult as I continue to look at properties (Chicago), and the sources of equity are much more clear to me now. I’m still interested however in how you’d factor in length of ownership when trying to make the rent vs. buy decision? Holy wow, thank you, thank you, thank you!!
🙂 Thank you Lauren! I’m glad this was so helpful!
When you’re making the decision, use the NYTimes Rent vs. Buy calculator. It’s the single best calculator I’ve found on this topic, and it allows you to play with all the variables (including length of ownership) while you’re making your decision.
I read a similar article a long time ago and found this no less interesting. Very comprehensive discussion. It truly is a myth that buying is always better than renting and
I would suggest the one thing this article doesn’t capture completely is the difference in housing quality. Renting someplace that is similar in amenities to what a single family dwelling provides (big kitchen, yard, personal garage, blah, blah) would cost way more than buying….in most cases anyway. That’s the missing piece…so it really depends on the lifestyle you want.
Hi Kurt —
Your question, in other words:
“Given the same monthly payment, can I get a better-quality home as a renter or a buyer?”
That depends on the P/R ratio. Nationwide P/R ratios range from 2.8 (low) to 46.3 (high). That’s MASSIVE variation.
At a P/R of 5, you’ll get a much better place if you own.
At a P/R of 30, you’ll get a much better place if you rent.
Conclusion? Given the same monthly payment, the housing quality that you’ll get depends on the P/R ratio.
Enjoyed the article. I’m sending it to my cousin who I recently tried to convince that it depends.
Hi Kurt,
Actually, in my neighborhood in NYC the quality of the rentals is EXACTLY the same as the condos (built and managed by the same company and with exact amenities) on the exact same block, all overlooking the East River. The same doormen, the same services and the same view! The P/R ratio is more than 34. So by renting the exact same apartment I am coming out way ahead. A friend of mine lives in the condo building, and thinks she can rent out her (same sized) apartment for more than double what I am paying. That will never happen, when there are multiple equivalent rentals available and the rents will never have to deal with an unpredictable condo owner as part of the transaction for the “privilege” of paying double…
Paula,
I love this article and your in depth treatment of this debate, and I will share it with anyone who talks about the lost opportunity in renting; however I think you made a two simplifications in the Math-heavy first section that I cannot agree with.
1) Rachel’s landlord needs to make money. In her $2500 rent, lets say he needs $200 a month in margin. That is just an assumption, but most landlords would not do it if they did not make a cash flow profit.
2) Owen had to pay $300 a month in HOA dues. If Rachel was renting that same condo next door to Owen, he would be passing that cost on to her as part of the rental amount.
These two points mean that Rachel and Owen’s homes are drastically different homes in quality, location, or features.
That’s $500 a month different. That means Owen’s costs in your model should be reduced by $500, or you should state that Rachel’s place is $500 crappier than Owen’s.
If we are supposing they live in similar conditions, then how much does that $500 change the math comparison? I suspect that is a material difference in your awesome math argument that they both got the same result.
Marc,
The landlord likely bought the house a lot cheaper and therefore had lower costs that still allowed him/her to make money renting to Rachel. But your point shows why you can’t pay anywhere close to retail in many markets and still have a real estate investment cash flow.
Excellent answer, Chad. I would also add that there are many kinds of landlords out there renting their properties for all kinds of reasons. Could be they inherited a house and don’t want to sell it. Or that they owned a house and moved, becoming landlords by default. Or any one of a thousand other possibilities that don’t involve a new purchase at market rates for a home.
My dad, for example, bought a house for around $68k and it’s now worth $260k. It started as his primary residence but now he lives in Colombia, retired.
Point is, many landlords and many reasons.
@Marc — I agree with Chad’s comment.
Here are some of the ways that Rachel’s landlord might be benefitting from this investment:
— The landlord could purchase the property at a steep discount, such as through a foreclosure auction, short sale, estate sale, or by “driving for dollars” (making direct contact with the owners of vacant houses.) This allows him/her to purchase the property significantly below market value.
— The landlord could be holding the property for the sake of inflation-protected wealth preservation, rather than as a cash flow investment. (Don’t assume all landlords share the goal of cash flow. Some simply want to diversify their assets.)
— The landlord could be making a speculative play on potential appreciation. (I don’t recommend this technique, but many landlords do this.)
— The landlord could have inherited the property.
— The landlord could have purchased the property decades ago, paid off the mortgage, and now enjoys the cash flow. They don’t want to sell/trade into a different property due to the hassle involved, so they let this property ride.
Many landlords; many strategies.
Wow, this was incredibly thorough and a very good read. Thanks for sharing
Wow! Outstanding post and a good reason why it’s so hard to explain this to someone if they ask your opinion. It took 5000 words to cover all of the variables in a concise, entertaining way. Now I can just say, “go read this…”
Thank you Mike and Lauren!! 🙂
It’s a bit questionable that you’re justifying your math with $300 HOA fees (that’s just dumb buying), 5% mortgage rate (can’t get 4% in this market?), fairly high market return rates (8%?-I figure 5% after inflation or 7% with out). I’ve done this calculation myself before, and come to the conclusion that the payout for the mortgage and expenses has to be at least 120% more than rent for renting to actually have a benefit.
The first house I bought tripled in 10 years (admittedly through forced appreciation and a lot of sweat equity). My current house gave me 5k in instant equity and has appreciated 15% in ~2 years (market only-oh, and you do have control over this to some extent based on location-key factor in both of the aforementioned examples-I’d equate it to as much control as you have in the stock market!).
Taxes-the only tax advantaged accounts you can use to shelter stock gains happen to also be accounts you can’t access until you’re old without a significant financial penalty + taxes. Assuming you didn’t overbuy, you might not have to pay a dime in taxes on a personal house sale. That’s huge, especially if you are actually making above US average money, which it appears your examples must be with a $2500 a month payment.
100 years of home price increases=3.1%, with 100 years of inflation at 3.0%.
Finally, you’re really going to argue that there isn’t a significant decrease in cost after the mortgage is paid off? Assuming Rachel and Owen are still alive at the end of 30 years, he’ll be paying about half what she is if their housing situation doesn’t change-that’s with a generous fix-it budget, insurance, and utilities.
I’ll admit that this is to some small extent real estate market dependent, and the whole P/R ration is at least a rational way to look at it, but I still believe that you rent until you can afford to buy. I don’t see anything in this article that convinces me otherwise.
Refer back to “I’m a special snowflake.”
“Well, the example that you used doesn’t fit MY very specific circumstances! Therefore, it’s not right!”
“I have different assumptions about my HOA! And the length of time I’m going to live somewhere! And the prevailing interest rates at the time I buy!”
Yep. That’s the point.
The myth that “renting is throwing money away” negates these variables. It oversimplifies that buying is always the better deal. That’s not the case.
The purpose of this article is to demonstrate that there are instances when renting is equal or better than buying. Don’t buy into this idea that buying is better 100% of time.
******
$300 is a normal HOA fee, depending on (1) the square footage of the house, and (2) whether it’s a single-family residence or a condo (which has common spaces that need to be covered by HOA dues).
In addition, 5% is a normal interest rate, historically speaking. Here’s a list of average 30-year fixed-rate mortgage rates on primary residences since 1971. Notice that 5 percent is the LOWEST average interest rate from 1971 to 2010. http://www.freddiemac.com/pmms/pmms30.htm
******
Regarding taxes:
(1) You don’t need to pay any financial penalties for withdrawing the principal from Roth IRA contributions. You can withdraw this penalty-free at anytime.
(2) You’re not taxed on capital contributions, you’re taxed on capital gains [in both stocks and housing]. And historically, the gains in housing will equal inflation + forced appreciation.
******
Finally: It’s fine if your particular, specific circumstances don’t match Rachel and Owen’s story. You’re a special snowflake, after all. 🙂 I think you’re missing the fundamental point of the article, which is: Do the Math.
Did the math. Using today’s average US interest rate in the same calculator you used and adjusting to the 7% average return of the S&P while eliminating the HOA fees (which are unnecessary-you eliminate them by buying a house that doesn’t have them) and using the 100 year figures for average inflation and housing price increase owner comes out nearly 9% ahead.
The point is that this isn’t a “special snowflake” scenario. The averages favor buying right now-I get what you’re saying when you say there are areas where that would not be the case, but you’re also failing to factor for people not saving the money they would otherwise be spending on a mortgage. Your average American’s highest asset of worth is their home, that hasn’t changed for many years, and your average renter doesn’t have an investment account worth the difference-so you’re actually the one arguing that the renter in your example is a “special snowflake.”
My specific situation is not typical-and I’m fully aware of that, but the truth is that right now, particularly with a low interest environment, renting is throwing money away.
Couple other items-you can’t say that the tax free account is going to work when the renter can’t lump sum that amount into it. They can’t, because if they were to make the maximum contribution it would take a decade or two, so taxes are a consideration. Also, there is no 20% tax bracket in federal income tax, so go ahead and bump your calculation up to the 25% marginal tax bracket, which is the likely bracket your examples would be in whether married or not assuming that they’re spending the recommendation of 25-35% on housing.
I’ve sincerely enjoyed many of your articles, and have typically not had any disagreements with them until this one-but I still think that you’re stretching to come to a balanced figure between renting and buying.
I think we’re in agreement:
Do the math about your own specific situation.
Don’t look at the average situation. Look at your own. Do the math based on your own specific numbers.
The math will have differing results for every individual, based on factors including:
(1) the interest rate at the moment — not just in December 2015 (“right now”) but also in 2016, 2017, 2018, 2019, 2020, 2021, 2022, etc.;
(2) the area of the nation where you live;
(3) the amount of time you’ll live there — 1 year? 10 years? 100 years?
(4) and a huge multitude of other factors.
Intuitively we all know that if you’re going to live somewhere for only 1 year, renting is better. And if you’re going to live there for 30 years, buying is better (unless the P/R ratio is super-out-of-whack). Somewhere in-between is the crossover point … but where? That’s a question only mathematics can answer.
Re-read my conclusion. You’ll need to do the math based on a massive number of factors, none of which are captured in the glib and oversimplified statement that rent is merely “throwing money away.”
One final point:
“Your average renter doesn’t have an investment account.” That’s exactly what we need to change. Afford Anything is a social movement. We’re creating wealth. This is a rebellion.
Miami is a coastal city.
Yes, Miami is the exception to the rule! There are great deals in Miami that make it an attractive place to purchase a home. 🙂
Great post! Per usual!
I’m looking to buy my first property (in Miami, FL) as a duplex or triplex as a live-in investment property (not sure if that’s the industry term), so as to off-set some of our costs and start building investments. As both a primary residence and real estate investment, how does that stack up in light of this article? Thanks!
@Cha Ching — That totally changes the game. You’re buying it as a rental property, rather than as a primary residence.
Yes, you might live in the house for a few years, but the purpose of the home is to generate income and investment returns. In that scenario, run these equations to make sure the numbers work: http://affordanything.com/2012/01/25/income-property/
(Note: When you’re figuring out the One Percent Rule or the Cap Rate — both of which are described in that article I linked to — assume that you’re not living there. Another way of phrasing that: assume you’re “paying rent to yourself.” This way you’re still using fair-market numbers.)
Paula,
I’ve enjoyed your blog often, but this, I feel this article was a total disservice to your readers.
I was disappointed among other things, with your continued focus on the early years in of a whopping (should be illegal!) 30 year mortgage, the charts that don’t begin to address today’s record low interest mortgage rates, your unrealistically high expected rate of returns in the market (opportunity costs), and your needlessly high expense totals. (No one needs a 3k/yr HOA unless there are goods or services associated with it that benefit the homeowner, and IF that was the case then the renter would in all fairness need to purchase the same accouterments.)
You used a preposterously stacked set of poorly constructed statistics, then changed the setup as needed to help make your arguments try to hold up.
I feel you should have instead advised your readers to 1. Only buy as much house as they need. 2. Always put at least 20% down. 3. Only get a 15 year fixed mortgage. Using those guidelines your assertions mostly fall to pieces, especially over THEIR lifetime, not the lifetime of the mortgage.
I suggest you re-run the numbers with those 3 guidelines, with the test subject living till age 78 3/4.
Respectfully,
Bob Frazier
Hey Bob,
First off, there are a lot of people on the internet who don’t sign their names to their opinions. You have the courage to use your name. I respect that and thank you for it.
I take the service that I provide to my readers more seriously than you probably know. It’s fine if you choose to disagree about my assumptions or anything else, but your statement that I did a total disservice to my readers is simply not reasonable. How am I doing them a disservice? By providing a hyphothetical example for the sake of illustration that will necessarily not match any one person’s experience, yet will make them think critically about the most significant financial decision that they may ever make?
How, exactly, is that a disservice?
From your comment, it seems that you have some strong opinions about what other people should do with regard to their mortgages. It’s not my place to prescribe how long a person should stay in their house before they sell it, what kind of amenities they should have, or how they should balance the present vs. future value of their mortgage dollars.
Sure, some people will buy a home, carry the note to term, retire and pass away — without ever selling their house. Many will not do this, though, due to job changes, family needs, and personal desire.
From 2001 to 2011, the average American homeowner held onto their homes for only 6 to 9 years.
The point of this post is to teach people to analyze their decisions from a mathematical basis and consider a multitude of factors that aren’t captured in the glib statement, “rent is just throwing money away.”
Mortgage rates go up and down, as does the overall and local real estate market. But critically analyzing important decisions isn’t going out of fashion anytime soon.
Well said, Paula. I think the article was a large service to a large number of people, and you made completely clear what your assumptions are up front.
Thank you, Chad! 🙂
Paula,
I feel sorry for the twenty something person who trustingly reads this article and then closes their eyes content to keep enriching a landlord… like you!
You say: “The point of this post is to teach people to analyze their decisions from a mathematical basis and consider a multitude of factors that aren’t captured in the glib statement, “rent is just throwing money away.”
I disagree! The point should have been to provide readers how to make the very best financial decisions in order to succeed at life. “Afford anything!” Isn’t that more the point?
In order to do that, why wouldn’t you include facts about the historically low mortgage Interest rates? (They’re not even on your chart.) Talk about ownership as a hedge against rent inflation? You really didn’t. Explain the long range reality that while rent is forever mortgage payments are not? (using fair, realistic and comparable numbers, that is.) You did not. Mention access to equity? No. The financial opportunity of owner financed sales as seller? No, not that either.
So yes, I feel it was a disservice. Totally. You avoid giving readers a more relevant set the very best current financial advice in order to make a more narrow point about rent using cherry picked data points. Given your position as a tremendously success landlord, how ethical would that be?
Hi Bob,
#1: I encourage you to unsubscribe. This blog clearly isn’t right for you.
#2: You think I made these points to enrich myself as a landlord?!? So — you assume that every renter in the USA reads this blog? Or do you assume that I’ll print out paper copies of this article and disseminate this article at showings? HOW, exactly, will this article help me sign another new tenant?
You’re making ridiculous claims about my motives.
I’m happy to have an intelligent conversation about facts, logic and data. But when you start attacking my commitment to my readers, I’m going to ask you to leave. Bob, I think we need to break up.
I welcome intellectual discourse. But your claim that this blog post is “unethical” is delusional.
I encourage you to start your own blog, devote half a decade in service of helping your readers make more informed choices, and then dispense any type of advice that you see fit.
#3: I don’t want to get into an internet battle with you about the factors you’ve listed. But since other readers will be wondering about these, here are my replies:
Low mortgage interest rates: Here’s a link to a list of historic mortgage interest rates from 1971 through today. The long-term annual average is 9.05 percent during the past 44-year timespan.
The title of this article isn’t: “In December 2015, assuming you have excellent credit, buying might be better, IF you can qualify for today’s interest rates.”
This article is an evergreen piece about how to intelligently make decisions based on mathematics rather than oversimplified cliches. Interest rates will rise and fall. Critical thinking skills are forever.
Ownership as a hedge against rent inflation: Rent inflation is included in the Rachel vs. Owen example. As you’ll notice, Rachel’s rent rises annually at the rate of inflation.
Owner-financed sales: Owner-financed sales carry severe inherent risks and should be handled with extreme caution. I’d encourage most primary residents (who are NOT real estate investors) to avoid owner-financed sales.
Access to equity: The entire article discusses access to equity, Bob. The question is: what’s the opportunity cost of gaining that equity? Are you better off purchasing equity, or purchasing an alternative asset?
Using other numbers: In case you missed it, I’ve provided links to calculators where you can test your own special-snowflake-circumstances. You can input any variables to see whether renting or buying makes sense in your own situation. Which, by the way, is the point of the article. Rather than believing hyped oversimplified cliches, use math to test your assumptions arrive at better-informed conclusions.
You say I should “provide readers how to make the very best financial decisions in order to succeed at life.” Yes, that’s precisely what happens when you DO THE MATH rather than listening to lazy, oversimplified cliches like “renting is throwing your money away.” (Or, dare I say, oversimplified, one-size-fits-all statements like “mortgage rates are at a historic lows … so everyone should definitely buy NOW!”)
If you want to read a blogger who encourages one-size-fits-all, oversimplified cliche-based group-think, I suggest you read someone else. You’re not going to get that at Afford Anything.
You tell ’em, Paula!
For the record, I do think your example tilted in favor of renting a little too much (and I’m a renter myself). 5% is a little on the high side for interest rates, and not everyone pays an HOA fee. On the other hand, renters typically live in less space than homeowners, which means they usually have lower utility costs. They also tend to spend less on home furnishings than homeowners….so these things somewhat balance each other out…but I do think it still skews it in favor of renting a bit to much. I also understand you can come up with endless hypotheticals to prove your point either way. So overall, it’s a minor quibble for an otherwise excellent piece. You’re trying to get people to THINK FOR THEMSELVES and showing them what that thought process looks like–and that is the main point.
Thank you, @mysticaltyger! 🙂
I’m sure statements like “mortgage rates are at a historic lows … so everyone should definitely buy NOW!” are a very real reason why the housing market crashed in 07′. Hey everyone! MORTGAGE RATES ARE SO LOW RIGHT NOW. You have to go out and get a home NOW even though you know, and I know, and everyone who’s ever known you knows you can’t afford it and it makes absolutely no financial sense for you right now! I really like this article and blog, thank you Paula Pant.
Dear Paula,
This article i found by accident by the big G-ing it on the searches but i am so, so glad i found it especially the P/R ratio’s if anything that alone is worth the 5,000 plus words in this article; and to the “Test” guy or “Troll” as we call it her P/R ratio is spot on with my area so i am not sure which planet you live on or came from but here in Maryland Ratio’s don’t lie…
v/r Brian C. (USCG Ret)
Good God Gert I have a headache ! Could you not have condensed all that Rent to Own article
in one paragraph ?? I would have taken your word on the bottom line result because I trust you !
Last time ( 1 month ago ) you discouraged me from starting a CURMUDGEON newsletter for
a lousy $ 5 sub charge. You had too stick it to me by pointing out yours is free !
I guess now I will just have to starve ( I only have one piss poor idea per year )
Warmest Regards,
Frank.
Haha! Thank you, Frank!
Did I ever tell you that “curmudgeon” is one of my favorite words? I learned it from this, which was one of my favorite books as a kid.
Hi Paula – this is one hell of an article, I’ll save it as a reference!
I recently bought a house that from day 1 should have been a rental except that we might end up living in it for 2 years first.
With your calculation, our house has a P/R of 9.4, it’s comforting to see that it wasn’t too bad a purchase.
Thanks for the super detailed post, this might very well be the ultimate guide to ‘rent vs buy’!
A P/R of 9.4 is great! That’ll work as a rental property, so I’d definitely call it a good purchase! 🙂
As a CA real estate Broker that owns several properties & a soon to retire (12/31) Senior Financial Advisor w/ a National Firm, I found your article dead on & painstakingly detailed!
Yes you made some assumptions .. you had to for illustration purposes .. but your bottom line is to use Critical thinking & do the Math, Always!!
Unfortunately a lot of people follow fads, get greedy looking for a Quick Buck whether in the Stock Market or Real Estate & eventually get slaughtered!
Absolutely! Critical thinking + doing the math = winning strategy! 🙂
LOVED your article and totally agree that it really really comes down to doing your math AND knowing your exit strategy!!!!
My husband is active duty so we move a lot and often 1-3 years. We have used personal properties as great stepping stones. When we move on to the next adventure they become rentals. It is a low entry costs (downpayment and interest rates). The key we have found is that personal open opportunities not closes, BUT you have to know your AREA, YOU (I self manage so that is one of our sweat equity sources) and your exit strategy/tolerance. It is a marathon not a sprint.
Absolutely outstanding article. Home ownership is the last line of defense for many pretentious homeowners who think themselves somehow “better” than renters. You’ve dismantled the home ownership myth with rock solid facts. Be prepared for many home owners to respond to this article with vitriol. How dare their status in sociey be diminished!
Thank you Emerson! I’m prepared for the onslaught … 🙂
One thing that I’ve learned about this year is the difference between capital expenditures and forced appreciation in our fixer upper.
We’ve spent close to $8K on non-value add improvements (insulation, new roof, wiring, plumbing work, etc.)- All of these are capital expenditures.
On top of that we’ve spent around $12K on improvements that will give us more than our return on investment.- A lot of the value we add is forced appreciation.
When we bought the place we just calculated a lump sum estimate for repairs $35K, and tried to determine if we can get an extra $35K out of the house when we sell. When we determined yes, we went for it.
It hasn’t bit us in the ass yet, but in hindsight that was sort of stupid (The reason that it hasn’t bit us in the ass is because our P/R ratio was less than 6, and even with all the improvements we’ll be <9)
That’s an excellent point, Hannah.
We’ve made a ton of capital expenditures on roofing, gutters, windows, siding, HVAC, plumbing, electrical, insulation, mold remediation, pest control — all of which are necessary, but don’t provide a dime in added rental income. Of course, we’ve also made cosmetic upgrades that enhance the rent. But yes — capex vs. improvements is a huge difference.
Thanks Hannah! 🙂
This seems to be the age old personal finance question. I am very grateful that you attempted to solve this problem. Whether it was actually solved is debatable…
I think this should be evaluated in a case by case instance.
As a landlord, rents (at least in my area) are significantly higher than the cost of owning a home by almost 40%. To me, owning in this area seems to be a no brainer if you can afford it and plan on living there for a decent amount of time.
I do agree with you however that most people only live in their homes roughly around 7 years. In this case, people often only break even or lose money.
I think it is the most sense to buy when you plan on owning the place throughout the life of the mortgage. Anything else seems to fall into grey area.
Deciding to rent or own depends a lot on your ability to look into the future. As we all know life can throw many things at you.
Regardless, I really appreciate how well thought out this article was. Clearly you put a lot of time and effort to deliver the best content possible. Thank you!
Thanks Rich Rabbit!
Yeah — unfortunately, the average American hangs onto their home for only 6 to 9 years (data from 2001 – 2011). With such a short timespan, it’s hard for any benefits of homeownership to negate the transaction costs (e.g. closing costs, etc.), opportunity costs, amortized interest, and more.
The longer the timespan, the better the deal — assuming, of course, that the P/R ratio makes sense.
Thanks for commenting! I appreciate it!
My husband and I bought a house when we first got married using that exact logic. It was hands down the worst decision we have ever made. If only I could go back in time and slap some financial sense into my silly 21 year old self. That house is a rental property now and a royal PITA. But, hopefully we’ll be able to sell it in the next few years and completely wipe our hands of that mistake once and for all.
Hi Paula,
Great article! I just had a couple of thoughts. First off, doesn’t it make a huge difference if a person pays more than the minimum principal payment? I did that, paid off my house in only 7.5 years and the house being paid off gave me the extra money to start buying for investments. Also, don’t you figure the landlord will raise the rent over that time period? Expenses will surely go up for the landlord (insurance, taxes, etc) and those will have to be passed on to the renter. I didn’t see that accounted for.
I also wonder about the opportunity costs, where exactly can you invest to earn 5-8%? Money in the bank is LOSING at minimum 2-3% per year due to (admitted) inflation. Stock market is possible, but you have to be a pretty good (or lucky) stock picker there. I have been trying since 2000 to bring my stock portfolio back up to where it was then and still down tens of thousands of dollars.
Real estate investments are probably good for 5% but I think most people aren’t really going to find that very easy to do either. It takes a lot of work, at least at first.
Hi Jill –
With regard to prepaying your mortgage: It depends on the opportunity cost. Here’s an article about the debate between prepaying your mortgage vs. investing the money instead: http://affordanything.com/2014/04/10/showdown-keep-your-mortgage-vs-crush-your-mortgage-who-wins-the-championship/
With regard to the 5-8 percent returns: I encourage that you DON’T pick stocks. Instead, you put everything into a index fund that tracks the total U.S. stock market. This means you’ll perform on-par with the rest of the total overall U.S. market — no better, no worse.
If you’re not familiar with index fund investing, here’s an article: http://affordanything.com/2015/02/25/investing-broken-down-to-its-ridiculously-simple-core/
As far as the 5-8 percent return data: From 1926 to 2006, the total U.S. stock market returned 10 percent as a long-term annualized average. Here’s a book about this: http://amzn.to/1IbqjMS
If you want to look at a shorter timespan, like the last 40 years, stocks returned an 8.88 percent annualized average from 1975 to 2014.
Warren Buffet states, conservatively, that he expects the overall U.S. stock market to produce 7 percent returns during the 21st century.
Thanks Jill! 🙂
Thank you so much for this article Paula! If only I had read this before buying a house 8 years ago it would’ve saved us a ton of money.
If I have any friends that are thinking of buying a house, I think I’ll point them right to this as something to mull over before jumping right in. We’ve been thinking about what to do with our house lately after deciding to get on the financial independence path. Once we hit retirement, renting is definitely something worth considering since we’ll have assets appreciating elsewhere.
Anyways, this is the best I’ve seen on buying vs renting since JL Collins’s article Roots vs. Wings!
Thank you! I’m sorry to hear that you lost so much money on your home purchase — but I’m happy to hear that I’ve produced something that might save others from the same mistake.
Thanks for the article, it’s a very in depth explanation of what I always have to try to explain when people question why we still rent.
From my own personal experiences, I’d also say that renting has helped us avoid lifestyle creep. When you rent, you have no inclination to renovate the space, put in new fixtures, or install a new hot tub in the backyard. Mostly because your landlord either wouldn’t let you or would raise the rent on you for the added value. With your own property, you are free to do as you want, which is nice for the flexibility but often times you will improve your home beyond what you need because, well, you can. Not necessarily a bad thing but it does encourage an increase in lifestyle and spending.
Hi Noelle –
That is an EXCELLENT point.
Homeownership has definitely caused my lifestyle to creep. As a renter, I didn’t care about granite countertops or fancy light fixtures, and most of my furniture came from free hand-me-downs from friends. As a homeowner, I like granite and fancy lights, and most of my furniture comes from IKEA.
Thanks for adding that to the conversation! That’s a great point. 🙂
Awesome detailed analysis. I’m personally a huge proponent of renting, for many reasons. But one of the main reasons if because I invest every spare dollar I have into cheap index funds, I don’t spend it or let it sit in a savings account. That’s not the way a majority of people operate though. Building home equity is sadly the only way some people save, in addition to maybe a 401k contribution. I just had a coworker the other day talking about how he wanted to buy to stop throwing money away from renting, but I just nodded because I didn’t want to get on my high horse about it 🙂
You should send your co-worker this article! 🙂 And I love index funds, too. 🙂
Great article. I am all for buying if the numbers work, you can afford it, and you enjoy working on your home. Drive around a neighborhood on weekends and you will see people doing yard work and/or repairs. I think you covered the money portion but not the time portion. In fact I don’t see any calculators that show people how much more time is devoted to owning vs renting. Renters typically don’t have to do anything but enjoy their weekends. Some people like working on their homes so as long as the numbers work, go for it.
The other thing that is commonly overlooked is increased commuting costs (both from a financial impact and most importantly, your time). I’ve notice most people buy further out of town to afford the home they want. This means more automotive expenses and more time spent in traffic. In some cases it would actually have saved money if one bought the more expensive home closer to work. Not to mention how much more time they sacrifice on commuting each day away from their loved ones.
I think owning a primary residence is a life decision and not an investment. Its a part time job based on the time you have to spend maintaining it and paying for it. Its not a great investment in most cases. Real estate investing is different than owning a primary residence since its a business and not a home. It is good to own in some cases and good to rent in some cases but don’t blindly assume one is any better than the other without more information about the person, lifestyle, and housing market.
Great points, James! You’re absolutely right — owning a home requires far more of a time-commitment. And if you add supplemental commuting costs, the time commitment is even worse. 🙂
Ah, the wonders of mystery cash flow. It is funny how people apply the exact opposite logic for homes to cars. “Who would buy a car in cash! I’m going to lease it!”
Great summation of it. We did a lot of homework before. Our P/E is ~12.2. We were comfortable with this. It’s a very rentable location. Our issue was that we only had 10% but knew we would have well over another 10% in the next year. Ended up having PMI for just over a year and got it cancelled. So the ~$1200 we had to pay there was worth it since we got the home we wanted. We’re definitely on the fence about investing vs. putting more towards principal. I think we’ll continue doing some of both for a while.
Hi Chris –
The “should I invest vs. prepay the mortgage?” question is always on my mind, as well. It’s a tough choice. Here’s an article I wrote about it: http://affordanything.com/2014/04/10/showdown-keep-your-mortgage-vs-crush-your-mortgage-who-wins-the-championship/
Congrats on your P/R of 12 house! That’s a great ratio, and at those numbers, ownership definitely makes sense, especially if you’ll hang onto it for awhile. 🙂
Hey Paula,
Here are some numbers for your raving fans who are still in disbelief.
If they no nothing about investing or purchasing a home, the golden rule is that you make money when you buy. That being said, my last three home purchases were foreclosures. My most recent personal home was purchase in the suburbs of Memphis, as you know. The going rates at the time, in the same neighborhood, given similar comps was about $171,000. I purchase our home for $153,000 at 2.875%, 5% down, with a 5/5 ARM.
A home in the same neighborhood (within a block) that we were going to rent was $1550 monthly. Given that, the total cost to rent from June 2014 to Nov 2015 would have been $28,055. This accounts for a 2% rental increase beginning in the month of July ($1581).
My mortgage payment, including PMI, since I opted to pay only 5% down, was only $958. This was until my escrow was reanalyzed a year later which brought the PITI to $977. So, in all, the total price paid so far for PITI has been $17,339. HOWEVER….
This doesn’t account for the following expenses paid since we’ve lived here for a little over 1 year:
$9,617 Closing Cost (including 5% down)
$5,500 Cost of redoing floors (ripping out old carpet and replacing with wood/carpet/title)
$3,000 Cost of Kitchen Suite (Stainless Steel Refrigerator, Dishwasher, Microwave, Stove) –
$220 Cost of Replacing a Toilet (I cracked it after tightening a bolt too much. Water was everywhere.
$375 Cost of a Broken AC System Drum (Part was on warranty)
$750 Cost to Increase AC System flow into Bedroom (Had to install another vent duct)
$60 Cost to Replace Kitchen Fluorescent Light Regulator (Kitchen light stopped functioning)
$2,000 Cost to Paint Entire House (House wasn’t painted in 20 years!)
$60 Cost to Replace Chandelier in dining room.
$60 Cost to Replace Home Office Light with Ceiling Fan
$560 Cost for Trugeen Lawn Treatment (Could have saved here but I hate gardening)
$400 Cost for Lawn Moyer
$500 Cost to Decorate the Lawn with Garden Materials
$250 Cost of Lawn Services after I already purchase two items above (Did I mention I hate gardening)
$23,552…Total…so far..on top of PITI paid…for a total of $40,691 to buy vs. the $28,055 to rent in first year and five months.
Fortunately, these expenses (and I’m sure I’m missing others) account for the fact that I perform most of my own small jobs (electrical, plumbing, walls) around the house.
That being said, things should even out over the next few years. Apparently, the home is now valued around $180,000, but it’ll cost about $10,800 in real estate agent commissions to sell at this value. In order words, we’re still in the RED…big time. haha.
Don’t believe me, here’s the house here: http://romeojeremiah.com/2014/04/14/purchased-a-primary-residence/
Here is the kitchen remodel we did: http://youngfinances.com/blog/how-to-remodel-a-20-year-old-kitchen-for-less-than-3000/
Good luck your decisions everyone!
Thank you Romeo! This is a fantastic breakdown of the nuance and detail that goes into every home. 🙂
Marvelous article, Paula. Have you seen “Housing Partnerships: Why the 2nd half of your home is worst investment you’ll ever make”? It is a way to own a home without making the ‘loss of opportunity’ mistake.
Thanks John! I haven’t seen it — is that a documentary?
Great job breaking it all down.
Thanks John!
Paula,
I am thankful for your article. I am currently looking for a home in Miami, FL and this article is helping decide what the best route to take is. The opportunity cost piece is golden.
Have you thought about writing a book? I have a 21 year old twin brother and sister who should learn about finance from you.
Avid reader and fan,
Caonex
Excellent article! You kept that entertaining enough to keep me reading the whole darn thing. We’re renting and we’re fine with it. We might buy in the future, but we might not. I agree that there’s a time and place for both situations.
Thanks Cat! 🙂
Paula,
Inflation is typically viewed at 3% a year however the government statistics on the actual CPI is misleading where inflation is probably more. Does the New York Times calculator accurately account for hyper inflation 3-5%? The thought is that by getting a large mortgage you are locking in with low rates 2015 dollar values and pay off with 2045 dollars values. Some call this dept induced dept distruction. I’m on board that those of us on the west coast markets that it is better to rent but are we taking inflation into account?
@Lane — In the NYTimes calculator, you can enter any assumptions about inflation that you want. Run the scenario at 3%, 4%, 5% … whatever value you want to set for inflation. Heck, you could even input a 20% value, just for fun, to see how the numbers shake out.
As far as the net present value of dollars are concerned (2015 vs. 2045) — that touches on the question of whether its better to repay the mortgage upfront (in todays dollars) or hold onto the mortgage so you can repay it in cheaper dollars over time. Essentially, its the question of “keep the mortgage vs. crush the mortgage?” Check out the link for a long discussion on that question.
location, location, location and credit. i moved to Austin Texas with a 6 year old paid, closed eviction to austin. out of a city of 1000 apartments only 7 take broken leases/past evictions. you either pay 2-3 months of rent as deposits and those locations in what we call war zones. i literally had engineers making $10,000 a month being turned down for apartments. its creating a donut effect in Austin, i sell homes to people on the edges of Austin for $0 DOWN but some closing costs USDA loans due to apartment rules. i worked in apartment industry 2 years as front desk consultant, 2 years as agent so far, Austin has 168 people moving a day and most having to live on edges, buy home, or drop 2-3 months of deposits. so if i can get $125,000-$150,000 home within 30 minutes of downtown with help of Austin homeowners down payment assistance and rent two rooms out to other young people needing somewhere to stay. i see it daily at meetups, and happy hours. as usual great post.
Thanks for this! I will have to pore over this to understand it (later, later….) but you DID make me realize that MY own special snowflake circumstances are bigger than I saw before! (And, at least, my last name actually IS Snow!!) I will have to roll into my calculations that I run the MFG co. I inherited when my husband died out of the (daylight) basement. I always (and still) discount renting, because the horror of having to move the company (and change the mailing and shipping addresses, and moving some heavy (for me!) equipment and so on. Owning means I have no worries about having to scramble to keep the biz operating (the landlord can’t sell it out from under me!) — but it ALSO means I have to calculate in the cost of an actual ‘place of biz’! If I did not have an entire floor I can devote to the company — I would have to rent a place for it. That fer shure changes the balance on rent vs. own!
I turn 60 in Jan. (My husband died in 2011.) It’s a 2-story house (an’ ah ain’t gittin’ any younger, eh?). I want to move back (from almost-north Georgia) to Washington or Oregon… But, I love my neighbors and neighborhood; I love my house, it does hold me and the company almost perfectly… I just replaced the roof, and the A/C and furnace (owee $$$) and want to do a zillion things to make the house more comfortable specifically for me — OR I want to move to a one-story house back out West (and future-proof my life!). These are all considerations that ALSO play into rent-or-buy, and into the premises that must be folded into ‘Do the Math.’ So, thanks for providing a guide to let me think more clearly than just: 1-story or stay?
Elenor
Just FYI, you go back and forth between “principle” (incorrect) and “principal” (correct) spellings. 🙂
Whoops! I always misspell that! Thank you for the catch. 🙂 Happy Thanksgiving!
Still some mis-spellings of “principle” when you mean “principal”. Unfortunately distracts from a very good and well thought article.
Very timely article. We are in the process of selling my elderly parents home. Built by them in early 1970’s for about $45,000 in a solid middle class neighborhood. Current estimated value is about $155,000. Just for fun, I calculated the compounded rate of return over the almost 45 years. Yep, turns out the annual return after inflation is about 0.5%!!!! Yikes! A giant reminder your primary residence should never be thought of as an investment.
Paula,
I read your incredibly in-depth post because I am a huge believer that renting should be temporary and everyone should have the opportunity to own real estate. (I also live in Phoenix with a favorable P/R ratio for owners). However, I have to say that you have made me stop to take a second look at this. I hate normal, mediocrity, and going with the flow because someone else says “that’s just the way it is”. Your article hit a nerve because now I’m feeling I may need to look at renting vs owning through your examples. Dang Paula – I’m speechless. Great post. No, amazing post 🙂
Thank you, Chris! 🙂
Hi Chris,
I have thought about moving 6 hours east for that exact fact! Compare things to Orange County, CA and the opposite is true. It really is all about your personal circumstances.
Kindest regards,
Robert
In some ways I think the “rent vs buy” conundrum is a big diversion from a more important issue. The big issue is to keep the percentage you spend on housing as low as you can tolerate so that you can save and invest 50% of your income. If you’re the typical American spending 30% of your income on housing, you’re probably not going anywhere financially, whether you rent or own, because you probably can’t save/invest a high enough percentage of your income for retirement at 65, let alone early financial independence.
@mysticaltyger — “The big issue is to keep the percentage you spend on housing as low as you can tolerate so that you can save and invest 50% of your income.” — YES! I agree. 🙂
Location location.
There are to many assumtions.
First i would buy a property that i know i am already making money.
Second if you want to move out or rent it out j would get a 5 yr arm which has super low interest. Or even get interest only loans.
Like you say for example san francisco and new york make sense to rent most people cant buy even if they wanted to, well technically if you bought 4 or 5 years ago in san francisco yiur profirs would have passed 500k if yiu sold today.
Now, i live in miami a rent that cost 2500 would have a mortgage of less than 2000 in miami same thing if yiu bought 3 years ago you probably have 100k extra.
Also , you assume everyone has HOA fees.
Also, new homes or newly remodel homes have little repairs issue.
Also, you say it. Most people only last 6 to 10 years which they wouldn’t make big roof repairs etc..
I prefer people to keep renting, heck every landlord wants that.
If you buy a home, try buying 10 to 20% under value, so if you want to sell in a couple of years at least you make something. Also, i believe home prices will continue to go up since there is a lot of competition coming from internatioal buyers. And yes, usa has become a renter nation. I also believe that only 20% of people will own all the real estate in usa…i dont know by when but the trend is getting closer and faster every year.
“Also, you assume everyone has HOA fees. Also, new homes or newly remodel homes have little repairs issue.”
Did you miss the Special Snowflake section?
I encourage you to re-read the Special Snowflake section, instead of griping about the fact that your specific life doesn’t match the example. You personally may not have HOA fees, but that’s not true for everyone. Furthermore, it’s irrelevant.
Your Special Snowflake circumstances don’t change the fact that everyone is responsible for DOING THE MATH. Don’t base the biggest purchase of your life on an intellectually lazy cliche. Instead, crunch the numbers.
In this article, I give you the exact tools and steps to run these numbers for yourself. I empower you to conduct your own analysis and make your own decision, based on your own circumstances, and rooted in logic and math.
Many people will grasp the lesson. And they’ll be richer for it.
Others, unfortunately, lack the ability to wade out of the details of a hypothetical illustration. They’re more focused on nit-picking the deviations between themselves and one illustrative example — “waahhh! my HOA is smaller!” — that they miss the bigger point. And in doing so, they shortchange themselves from an opportunity to learn.
Paula,
Firstly, your articles are nearly always good. This was superb! I have already marked it as a favorite on my internet settings so I can refer others to it in the future.
I see you are getting a little frustrated with some detractors picking at specifics and missing the point. Don’t worry, I’m not going there. I was starting to see Bob Frazier’s point until his last post where he started giving more clichés on house-buying…
Which brings me to my second point. One of his comments was, “…why wouldn’t you include facts about historically low mortgage rate?…” This fascination people have with low rate mortgages really frustrates me… no that’s not right… it REALLY FRUSTRATES me!!!
My understanding is that residential real estate prices are linked inextricably and inversely with mortgage rates– as long as the vast majority of people must finance their purchase. The link is SO strong it is nearly as strong as bond prices to interest rates. As long as people only care about how much down and how much a month, a rise in rates will cause a drop in prices and a drop in rates will cause a rise in prices. People act like they aren’t related but when more people can borrow more money demand goes up. These people can pay more either for the same house in completion or try for a better house. Either way the market will respond to the increase in demand and raise prices. It happens every time.
Because of the lock-in nature of mortgage rates, people should actually bemoan a very low rate. To properly “hack” the rate, one would want to purchase when rates were high and prices correspondingly low. Then you would lock in a great PRICE for the house and a poorer RATE. But, guess what. They have this thing now called refinancing! You don’t have to stick with a high rate if rates go down. Those who bought in the early eighties had the best of both worlds. They could buy at a cheap price, then ride the rate train all the way down. Today with record low rates people are having to buy expensive houses and rates have nowhere to go but up. Granted if they lock the rate it won’t move up. But they aren’t presented with the opportunity of a cheaper price—they can’t get both price and rate like others have.
So when Bob and others speak of low interest as a current benefit in Real Estate I find this either disingenuous or ignorant of the facts.
What do you think? I would love a comment. I also think it would be a great article.
Thanks,
Frank
Hi Frank,
Thank you for your comment! It’s great to read thoughtful, intelligent discourse in the comment stream. 🙂
I was fascinated by the idea that there may be an inverse relationship between mortgage interest rates and average home prices, so I spent some time researching this. While that idea makes perfect sense in theory, I couldn’t find any data supporting it. Here’s what I read: Bloomberg, Forbes, Economist (on a slightly different topic but with a few related points), Seattle Bubble (great piece with Robert Shiller references).
I’m not dismissing the idea; I just can’t find data that supports it. If you have any stats, though, I would love to read it.
Your point about the 1980’s makes sense: both inflation and interest rates were high, but the 1990’s housing bubble hadn’t started yet. People could lock in a low house price, then refinance later when rates dropped. Best of both worlds.
The hypothesis makes sense in theory. But history seems to have played out differently — at least, according to the articles above. But this point is worth further consideration and further reading.
Thanks Frank!
Wow, those were some great references.
I agree with your analysis: Excellent theory, little proof in the data.
Still the logic is SO compelling I have trouble not believing it. I think the reason some of the historic data, especially post ’85 doesn’t show it is because there are SO many things that go into housing prices it is getting overwhelmed by other influences like demographics and inventory.
The Seattle bubble guy presented my argument far better than I.
Thanks for your response, if I find some more compelling data I’ll be sure to let you know.
-Frank
Paula,
Thank you for the detailed post. I tend to disagree with the overall premise of the post. While you made a very valiant effort at comparing a rental and owner occupied home owners situation, i think there are so many variables that it would take a book to sort out the nuances.
Perhaps I missed it, but one item that I think needs addressed is taxes. Taxes are the #1 expense for most working folks. Homeowners in the US get two very good tax benefits from home ownership. Interest deductions and capital gains exceptions on sale. Those count greatly into opportunity costs. As far as i know, residential renters do not get that benefit.
The use of leverage is extremely important as well. No other investment allows me to put down 3.5% or lower for Military vets to control as much.
If I plunk down 3500 on a 100,000 dollar home that appreciates at 5% annually (historic to the US). My gain is 142%. I’m not sure of any other investment save for a business that would allow that kind of return tax free. Its very easy as a homeowner to tap into that equity for future use. No opportunity lost.
I control a fixed debt in an inflationary environment. My $600 payment will not be worth $600 in 10 years. Its worth 3% less very year. My payment is essentially 3% less every year. I think that inflation reduced payment offsets any increase in taxes and insurance.
I do appreciate you pointing out the true cost of ownership and how wise it is to do the math. Some areas renting will make sense. Heck I have 100 year old rental that makes perfect sense as a renter. They get 800 sq ft for $700/ month. It works for me because I know how to buy at a deep discount. Not everyone does. If they paid market value for the property. Their payments with taxes and insurance would be well over $900/month. That does not count capital improvements and ongoing maintenance. (tenants pay utilities, so that is the same).
In the end, if folks want to control their money and future, they better learn to break out that calculator and start running the numbers, all of the numbers before making a 6 figure financial decision.
While I may have disagreed with your post on many aspects, that is a good thing. A friendly disagreement fosters a much needed discussion on a subject few folks take time to dissect.
Jason
Hi Jason,
Thank you so much for your comment! One line stands out:
Many people have objected to the idea that Rachel could rent her home for the same rate that Owen would pay to own it. “But the landlord needs to make money!,” they’ll state. This shows their ignorance as to how landlords make money.
As you point out, one of your investment properties — if purchased at market rate — would cost MORE to own than to rent. (You mention that your renters pay $700 per month, but if they purchased it at full retail price, they’d pay $900 per month plus maintenance plus capital improvements.) This property is a good investment for you, however, because you purchased the property significantly below market rate, at a deep discount.
This is a skill that successful investors (like yourself) develop through learning and practice. It’s a skill that most owner-occupants don’t possess (due to lack of training, practice, investor education, etc.)
As an investor, I purchase an average of one property per year. Practice builds skill. The more I buy properties, the better I become at the skill of buying deeply discounted properties.
Owner-occupants, by contrast, buy a property once every 5 to 10+ years. They’re not searching foreclosure auctions or mailing letters to the owners of abandoned, boarded-up houses. They’re paying full retail.
The assumption that “Rachel’s landlord needs to make money” ignores the fact that owner-occupants pay retail while investors don’t.
****
At any rate, thank you overall for your comment. I’m happy to read a variety of opinions on such an important topic. As you said, this is much-needed discussion about a six-figure subject that few people take the opportunity to dissect. And that’s the ultimate purpose of this article: to encourage readers to crunch the numbers rather than bowing to a cliche.
Cheers,
Paula
As an Air Force officer, I know I’m going to be moving every three to four years. I bought at my first duty station and sold three years later, making a nice profit. However, I’ve heard so many horror stories of guys with 15-20 years in with three underwater houses ask over the country without any relief in site. I got lucky on the first house but I’m not taking that risk again. I’ll be renting until I find a more permanent place to settle down, probably after I get out of the service. Great article, I’ll be referring military types who want to “stop throwing away money” to it often.
So many people forget about the fact that there are plenty of payments to be made even after you “retire” your mortgage. Taxes are something many tend to forget, but they keep on increasing, and depending on which part of the country you live, they can increase rapidly. Great authoritative article.
And in your Owen and Rachel example, I would MUCH rather be Rachel because renting and investing in an index fund is just so much easier than being a homeowner. You don’t have to worry about repairs, maintenance or any surprise bills in the mail. There is something to be said about quality of life as a renter and a homeowner.
>There is something to be said about quality of life as a renter and a homeowner.
This absolutely. People always say that home ownership is “worth it” despite all the downsides, but honestly… I just don’t see it. Having a back yard is cool, yeah, but so is infinite free repairs and never having to do yard work.
To each their own I suppose 😉
I’m 66 and bought a $210 000 condo two years ago with 20% down and a 30 year mortgage. The bank is more optimistic about my longevity than I am. I’m living on a pension and am house poor. I’ve been thinking of selling and renting. I’ll probably loose some money on the sale. I don’t want to be tied here for the rest of my life wishing I had freedom to travel a bit, visit my kids in another province and take in the occasional concert.
This article makes me feel not alone in my decision to look at renting as an option. It makes sense for me. In my generation home ownership is tied to self worth. If you own a home you’ve made it if you rent you’re struggling.
I’m struggling now. I’ve probably made every bad financial decision out there. Six months ago I found the online financially fiscal community. I’m making progress. Paid off one credit card and on the way with number 2. Do you know there are lots of blogs for 20 and 30 year olds. Practically none for seniors. Are all the rest of them financially secure? Maybe not.
Thanks thanks thanks.
It might make sense for you to rent if your cost to rent is significantly less than your total monthly payment including HOA dues. This is an oversimplification but you will want to consider what your income tax bracket is as a homeowner and what it would be as a renter. You also mention that you may sell at a loss. Based upon your current figures it seems that you paid a down payment of at least 42,000.00 plus your closing costs. If you sell you will like pay a real estate commission plus closing costs and costs to move, including movers, rent deposit, first months rent etc. Pencil it all out. If you have Microsoft excel, you can find plenty of tools to help you. Best of luck to you.
For the most part I tend to agree with you but it definitely is different depending on where you live. In most of the united states, yes equity rises with inflation but in hot markets like Austin, TX, the equity appreciation is far greater then inflation and in situation like that, it is smarter to buy and not rent.
However if you are in the mid west somewhere, like where most of my rental properties are, yes it may make more sense to rent.
I am in a fairly hot real estate market (San Diego / Southern CA). Bought in 1987, sold in 2014 (27 years). Total return without adjusting for inflation over those 27 years: 5.2% annualized. Sure, buying for 185k and selling for 750k sounds amazing, and having such a large chunk of cash is nice, but total gains are much less than what I would have done with historical returns in an index fund even factoring in tax differences.
Paula-I enjoyed the article and I think you very clearly laid out the math so anyone who wanted to tweak the variables could do that to make their own informed decision. It honestly shocks me how fired up some people get about this topic.
Having said this I do prefer to own because of a couple of personal preferences that I just prefer. One of these is that I feel that having some of my net worth tied up in my home gives me diversification which I like.
I also live in a suburb (near Rochester NY) that has a low price to rent ratio.
Thank you for what you do!
You make some excellent points! We own, but I often wonder…. The two biggest appeals of renting to me are 1) flexibility–easy to pull up stakes to pursue opportunity or adventure, and 2) I’m not vulnerable to huge, unpredictable maintenance expenses. Some day I think we will be renters again.
This article contains precisely the kind of knowledge that desperately needs to be disseminated on a massive scale. Our society seems to reflexively believe that home-ownership-via-the-means-of-a-multi-decade-mortgage is somehow a normal and entirely natural course of action for any reasonable person to take. I’ve talked people who make *weekly* mortgage payments: the constant threat of defaulting on their mortgage payments looms over them, and it causes them real and palpable stress. Moreover, since they’ve signed up to 20+ year mortgage deals, they’re essentially living under that threat for the rest of their adult lives. It’s time we all free ourselves from this scourge. We need new investment strategies that result in real wealth for our citizens. I commend the author of this piece for a valiant effort in encouraging all of us in such new directions. 🙂
Great article! I haven’t seen this information explained so carefully and in such detail before! Thank you so much.
PS: Hope you’re enjoying our humble little ‘burg. 🙂
Very inspiring (and through) and hey some of us actually like math! 🙂 One aspect that I have always considered, is a mortgage is a ‘forced saving plan’ for 80% of the population.
Yes everyone is ‘ a special snowflake’ but the assumption that most people use the saving associated with renting (opportunity ‘savings’) for anything other than lifestyle expenditures, is usually false.
No I don’t have any analysis to prove my point, so I am using the lazy way and generalizing my personal experiences and assuming they are true for everyone 🙂 (rather than doing 10 minutes of research and math … but that’s more a comment on the instant headline grabbing web trend … oh another generalization).
But IMHO another factor people should deeply consider is their real ability to save / invest without someone else (e.g. a bank) demanding payment.
This was such a great article. Thank you for taking the time to write up such an informative post.
Hi Paula,
I wanted to know, where does one get the data to determine P/R ratios for their area? (I realize I could google this, but I don’t have possess the tenacity to determine if the data I’m reading is coming from a “straight-shooter” such as yourself, or some namby-pamby economist who subscribes to the platitudes you so skillfully destroyed). Landlords don’t just list their property’s values in their rental ads (and if they did, you couldn’t trust it). I certainly can’t afford to have potential properties appraised. I apologize if this a silly question; I’ll be the first to admit I don’t know s*** from shinola! I do feel, though, that thanks to your article, I do know a little something about something-or-other, and I’m eager to put this new knowledge to use. I am, though, also aware of the dangers of being armed with too little knowledge. So let’s build upon this, yes?
Thank you!
Hi Patrick,
The sales price of any home is public record. If you Google a specific address (or look up a specific address on Zillow, Trulia, Redfin, Homesnap, or any other home-listing website), you’ll be able to see the last sale price of the property.
To find the P/R ratio, look up the rental price of a property (which is advertised publicly by the landlord) and compare it to the sales price. Repeat this for a decent-sized sampling of homes, throw out any extreme outliers, and average the data.
Alternately, you could look up the estimated rental price on a website like Rentometer.com, but this data won’t be as accurate as the actual rental asking price.
One caveat: while the sales price is public record, you WON’T know the value of upfront repairs to make a home habitable. For example, if a landlord purchases a home for $50,000 and then invests $150,000 to get the home rent-ready, then the value of the home is $200,000, even though the official sales price is only $50k. That’s why you should throw out any extreme outliers. That’s also why you shouldn’t perform this experiment in a neighborhood with a lot of extreme renovation — e.g. a street with vacant, boarded-up houses that are slowly getting rehabbed. In those areas, you’ll need to talk to the other landlords directly. This is the approach that I took for House #5, which is in an area with vacant, boarded-up homes.
Hope this helps!
Hi Paula,
Great article and very informative! I would love your take on how income tax deductions specifically relating to mortgage interest and property tax deductions should be considered? As this is often sited a major benefit to owning vs renting. This probably again needs to be handled case by case as states with higher property values increase these benefits, but would be interested to hear your methodology in analyzing the impact of these breaks. Thanks for sharing the knowledge!
Jamieson –
By definition, a tax deduction means that you’re spending $1 for the sake of saving 20 to 33 cents.
Tax deductions are helpful for reducing the impact of costs that you would have paid for anyway. But don’t take on new expenses purely for the sake of the tax deduction.
Think of it like a sale at the store (such as Black Friday sales). If you were going to purchase the item regardless, then a sale is helpful. But if you’re influenced into buying something that you otherwise wouldn’t have purchased, then the sale has caused you to spend more money, which has a net negative effect.
I’d never hold onto a mortgage for the sake of keeping the tax deduction. Yes, there are non-tax-related arguments in favor of hanging onto a mortgage (that’s a different conversation). But in terms of taxes, I’d save much more money by not paying any mortgage interest in the first place.
Thanks for reading!
– Paula
Thanks for the reply! I get that you shouldn’t buy the house for the tax break alone, but I guess my point is that if your getting the tax break in one scenario and not in the other, it should be folded into the analysis. So in the “buy” scenario your recurring costs would be offset by the tax benefits which are high in the early years then tail off as you pay less and less mortgage interest. Since the tax break is readily available for everyone, I don’t think this falls into the special snowflake bucket. Thanks again for dropping the knowledge!
Hi Jamieson,
Ah, I understand what you’re asking now. Thank you for clarifying that. In the example that I illustrated — Rachel vs. Owen — Owen’s tax break is factored into the analysis. As the example shows, Owen is in the 20% marginal tax rate, itemizes his deductions, and receives a tax deduction on his mortgage interest. Rachel is in the same tax bracket, and does not receive a mortgage interest deduction. In that scenario, Owen and Rachel break even.
Of course, the Owen/Rachel scenario is so filled with specifics — rental rates, purchase prices, interest rates, maintenance costs, tax bracket, length of time you’ll live there, etc., etc. — that no two people will exactly fit that scenario. If you’re an individual trying to decide upon the best course of action in your own life, I’d encourage you to input your own variables into the Rent vs. Buy Calculator. (It’s free, and I have no relationship with that website). This will allow you to run scenarios that weigh all the variables, including mortgage interest deductions, when you’re making the choice.
Thank you so much for reading and commenting! I appreciate your addition to the conversation. Welcome to the community! 🙂
I never had my own house or apartment. Have been renting for over 10 years already. Different cities, different places. Always dreamed about my own house somewhere by the sea or lake. And for me, to decide whether it is cheaper to buy or rent is the hardest thing.
Interesting article, very impressed with the level of attention to detail. I think there are a couple of other points that would be worth mentioning however:
1. Psychology. Most people who could save money by renting instead of buying, probably will spend the money instead of investing it – mortgages are a form of forced-savings. Some people have the discipline to invest $X every month and live within the means provided by the rest of their pay check – but in my experience, most people do not.
2. I’m not sure it’s fair to compare space you can rent for $X with space you can live in for the same amount of money. In my experience, you get more value (square footage, amenities, neighbourhood) for your money when you buy than when you rent. I’m sure that’s location dependent, and there are even possibly areas where you get more for your money renting – my point is, I think without making some kind of equivalence between those values, this analysis could be quite misleading.
Thank you Thomas! I’m glad you like it!
I agree 100% with your remark on psychology. Are you a new reader to this website?
The Afford Anything community is full of people who are disciplined with their money. Several of the readers at this website save half (50%) of their income or more. Many more readers save 30-50% of their income. And those who aren’t there yet — those who are at the beginning of their journey — are people who aspire to this level of savings and are actively inching closer to it — one step at a time, one percent at a time.
This is an awesome readership, and an incredible, savvy, smart community. We understand that the best thing money buys is time. And that retirement doesn’t have to wait until you’re 65.
We’re not representative of the majority of the nation. We’re different. We’re rebels. 🙂
We’re the people who invest our money, rather than waste it on junk. If you’re new here, I invite you to poke around on this website more. Join our movement. Welcome. 🙂
Interesting article but I believe that your analysis is flawed. Its makes generalizations and misrepresentations that the average reader would overlook. While I believe that renting in some circumstances makes more sense than owning, personal lifestyle choices must also be factored in. You state that mortgages never end. In fact, for the smart homeowner, they do. What does not end is the cost of ownership. Things, like taxes, maintenance, homeowners insurance, HOA dues (not applicable in all circumstances) are recurring costs. But then again so is rent, renters insurance, Maintenance (yes this might actually be included) are continuing expenses. Also, while you included equity gains, you conveniently neglect what the value of the equity gain would amount to over a ten year period. So all in all, a decent article but one that is obviously slanted toward renting.
Hi Robert — I respect your comment, and I agree that both the costs of homeownership and renting continue in perpetuity. Housing costs never end, regardless of whether you rent or own.
One statement that you made is incorrect: You state that I “conveniently neglect what the value of the equity gain would amount to over a ten year period.” In fact, if you re-read the analysis, I do not. It’s included in the final tally.
The irony is that a macro lens zooms /in/. Nonetheless, great article! It’s nice to see some solid analysis, as opposed to quoting puppets in support of a cliche argument.
Oh man, I should have said “wide angle lens!” Good catch. 🙂
Have bought and sold a home and assumed I’d buy again in my new city but the places I can afford and could tolerate here make me ill at the thought of emptying my bank account to get a mortgage. I think I’m sold on renting and investing my cash instead. Makes even more sense as a single person to rent smaller apartment (unlike renter rachel) with a smaller rent payment than the PITI (and more) on a any house I’d buy and invest those extra dollars too! I never really enjoyed all the upkeep on my last house, I just thought thats what reaponsible grown ups did! It feels good to have the facts on my side that renting is a good financial choice!
A very interesting article. I happen to live in a place (Tel Aviv) where the price to rent ratio is around 30. This would not appear to be a good candidate to purchase. However, when you run the numbers on the New York Times calculator, the result appears to be primarily based on two variables, the expected amount of real estate appreciation and your potential outside investment return. For example, if you assume you can earn 4% on your investments and a 3% assumption of real estate appreciation, the decision is relatively neutral. If investments earn 6%, it is better to rent, unless real estate appreciation is 5%…… What types of assumptions should reasonably be used for investment gains and property appreciation?
Such a great post! Very detailed and informative.
Slightly high rate aside, I have almost zero problem with anything in this article. Said as both a property owner *and* a renter. Almost. The one thing I’d like to point out is that you use HOA as a standard for home ownership when, I believe, only about 30% of current homes are governed by an HOA. So that is, by definition, a special snowflake case in and of itself.
That said, it still doesn’t drastically change the math, just slightly alters it. And it’s still not a slam dunk in the “owning” column even with that change.
Thank you for this post!
As a millennial living in a monstrously over-valued market (Toronto, Canada with $350K houses going for $600K to over a million in the suburbs) I feel like everyone from older generations says the only way to get ahead is to own.
Glad I’m not mad!
Renting is part of our debt repayment plan. We can’t afford to have housing mishaps crop up while we are aggressively paying off out student loans. Renting will afford us the convenience of not having to worry about the long term care and management of the house we live in, and we’re likely to live a bit more comfortably in this city.
Awesome article.. from a purely financial perspective this makes a ton of sense.
There are other considerations though outside of financial:
– By buying you can make the place completely bespoke to you, how you’d like it. With renting the options are a lot more limited.
– There can be a big cost to re-furnishing, re-decorating etc a new place, so if you have to move every year or every couple of years (in the renting use case), have to consider the cost of that.
Also re: oppt cost with stocks, one thing I keep hearing again and again is that in today’s market with interest rates at record lows (98% percentile compared to all of history), we cannot just expect the same 6-7% real return from stocks going forward, and that is will be a lot lower than that.
Great post! What I find funny is all these folks arguing about the assumptions. If you want to use a different HOA fee, interest rate, etc – just rebuild the model with your own assumptions!! Geez.
A lot of work went into this(and the cost to read is free!), so what I have to say is, “Thanks!”
BTW – the podcast is terrific!
One more thought – I do consider some qualitative aspects in our “buy” decision. I don’t want to be forced to move, and also we want to make some personal changes to our home. On the other hand, if we WANT to move soon we’ll take it in the shorts on commisions and fees.
THANK YOU!! Finally, someone with sanity! 🙂
Thank you for the very informative article! I looked up the P/R in my area and numbeo says it is 7.56. It’s not so much because houses are cheap but because rent is incredibly high in this college town.
We bought a house last year. I think it actually would have been a better financial idea for us to stay in an apartment because the “niceness” of our apartment wasn’t anywhere near that of the house we bought. But we love the house and after doing lots of research on rent vs buy decided that buying was the right choice for us (and we accept that it will cost us more money in the long run).
Also, are you saying that if I don’t buy socks, buying a house is always better? Sandals here I come!
Great article. We are definitely in the rent not own camp right now. We travel full-time and having our money in the stock market rather than tied up in home equity gives us a mobility we could never experience if we owned a home.
Opportunity cost is so often ignored when looking at these things and I definitely agree that emotional decisions have a big effect over our rational brain. When we were younger, we wanted to nest and have a place that we could put our signature on. Now we are approaching our 50’s – owning stuff is not that important and we just want the freedom to experience travel. Renting gives us that freedom.
Brilliant article! Thanks for taking the time to write this.
Great article. Accomplished it’s goal of getting some people to critically think. Others have decided to project their decisions as the only proper choice. The name of your article and stated objective were clear. Actual data to back up an argument is more convincing then an emotional cliché and closed mind.
Some people are still missing your point and won’t allow themselves to believe that people who make different decisions are not “throwing away money”.
There are certainly a number of layers deeper we could go with both sides of the argument, but in the end much of it is speculation. Will taxes go up, down? Who knows? Will real estate in your area explode and you’ll know to sell at the top? Will an accident occur on your property that your liable for? Will landlords raise rates with the scowl of a long toothed vampire?
Will your employment, health, martial status (divorce) or finances change while owning a house to the point where you cannot afford the mortgage and lose everything including that down payment you saved for and that wonderful interest rate? This one particular situation is completely avoidable with renting and is an important consideration.
For me [emphasis on my particular situation with no assertion of a universal truth] the choice is simple at this time in my life. I want flexibility and I don’t want to deal with hassles. Pains in my rear….you know, all those things that come along with home ownership. I will simply call the landlord and relax when I’m not working hard at my profession. I can devote more time to my career. I can spend extra hours in the office or working at generating other streams of income instead of laying tile, spackling holes, changing fixtures, changing appliances, keeping the landscape, caulking the bathroom, cleaning the gutters, killing the rodents, cutting down the growing trees. It goes on and on and on. I can enjoy all these things later in life after the index fund investments afford me the flexibility to purchase a home in cash should I choose to do so.
You can still send your kids to the right schools by renting in the right areas instead of buying. And guess what? If those best schools in your states change year to year and you want to tag along – flexibility.
Need cash for a sudden expense that’s not covered (death in the family, loss of job, health issues)? No problem, I can tap into the taxable investment account that’s been earning ~ 7% per year on every spare dollar I saved because I don’t have consistent maintenance expenses with owning a house. My money isn’t tied up in a non cash flow generating asset.
After 10 – 15 years of savings and market returns, you might even be able to buy a home outright in cash. Now you’ve skipped right to that stage of home buying when your monthly expense doesn’t include a mortgage.
That’s just me. We’re all different and there’s a strong argument for home ownership.
I know this is probably a really dumb question (sorry :)) but if you get a $250,000 mortgage but you pay the bank around $700,000 (or whatever) because of interest….how is that an investment?
Surely that is a massive loss because even if you own a $250,000 home outright you still paid the bank way more?
It seems deceptive to make the featured example one that is worse than the national average, and much worse than the author would have purchased herself.
[To put this into perspective, my bare-minimum-criteria for any rental property that I purchase is a P/R ratio of 8.33.]
In the Rachel vs. Owen example, their homes carry a P/R ratio of 15.5.
Fun facts about P/R ratios you can use to impress your friends:
The average is 11.95 nationwide.
The median is 11.27 nationwide.
Do you understand that “average” means that 50% of houses have a HIGHER price-to-rent ratio?
If the nationwide “average” is 11.95 (nearly 12), that means that 50% of houses across the nation have a HIGHER P/R ratio.
Also, you conveniently forgot this fact:
Would you tell someone living in an area with P/R ratios of 25+ that “renting is throwing their money away?”
Several of your cost assumptions for homeowners are higher than average, including P/S ratio, HOA fees, and even current mortgage costs. (Not to mention an illusory 20% marginal tax bracket for someone paying $30K in annuall housing costs.)
You don’t do this for renters.
You use national long-term averages for price appreciation, then use local real-time P/S ratio statistics, justifying this by saying that you didn’t use the highest possible P/S ratio.
And you didn’t mention that capital gains on sale of a principal residence are largely untaxed, or that sellers can often negotiate sales commissions, or even list on their own.
You can make whatever point you want, but it’s like putting your thump on the scale, and they saying that what you were weighing was heavier than you would have thought.
Okay. Let’s make this more elementary:
Some people get so caught up on specifics of one hypothetical that they miss the larger picture. So: let’s skip the Rachel vs. Owen example. Read the REST of the article, which is 5500 words long. Then answer the following question:
Do you — or do you not — agree with the following statement: “Renting is throwing your money away.”
Yes or no?
Does this statement apply in all cases, across all historic time periods (not just 2016), and across all parts of America:
— Regardless of current market interest rates
— Regardless of P/R ratios in your area
— Regardless of the amount of time you’ll live there
True or false? In 100% of cases, “Renting is throwing your money away?”
Is homebuying a slam-dunk case for 100% of Americans?
Is that your position?
Because THAT is the point of the article.
Don’t be so small-minded that you quibble over details, while missing the bigger picture.
— Paula
*********
(And by the way, I’ve answered the capital gains tax question MULTIPLE TIMES in the comment stream. Please read previous comments above.)
********
P.S. If this makes it easier for you to understand:
Intuitively, we all know that if you’re going to live somewhere for 1 year, renting is better. And if you’re going to live somewhere for 50 years, buying is better.
Somewhere between 1 year and 50 years is the crossover point, where buying becomes better than renting. It might be 5 years. It might be 10 years. It might be 15 years. It might be 20 years.
The question, then, is: Where is that crossover point? How can you solve this puzzle?
The only way to calculate this is by DOING MATH.
There are no human beings whose lives will correspond 100% with the national averages. Every human will have unique data points, based on prevailing interest rates, P/R ratios, HOA fees, tax brackets, and a long list of other factors.
That’s why every person should do the math based on their own personal circumstances.
And don’t buy into oversimplified cliches like “renting is throwing your money away.”
You seem to have missed this. You are so caught up in being a Special Snowflake — “wahhhh, your HOA fees are too high!!” — that you missed the point.
If you don’t like the example, just re-run the model with different assumptions!
Don’t be an Internet Complainypants. It won’t get you anywhere.
Stop pretending like your article was unbiased, you were clearly trying to make renters feel better about their decision to subsidize the net worth growth of landlords.
Paula, thanks for the article. Could you please address the following arguments in favor of buying:
1. Leverage. You’re getting housing appreciation on the full amount of the house, but you’re only investing the down payment. Just looking at pure ROI and assuming 20% down, Rachel’s market needs to produce 5X the return to Owen’s. In other words, she needs to make 10% return for his 2%.
2. Risk/Volatility: For the head to head comparison to work, you assume that Rachel invests all the money in stocks. However, this is a risky endeavor and not many people will have the guts to do that. Stocks are naturally more volatile than housing.
Thanks.
Boris
Great article. Best rent vs buying article, and very to the point, and clear. I am renting now, and going back to school. everything you said makes sense, and very clear. I enjoy reading your articles you our to the point. Thank you.
I’m a relatively new follower of your blog, but so far I’m loving it. You did a lot of detailed research in this post and I genuinely appreciate it. My husband is a strong advocate of “renting is throwing your money away” so I’m glad I came across this article. After putting our “special snowflake” details in to the nytimes calculator I’ve concluded that in our area he is right. Our rent is $720 and a mortgage for a similar environment would be $450. Also fun fact, the root word of mortgage is mort which means death in french, so the translation of mortgage is a contract until death. Mortgages were first intended to never be paid off, just like renting. Obviously it’s gotten better, but like you said do the math to see which is better for you.
I LOVE THIS COMMENT!
I’m so happy to hear from someone who says, “We plugged our numbers into the calculator, did the math, and figured out what’s right in our specific situation!” That is a perfect example of making intelligent, informed choices!! 🙂
Thank you Kaitlin!
Hi Paula,
I am 15 and was just trying to understand your article. Could you point out what is wrong with the following argument:
Assuming, the rent on a property is $2000 per month and the mortgage is also $2000.
So on a mortgage, I am saving some of the money (after taxes and interest payment)in the form of principle repaid. So isn’t buying better?
Not in every circumstance. Here are a few reasons:
(1) You pay the opportunity cost of missing investments elsewhere as a result of tying up your down payment and losing liquidity. The cash tied into your equity, historically, keeps pace with inflation. It rises in nominal dollars but not in inflation-adjusted purchasing power.
(2) You also pay substantial transaction costs each time you buy and sell the property, meaning that you’d need to hang onto the property for a significant time period in order for the equity gains to compensate for these fees. That’s why people don’t buy houses to live in for short durations.
(3) In your example — in which you can buy vs. rent an equivalent home, both for the same amount — the owner pays repair and maintenance costs, and typically also higher utility costs, all of which negate the positive effect of equity gains through principal reductions. (Re-read argument #3, which is towards the bottom of the article.)
Hope that helps!
Paula I may have missed and apologize if I did. But what would be helpful for the reader is the reality of your situation when writing this article. My assumptions (yes an azz out of me maybe) are that you have likely never owned a home? Also you live in some place up in the northeast. Something’s you point to are actually not factual in 95% of the country.
Points like homeowners missing out on Opportunitiy Cost. If I understand what you want to say, my counter would be that if I see a fantastic investment opportunity. I do not need and go to a bank, I do not need to touch my bank accounts or cut open the mattress! I simply write a check out of my equity line. If it is such the opportunity that you portray the renter to have? It will be worth using part of the equity I have. Which by the way is a benefit you do not afford the homeowner in your article.
Everyone in responses agreeing with you and your points in the article. Don’t really account for one other renters reality. They live there at the owners discretion. I only have to give you 90 days notice to vacate! You live in that house because someone allows you. No thanks! I like to have control over things like where my family sleeps!
Hi Paula,
Thank you for this article! I live in Manhattan & always knew that my gut decision to rent, not buy, was a sound financial choice for me … I just couldn’t articulate all of the reasons why. I’d previously been told that each of the three premises you debunk were the “sacred cows” of long-term housing decision-making. But, there’s a lot more to the story than that. After plugging in my numbers & falling soundly into the “run screaming in the other direction” camp, I’m confident that my current strategy of not buying is the right one for me at this point.
Your wonderful interview with the Mad Fientist hooked me on to your podcast! Now I’m methodically making my way through all of your episodes with J. Money on my commute. So appreciative of the knowledge you’ve shared thus far. Having a community to rely on in the early stages of pursuing Financial Independence is such a motivator. I hope you have a wonderful night!
It all depends on how much you plan to stay in that house. If it’s short term then it’s worth it, if you are staying for a few years then it’s probably not worth it. This also depends on the country and your income of course.
Informative article. It’s so important to receive all the information you need before investing.
Should have been Renter Rene.
Great Article.
My personal opinion is that every article that talks up renting vs buying goes at it from a wrong headed perspective. In other words they always choose a mediocre buying situation, and an awesome investing situation for the “other” scenario. That is not to discount the great point that DOING THE MATH is eminently important. Because it is. Every market IS different, and you’re a fool if you don’t run the math for your area. Some areas are not optimal for buying… But in most areas I think it pencils out pretty good.
There are a few things that always perturb me about these articles though. In my opinion the primary valid reason for not owning is if you’re not going to be staying in the area long. If you’re really unsure if you’re going to want to live in the same city in 5 years, that’s a very valid reason to rent vs buy… However if you’re going to want to stay in the city for 15 or 20 or 30 years or whatever, that is where ALL the magic happens with buying if you’re doing it right. And to ignore that and look at the shorter time horizon as most of these articles do is somewhat disingenuous IMO. No kidding that renting looks good if you’re looking at buying in the wrong situation… But to not point out how much better buying starts to look after a long period of time I think can be misleading for people who DO want to stay in an area for the rest of their life. I get the point of disproving that it is ALWAYS better to buy, but who the heck doesn’t get that at a basic level? Anybody who thinks buying when you might move in 2 years is a good idea is an idiot, and they shouldn’t need an article like this to explain that.
For the record I think you did a far better job of being fair and balanced than many other similar things I have read online. You even went so far as to justify using 10 years since that is a common time period people do in fact own a home. So there is some validity there. A few caveats being that MANY people who sell, only do so to move across town, which means they didn’t necessarily NEED to move or “suffer” too terribly because they were locked into a house… But simply wanted to for whatever personal reasons. Those people can carry forward their gains tax free when they need to move. But perhaps people who actually care about the financial side of things more shouldn’t move in the first place… And if you don’t care more about the money, then you shouldn’t worry if it was the best financially or not. But I’m getting side tracked.
Back to point I think the biggest thing that people “cheat” on in these types of articles is the down payment. Everybody always hamstrings the situation by using 20% down, and then comparing that to investing is something more risky than buying a house with 20% down. That’s not fair. Personally, I’m of the mind that every person at all times should at least think about things as an investor would. You can choose to make decisions for other reasons, but you should know that you’re not making the best financial decision.
There ARE situations where maybe you should put 20% down… But seriously, you’re losing all the awesome leverage that real estate offers if you do! Even at 10% (which is not considered being wildly irresponsible) the math looks sooooooo much different, and more favorable to buying. If you go to 5% it magnifies even more.
I guess what I’m saying is that 95% of people shouldn’t even consider putting 20% down as it’s a less optimal way to INVEST in real estate. If we assume someone is going to stay in a house for 10+ years (which frankly if you’re buying a house that should be the plan) then there’s little reason NOT to use one of the lowest rate loans available to buy most of the house with the banks money. If you want to talk opportunity loss how about if Owen put 5% or 10% down, and then ALSO invested the rest of his cash on the market? He would be well on his way to making a LOT more money than Rachel. If Owen planned to stay in his house for a long time, or forever, he’s taking on essentially negligible risk by doing this, yet he’s making a lot more cash. What if Owen took out some of his equity built by inflation and making his payments to then invest more on the market? Or buy a 2nd house? Then he’s even further ahead of poor Rachel.
Leverage is key in real estate, and yet everybody ignores it as if it’s “not fair” to compare it that way. It’s like comparing 2 cars in a 1/4 mile drag race. One is a factory model Corvette, and the other is a custom hot rod dragster. They race, and under the rules of the race they come out in a tie… But then you find out the top fuel dragster was required to run on regular pump gas instead of the high octane stuff it’s designed to run on… Well no wonder it didn’t perform better.
Real estate and leverage were made for each other (due to real estate being such a stable underlying asset, your math about the inflation adjusted price essentially never changing proves this), and to tell people to poorly buy real estate, but to brazenly invest in the stock market is not a fair comparison. The market is risky. Using leverage is real estate is also slightly risky… But if you’re going to compare the 2 you need to compare going about real estate in a more “investery” way or else it’s not a real comparison. Compare intentionally over safe real estate buying to bonds, which would be more appropriate, if you want to go that route.
What about using leverage in stocks you say??? That’s a WHOLE different, vastly higher level of risk vs 5% or 10% down on a house, which is relatively safe if you plan to stay there a long time. It’s not a fair comparison because of that different risk level, just like telling people mutual fund vs 20% down real estate is not comparable in my opinion.
Anyway, I’m not saying there aren’t some situations where renting is better, but I think telling people renting is what they should do their whole life is a bad idea. I get that YOU didn’t do that, but so many articles do that it drives me nuts. Unless you HAVE to move every few years most people will be better of buying a place when they’ve figured out where they want to settle down. End Rant!
I read the article, skipped most of the comments and was about to write a comment and the last one above pretty much said what I wanted to say and more!
As Paula said, its not black & white. In general I believe buying a house is like buying a car – buy a good used one at a reasonable price that will allow you to enjoy life as well. Keep it for as long as you can – to me, this is 10+ years. I bought my current home at the top of the last bubble in 2005. After 11 years it has beat inflation and if I rent it out now, my total payments will be half the rent. I bought a brand new car and have kept it for 12 years now.
Buying vs. renting is also a lifestyle choice. Its hard to put numbers on personal likes.
In the comment VK is arguing that all the rent/buy articles are overly optimistic on the rent equation and pessimistic on the buy side…but if, as Paula in her article did, using ‘average’ situations the buy equation is terrible. So why do comments say Poor Paula is being unfair to Owner Owen?…
Personally, I suspect lots of comments falling into the ‘special snowflake’ category are fueled by someone having spent a very large amount of money on a house and it is human nature to resist the idea that the purchase was a mistake. Indeed, there seem to be enough ‘special snowflakes’ on the comments board to make a smoothie…ummm, now that makes me want to go get a smoothie…
But snapping out of the smoothie-craving coma…to look specifically at VK’s comment/arguments.
Doing the Math…I’m in absolute agreement with VK and Paula that peole had to do the math. So VK’s comment is right on the money there, but VK starts to go wrong when saying most areas pencil out pretty good.
VK is clear that short term stays are better with renting and long term better with buying, a concept readers of Afford Anything should intuitively grasp. VK argues people who buy should stay 15,20,30 years…but that ignores the data on what American’s actually do. People aren’t rational, even on something as important as the biggest purchase of their lives, so what do our real irrational emotional people do on average?
Prior to the Great Recession the median home ownership duration was 5.9 years…that is half of everyone sold in less than 6 years…are these people nuts! Now I want a bowl of nuts. Only 10% of people stayed in a house 21+ years. That ownership duration ticked up after the Great Recession to a median of 9 years with 15% staying longer than 21+ years. There is a nice graphic of this (a bit out of date as it was 2011, but works to show the tends) here:
https://www.creditsesame.com/blog/how-long-are-americans-staying-in-their-homes/
So arguing that Paula is ‘unfair’ using 10 years is Renter Rachel and Owner Owen is flat out wrong. Historically Paula is being generous giving Owner Own at 10 year time frame and the 20 year time frame VK suggests is the special snowflake situation.
Damn, now I want a smoothie again…maybe a nut frosted smoothie…
But people don’t have to move VK argues…well, again that is theoretically true but our real average irrational American’s don’t seem to follow VK’s logic of not needing to move. If we add up the people who cite ‘must move’ reasons for selling a house ….with must-move covering things such as ‘job relocation’, ‘change in family situation’, ‘avoiding foreclosure’, ‘cannot afford mortgage’, and ‘cannot manage upkeep’…it comes to just over 40% of all sales. So lots of people must sell and can’t just hold onto the property.
The main problem I have with VK’s comment is recommending high leverage by putting something like 5% down….paraphrasing what Archimedes said “give me a leveraged loan big enough and I’ll buy the world”
VK talks about the rosy glowing upside of leverage. If you buy a million dollar home with 5% down ($50K) and the home goes up in value by 10% when sold you pocket 150K, and if you got a 20% gain in value you’d pocket 250K…a fivefold return! Minus some closing costs…but Woohoo you’re thinking…why don’t we buy lots of houses with 5% (20 times leveraging)…
Leverage magnifies gains…but it has a wicked sister…leverage magnifies losses just as effectively as it magnifies gains. If the million dollar house bought with 5% down drops in value by 20% is now worth 200K less than what we would owe on it. If you fall into the 40% of sales that are forced on our average irrational American that sort of loss would probably bankrupt most people.
But VK says homes are a stable asset? That also ignores history, there are lots of times, cities, towns, and streets that have dropped 20% in value over just a few years. Think of Flint Michigan, properties there collapsed over 50% from a water switch that may not even have affected each hose…the stigma will take a generation to get rid of. I’m not making smoothies with Flint water!
Since your house value is based on comparable if someone down the street forecloses, or sells undervalue to move quickly, or that a nice elderly couple who sells 30% under market to their kids to escape gift taxes…those comparable low value sales can easily knock 10-20% off your house value…ouch, that nice elderly couple did a number on you without even knowing it.
Paula gave Owner Owen a 5 fold leverage (20% down) and Renter Rachel no leverage at all…if Paula had given Renter Rachel even a modest 10-20% leverage in the stock market (called margin investing, people do that as high as over 50%!) Renter Rachel obliterates Owner Owen’s net worth
Not that I’m recommending margin investing without seriously knowing what you’re doing with math and risk projections over a decade…but then I’d have said you shouldn’t buy a house without seriously knowing what you’re doing with the math and projections over a decade…but I’m oh so wrong, seems lots and lots of people buy without doing the math.
Buying may work for your area…it may work for you…you may want to emotionally regardless of the math…that’s all fine. But, run the numbers first to make an informed choice. Seriously, drink fewer snowflake smoothies and do the f-ing math!
End counter-rant…
HUGE +1 to that insight (and to your entire comment, which is research-backed, logical and well-thought-out!!) 🙂
I agree with you that buying isn’t always better than renting. You explain this very well in your article. Great read!
This article is flawed for the following reasons:
1. You didn’t account for tax breaks on the mortgage interest you pay.
2. If your house rises at the same pace as inflation, let’s say 3%, and you have 20% down on the home, you’re actually getting a 15% ROI because your down payment is leveraged.
Here’s an argument I’ve wondered about for a while now. What’s your thoughts on it?
If the price of housing matches inflation (say 3%) and wages typically match inflation (again, 3%) to offset cost-of-living increases… then in absolute dollars fewer people are able to afford owning a house over time.
Which somehow magically implies additional value for home ownership but I can’t recall the rest of the argument now. 🙂
Hello Paula
Interesting article. As, I am in a predicament at the moment I live in a single family home in NJ. Taxes are a killer, i work in NY. I have to pay 2 state tax. I purchase my home in 2001 with my brother, her job has relocate. I pay my brother his portion in 2012. I am now a single homeowner. I have done over a significant amount of renovations. I am starting to realized its too much house for 1 person. Jersey City is in the process of doing a tax reval. As I stand my taxes are very costly for a property owner. I am a bit torn on selling vs renting. I can easily move in with friends who are in rent control apt in NYC. Cut paying 2 state taxes and save. Upon reading your article, society has lied to me as to the American Dream. The stress of paying a mortgage is killing me. I am wondering if investing my money will be the best bet. Any suggestions?
Regards
Nita
This is a great concept in theory if you zoom out. Except that people don’t buy homes ‘zoomed out,’ they buy homes in a specific location where real estate appreciation / depreciation can greatly differ from the national average. For example, I own a $700k condo in New York that I can sell for close to $1 million now. That is a $300k return in only three years. The stock market would not have given me that. Also, the retiring in 10 years scenario also assumes the same spending for 10 years. What if someone wants to have kids and those kids need a larger home. The cost of moving to a larger place to rent will automatically cut into your savings and thus your expected retirement age. I think the key take away here is understand what you are buying and research your alternatives.
Appreciation of your condo from $700K to $1 million in three years sounds good…though if you sold you’d have 50K or more closing costs, netting you $250K…great right?
Well… using the Nasdaq investing your $700,000 on 29th August 2013 (exactly your stated three years ago, as of my posting date today) with reinvesting dividends…you would have taken your $700K to a net worth of a cool $1,721,674 and 17 cents…let’s not forget the 17 cents…not that it can really buy you anything these days.
Appreciating one of Paula’s main points (sorry, had to make the pun, it was just hanging out there begging), the ‘opportunity cost’ of the equity in the home should be a factor in the cost calculations of buy vs. rent. Everyone should do the full math comparison to work out if rent/buy is better for them…but it’s not just the math…people may want to own and spending money on what you want can be fun…but it’s not an investment.
Was I being favorable using the Nasdaq over a total-market index and lucky on the exact three year ago today date…sure I was, but it is a major investment index so it isn’t as if I picked some random stock to fit the argument…and New York was a favorable real estate market over the last three years for the buy side of the equation.
Of course 17 cents and games like mine massaging numbers into a feel good exercises on either rent or buy history will buy you a 17 cent cup of coffee…
Nasdaq calculator at:
http://ir.nasdaq.com/calculator.cfm?ndq_form_post=1&initialAmnt=700000&calc_method=amnt&historic_Month=8&historic_Day=29&historic_Year=2013&ReinvestDividends=1
I doubt he paid $700k in cash for his condo. People usually borrow money to pay for housing. If he put 20% down that is only $140k not $700k. $250k is an extremely good return on $140k, far better than the stock market.
Sorry…still no dice on his beating the market…and not even close to the ‘far better than the stock market’ you suggest…run the numbers…
If he put down 140K as the 20% on a 700K condo and sold out after three years at 1 million…making the 300K gain in his post. That is eroded by closing costs (I gave him a ridiciously generously low 5% closing costs, i.e. costs of 50K)…but since he has a loan now rather than outright purchase he would have had to have paid three years of interest on a 540K loan…I’ll give him a low 4% rate over 30 years (most banks won’t do condos at under 4%) resulting in interest payments of 63K over three years. So in that situation he made 300K minus the 50K closing from before, but now also minus 63K interest…so he nets 187K (and I’m not even charging 10K or more in closing costs to him from the original purchase or any repair/rennovation costs that he’d have to make as an owner for three years).
The Nasdeq on 140K over the three year time frame being argued would have grown to 344K…or more precisely a net of $204,333.84 and a half cent…lets not forget the half cent.
So, even with your assumption that he has a 5x leverage on the condo, no closing costs at purchase, super low closing costs at sale, and no repairs/rennovations of any kind…the Nasdaq still beat him by over 15K…and an index fund doesn’t have any of the hassles of buying/selling…and you can add/remove from an index fund any time you like.
Lengthen the time frame and his closing costs ameloriate down, but his interest costs go up, property appreciation would give a bit more gain, etc. Sure, one can come up with some set of assumptions about the situation, or about what the market will do, and make ownership or rental come out better…but on average housing returns never match stock market equity returns.
The point of Paula’s article above was not to analyse any special snowflake situation like CondoBuyer’s assertation…and use that to say owning is great, or renting is great, or that CondoBuyer’s particular decision was great. Human nature makes everyone want to think their decision was great regardless of what it was…that thinking misses the point of the article.
Paula provided a framework to run all those sort of numbers I ran above in order to decide if buying/renting might work out better for each situation.
Please run your analysis again using today’s mortgage rates. I can get a 30 year fixed at 3.1%, and only put 5% down. And who pays $300/month in HOA fees ? Nobody I know.
I think your only real takeaway here is “Don’t put 20% down!”. Home equity is an inferior asset to mutual funds, no question about it. But you can minimize your down payment, sometimes you can even get cash back. When we bought our first house we got $5,500 in cash back from the deal and didn’t spend a dime on a down payment.
James – you definitely do not stay in NJ 🙂
Property taxes and HOA fees here are criminally high. For example a 15-20 year old $350,000 town home, would have annual property taxes of around $9000 and $275-375 in HOA fees per month. Some other parts of the country may be a different story and hence as the author says … run your own numbers,
If the author really wanted to illustrate the variation I think she would have provided a table with multiple scenarios. Instead she cherry picked an unrealistic scenario where owning = renting.
Virtually everything that I have read here I agree with!
But the fact is, all of the money that I own is tied up in the equity in my houses and I have done pretty well with Real Estate. I live in a part of the country where rent for a studio apartment can top $4,000 per month! My house payments are cheaper than most people’s rental payments.
If a person wants to invest heavily in the Stock Market, the obvious answer is, “move to a cheaper part of the country”, but I love my beach home and temperate climate, no tornadoes, snow drifts or triple digit heat, and it’s where my family lives too, I wouldn’t want to leave for a cheaper State just because I want to save for retirement.
Every person that I know that has made good money has done it through Real Estate. Yet, I do believe what this article is saying.
My final analysis is that if a person chooses a strategy that works for them and follows through with it with 100% commitment – they will succeed. For the past 80+ years, on average, the stock market has gone up about 7% per year. And, on average, for the past 80+ years Real Estate has gone up about 7% per year. Real Estate has higher expenses but it also has greater potential for monthly income from outside sources.
Probably the one area that this article overlooked was possible rental income(s) from rooms in a house. If a person buys a house when they are young, before marriage and kids, they can actually be semi-retired just renting a few rooms out to friends. Yes, they may not have cash in the bank, but if the rents cover the mortgage, they do have time, which is worth more than money! Most stock market investors don’t think like that, but there’s more than one way to solve any question or problem.
In a perfect world, a person would have both stock market and real estate investments.
1st disclaimer: I currently rent
2nd disclaimer: I work for a major financial services company
3rd disclaimer: I bought a condo in Dec 2004 for 272K and sold it Feb 2005 for 412K
There appear to be some very savvy and disciplined respondents to your very detailed comparison. And to those savvy people, it is true, each situation is unique and you need to run the numbers. But for the undisciplined masses (which I think is the majority of the people not even reading this), I am afraid, they are not nearly as savvy. For the masses, unfortunately, even though they may very well incur huge opportunity costs by buying, the recommendation may just be easier to have them buy instead of rent. Why do I say that? Because for most people who rent, I doubt they are savvy enough to invest the difference. I suppose I could be called an arrogant schmuck (or, maybe, a realist), but I don’t think the masses would invest the savings at all…I think it would get spent on BMW leases, expensive dinners, expensive clothes, and expensive vacations. Therefore, dumbing it down, at least buyers have a forced savings plan. The alternative, I am afraid, is that the population at large would have nothing after 30 years of renting as they would spend any savings immediately and not invest any of it. The buyers, after 30 years, would at least have…something.
oops, sold it Feb 2006 for 412K…lived in it for about 14 months, not 2!
After reading through this I have a question. Where did the author take into account that, after 30 years, the owner has an asset that the renter does not… the house. His principal is not actually an expense, since he was paying himself. Where was the house asset included in the final conclusion of the rent vs buy story? Did I miss a step where that was accounted for?
Yes, that is accounted for in ‘opportunity cost’…which is the cost of having money tied up in a non-performing asset (a house)…and in the final ‘net work’ estimates.
Houses on average over the last century appreciate 0.2% over inflation (see the Nobel Prize winning work on assets by Fama, Shiller, and Hansen). So the money in the asset after 30 years is generating essentially negligible gain for the owner, but the same money in stocks or bonds would generate income…but the owner gets low cost housing, that gets into a long discussion about ‘imputed rental’ return rate and such, which is a complicated set of estimates.
The problem for the renter is that the vast majority of renters are not sufficiently disciplined to be investing the equivalent ‘principal’ payments each month. For a disciplined financial person renting (or owning very modestly) is much better.
One of the points to consider too is IF you buy a house, how much house do you buy. If your house is an investment, you want to choose one with low fees (maintenance) – an index fund of houses perhaps. And IF you rent, be careful about how much you rent. Hip and new costs extra in rent or mortgage, just as much as in clothing, and you should pay attention to that cost/benefit ratio and make sure you are making a decision after running the numbers. (Not to say that you have to forgo granite counter tops, but that you should know what it is costing you.) It is just like a car – part utilitarian, and part lifestyle. DO NOT confuse the two, or your math will useless.
P/R comes to 16 for me. Rent increased at every lease renewal but that inflation was not seen in raises. I was looking at tapping into the money I put into savings to cover the rent increases eventually. Where the mortgage payment would be steady, acknowledging that taxes can increase. I was also looking for the emotional stability of settling down with a house. Between relationships and jobs feeling like I had one foot out the door, I now have a job I am very happy with, and plan to stay a while. I also asked my real estate agent about renting in the area, that if the job situation changed, I can rent this out.
My commute was another factor, rent (before water sewer etc) is $300-500 more expensive closer to work, but my tolerance for the commute from my previous apartment was getting much shorter.
I am happy with my choice for now. We shall see what the future holds. 🙂
Socks are optional in Hawaii. Just saying…
Thank you for sharing this detailed information. I agree, as some of the previous commenters have replied, that unless an investment is placing money in your pocket monthly, it is not truly an investment. What good does all of this money have when it is simply built-in to the home your purchased. Many people, especially millennials, love the idea of renting for a long period of time. This helps those in the rental property business as their true investments do make them money each month (or at least that’s the way it should be). For those that own investment properties, it is a good idea to employ a property management company to help manage all things rent related. This way those capitalizing on the benefits of rental home amenities and those leasing rental homes, and thus capitalizing on them as well, both win.
Great article Paula! Best line – “Wealthy people think for themselves. Mediocre people cave to social pressure and lazy cliches.” This is such a true statement in my experience. Unfortunately, I’ve found myself being influenced by those cliches and social pressures in the past, perhaps most of us have. Now though, I try to question everything and do the math myself to make sure I understand the situation and that I’m doing what is truly best for me.
Thanks for the article – very helpful as I try to wrap my head around the prospect of buying.
Question: I’ve read you can deduct mortgage interest from your taxes. That seems like a huge benefit, especially in the early years when a large amount of your monthly payment is amortized. Thoughts? Thanks, Tim
Hi Tim – glad you found the article helpful! Not sure if you’ve had a chance to look through the comments, but Paula addresses tax deductions in this one: http://affordanything.com/2015/11/24/is-renting-better-than-buying-should-i-rent-or-buy/#comment-242132 Hope that helps!
I can tell you this, my landlord’s expenses are about half my monthly rent payment. That is her property tax and hoa fees and maintenance costs are about $5000/yr and I pay $9600 per year. So I look at it like if this was my place and I had no mortgage, I would only save about $4600/year. That hardly seems like a reason to spend $130,000 to buy a house. I’ll wait until I’m over 50 and know that I’ll be living in the same place forever to buy a house with cash.
Hi
What I want to mention is that the theory is right only that to put in practice is different.
Indeed, if the cost of owning a house is 2000/month and the cost of rent is 1000/month you can save 1000/month.
The biggest question is what you are going to do with the 1000/month????
If you invest them, definitely you will do better in long run but, most of the people will spend them on unnecessary stuff or will save little.
Also, you have to learn how to save/invest money which is not really easy.
Bottom line, if you want to get financial independent soon you can do it in both ways…. rent and invest the savings in good return investments or buy a house, get a capital gain or rent a part of it to get extra money.
The biggest problem is that most of people are not prepared/educated for the complex financial issues of these days. They are afraid of investing or renting or dealing with the taxes…
If everybody will rent then who will buy the houses….
Thanks, Cris
Let me just say, I love you. That was the single most refreshing financial article I’ve ever, ever read. Smart, unbiased, direct, and did I mention well written? As an editor and writer I give you big points on readability and lack of errors too! Brilliant. I’ll be back for more.
Thanks.
Thank you for a great article! I’m rather new to the idea of investing in real estate, and even if you clearly state that this article isn’t about that I still learned a lot. 🙂
We bought a house a few years back, and we bought it with our hearts, not our heads. We ran some numbers but not that much. We still live cheaper than we would by renting. But… we bought a house in need of renovation. So I’ve recently come to realize that there’s probably no way that we will get the money “invested” in the house back if we sell it. Ok, the intention isn’t to sell, but to live here till we’re old and gray… but still.
On the subject of buying a home to live in, most people talk about it as an investment. And sure to most people it will probably look like their house is a great investment when they sell it. They get more money than they bought for. But, just like you say, they don’t see to the inflation during the time they owned the house.
I recently read a book where they referred to houses you live in as a (loosely translated) “tearing asset”. They explained that those kinds of assets, in fact, act like a debt. I thought it was a rather good explanation of how a house you live in can feel.
It’s painful to read some of the comments complaining about how in their specific situation buying is better, I wonder if those people even read the article or are really that dense or if, like another reader pointed out, it’s just human nature rationalizing a bad decision so they don’t feel bad. The whole point of the article is that depending on your specific situation it might be more advantageous to rent or buy so simply saying renting is throwing away money is wrong.
In my personal case I much rather rent for several reasons, I love the flexibility to move fast in case I get a better job offer somewhere else or simply feel like changing my surroundings and decide to live in a different place instead of being stuck in the same place for years or even decades, I love not having to deal with repairs, maintenance, taxes, fees, and other headaches. I simply pay my rent and don’t have to worry about any of that, and with the cash I have available for not having bought a house I can get a much better return by simply investing in the stock market, and stocks are orders of magnitude more liquid than a house, I can sell a stock in 5 seconds if I need money, how many months would it take to sell a house? No thank you.
On the contrary, I’d say the point of this article is to use made up numbers to try to convince people that renting is NOT throwing money away. The author is setting up skewed scenarios to make it look like the homeowner is throwing away just as much money as the renter. Look, anyone can throw money away if they make poor decisions, that’s not useful information. What is useful is learning strategies that result in long term growth in net worth.
The article makes the point that Owen pays a huge opportunity cost by investing $100k in his house rather that putting that money in the stock market. That is true, but what is not true is the assumption that he had to put $100k into the house in order to purchase it. You can get loans for 5%, 3%, or 0% down, allowing you to put that savings in a mutual fund where it belongs, just like the renter. You can buy a relatively new house that will have low maintenance. You can choose not to spend money on renovations, You can shop around for low cost insurance, you can shop around for low interest rates. My costs are vastly lower than Owen’s in every category.
Most importantly, you can buy multiple properties and rent them out to tenants so you get other people to pay your mortgages for you. That is the most frugal strategy in the long run.
Actually I think you are missing the point of the article…Paula is showing that renting can be a better decision or buying can be a better decision…and the tools with which to determine in a particular area or situation what might be wise. The PR ratio is a key factor in determining whether renting or buying would grow net worth faster.
You might disagree with Paula’s assumptions for Owner Owen or they’re different to your part of the world, but if you look at what the average home owner does in the US she is actually being quite down the average line verging on generous to Owner Owen. Remember, the average US home ownership duration is about 6-8 years (which is nuts if you ask me, owning needs 10+year frames to scoot nicely ahead!), half of all owners don’t get a mortgage interest deduction, she gave average insurance costs, average repair costs, etc. You’re saying you can get lower insurance and not renovate, sure, but that isn’t what the average homeowner does.
Same as Paula shows a renter can come out ahead investing, but the sad observation is that the average renter does not put the extra funds into investing. So the average renter does not make use of the advantages Paula presents.
So while rental does/will usually come out ahead, for most people because they are not disciplined, owning might be better even if not optimal due to the forced savings nature of owning.
All your examples illustrate is that a dumb homeowner is going to waste as much or more $ as a renter. Why did Owen put 20% down? Why did he pay $10k in closing costs? Why is he paying 5% interest? Why is he spending $4,500 on maintenance every year? These are crazy costs.
Most people are poor because of these reasons.
1. They are “owning” house with mortgage.
2. They are “owning” car or two with another loan.
3. They live paycheck to paycheck having no savings.
4. They go for kids hoping kids are healthy and knowing they are already in debt. Yes, government child support, but is it enough for food, and everything for kids??
5. They live in a relationship. Your girl will always want to laid on your shoulders… so you pay mortgage and he providing $eX.
You want to be rich? Do the opposite.
1. Rent studio apartment.
2. Live alone.
3. Don’t have kiddos or pettos you can’t afford.
4. Say no to car, say yes to bicycle or public transportation.
5. Live poor and save more.
6. Stop shopping to impress.
Because this is the life you need to. And it costs far less than thousands of dollars month.
I think it really depends on the circumstances. The problem is, jobs are not paying as much as they used to. Affording a home is a luxury — the key word being affording. Most people cannot afford the home they live in. If it eats up more than 1/3rd of your monthly income in mortgage you are a fool to consider buying it. However, the same goes for renters as well. In LA County the cost to rent a 1 bedroom hovers around $1500-1800 per month (this is not in the best of areas). Is getting a condo a smart idea? Probably not- that is $2,600 a month on average, and house could easily run into $4000 per month. In the city I live in within LA County, only 40% of people own a home. Most of the young couples I know have left the state due to the cost of living. Other people are struggling to pay $650 to rent rooms out in various parts of the city. Ownership is not feasible for any of them. So to make it sound like it is the same cost? Nope. However I do wonder what will happen to them when they are older or unable to make a rent-payment because they are already spending 60% of their income on rent. How will they survive after retirement? Not all places have HOA fees (this article kind of exaggerates that). The only people who will probably do ok are those who inherited property from the lucky ones who bought it before the housing bubble.
This article doesn’t really take into effect the flat wages for the last 40+ years, inflation of cost of other goods and services, rising tax rates, etc.
If you are young you are basically screwed.. Be honest.
Rent now- its only 1500/ month for a one bedroom next year it goes up $100, then another $100, then another $100. A decade from now you are $2500 for that little 1 bedroom and your wages only went up $300 a month. Yeah try that one..
Thank you for the pointing out renting is not waste of money, lot of people think renting is loosing money. Even the people who live in rent. This is one of most famous myth in these days. For who is one the doubt of renting or buying should read this. Cheers. Keep the good things coming.
Unfortunately, tenancies often come with additional expenses – your monthly/weekly rent isn’t the only thing you’ll have to pay. All small repairs to your rented property will have to come from your pocket. Additionally, your landlord can always keep a chunk of your deposit for things that are “beyond normal wear and tear”. However, those two are rather accidental expenses. Life happens.
The not accidental expenses include things like moving to a new flat/house which will eventually happen and in most cases happens a few times throughout your life, actually. Costs like tenancy cleaning, packing, purchasing additional furniture for your new flat, assembling and disassembly of furniture etc. The costs for all of these (and if you multiply it a few times) are huge, especially if you hire someone to help you out. The alternative is to do everything yourself if you have the time and energy to work 9-5 shifts, do house chores, take care of your family and pack your belongings at the same time.
Renting is often the only option you can take as the deposit required to buy a house is way out of most peoples budgets. Here in the UK and a great deal of Europe renting is becoming more and more the only viable option.
Thanks for providing such a detailed breakdown
Flawed article for most of Europe, in Portugal where I live for instance, I will pay my brand new house of 100000€ in 35 years with a rent of 350€, for the same house if I rented I wouldn’t find anything below 500€ unless it was an old house or in the worst neighborhood of this area. Renting here is throwing money away unless you are a guy who’s never too long in the same city/country, in that case it could make sense.
Paula P, I found this tremendously detailed and thoughtful analysis. I was a lifelong happy renter until I met the future Mrs. Smilap, who had just bought a monster house. I can see the case for both sides (i think that was the point). It got me to thinking what I would and wouldn’t miss if we went back to renting. I wouldn’t miss spending a small fortune for a replacement roof with asbestos abatement(30k) or all the other 1000 dollar little items that come with an 1860’s stone house.
What I would miss and different people would assign different values to this: the freedom to do what you want with the place. When we wanted our first dog we went and adopted a dog, no permission or deposit. When we want to alter a space, we alter it. When it’s time to take down a tree or plant one or smoke a cigarette in the dining room or spill paint in Mrs. Smidlap’s painting studio (marybegley.com), nobody cares except us. For me, I would assign a value of 1000 per month to these freedoms and life enhancers, but all of us are unique. Excellent article and I will be sharing with people I care about.
In all honesty you are a professional investor trying to compare a everyday person who will usually take this article and say see I should not buy a home and this is why. The truth is it is always better to buy for people who do not have time on there hands to do all this reaserch and strategically saving and investing there money correctly. You proved that someone with the correct knowledge and know how could make as much as someone who owns a house. Your not basing it of reality at all. Most people who own find themself in better postitions financially than renters. People who own or are paying off a home and if pass away leave family something behind for family members to keep or sell. The article was awsome but honest most people will not do that reaserch and investing and just lose out. So yea if your going to master mind your spending then it could be better in some very small cases to rent but overal most people go to work home and live life not doing all the effort your saying to do however easy it is or however hard. My thought would to tell people its not a myth because its better truth for the average american family. Your mortgage put money back in your pocket yes it does , you can earn equity of your home yes you can , this helps build your credit yes it does , you get extra tax right off yes you do , and you do all that doing nothing extra than someone renting lol. No extra reaserch no other investing no putting money away to try and invest somewhere else. Most of us are to busy to do all that but in one payment like rent but instead its mortgage you get all those benifits. Its like paying rent but with the bonuses. Like I said I like this article it has some good points of showing you how to rent and stay up with a owner but reality is most will not so it is always better to own for most.
Couple of thoughts – Pro Home ownership…
1 – The author assumes that rent and mortgage will be the same. If the renter chooses to live in the same neighborhood where the same individual would choose to buy… they are likely going to be paying more in rent, than they would in mortgage. So I think that math is flawed. Unless you’re renting from someone who’s owned the property for 10+ years, you’re unlikely to get a lower rent vs mortgage cost. Generally, rent is always higher than the mortgage. This is a big item that’s not being addressed.
2 – Location is also important. You can’t just buy a house anywhere and expect miracles, it’s all about location.
3 – Costs can be greatly offset if the individual learns how to do repairs him/herself. This can’t be understated.
#1: Rent is an expense. Mortgages build equity.
I have a problem with this quote:
“During the first year, roughly 83 cents of every dollar goes towards interest, taxes and insurance (ITI) in this example. You’re not building $1,448 in equity with each payment. You’re building $250 at best.” I don’t care about my expense, I care about my appreciation and equity and making smart investments, not buying a house in a suburb outside of detriot and penny pinching until my $50k asset is worth $51k 5 years later.
I’m fine with my payment being majority interest because a) it’s deductible and b) it allows my to use my tens of thousand of cash to leverage a hundreds of thousands of dollar asset–that hopefully appreciates. Yes, I’m taking a gamble, but the cost of the gamble is loow in my opinion. Multiple times in the past, I’ve added a bedroom to a house for $1,000 expense once, that then allowed me to rent that room for the past 5 years at $750-900/mo almost every month. It’s about buying the right asset, not ‘investing in real estate.’
#2: Rent is forever. Mortgages end.
I’m not reading every word of the article, but here’s a statement that I believe they are discrediting themselves:
“Flawed logic strikes again. This reasoning presupposes that your mortgage is your only payment. That’s plain wrong.” They just talked about how expense the interest is in the beginning (I’m still in the beginning of my loans, have only owned for 8 years on the oldest property. And then they list all the scary expenses, and here’s my best guess on what they average out to be with my houses each year. Remember, my houses rent on average, four rooms, so a fair argument for my strategy would be
Maintenance & Repairs $2k/year,
Renovations / Depreciation, these are optional, ignore them if you’re the type of penny pincher wanna be homeowner the author is. <3
Property taxes $1400/yr,
Homeowner’s insurance $1000/yr,
Utility bills n/a usually paid on top of rent, bad argument.
Municipal usage fees (water $30/mo, sewer $60/yr, trash included)
Homeowner association dues (if applicable) – n/a
Transaction fees, commissions and closing costs – one time costs, work it into your purchase price.
Opportunity costs -wtf is this?
(oops, wrote mine before looking at theirs, oh well)
However, I do strongly agree with this: [Quick tangent: Unfortunately, many investors don’t do their homework. They jump blindly into the waters, assuming “if the rent covers the mortgage, I’m cool.” Then they lose their shirt.] Don't lose your shirt Melissa.
#3: Renters don’t benefit from rising home values. Homeowners do.
I'll agree with this point, especially the ending sentence: "“Buy-and-pray” is not a wealth strategy." Take a risk or not, look at their numbers, or get more specific with your own numbers.
While I agree with the basic premise of this article, the author leaves out an even more compelling comparison: the experience of owning versus the experience of renting. Owners spend significant amounts of time searching for the “right” home, renters are far more flexible in their criteria and thus spend a far smaller amount of search time (hours or days, not weeks or months). This dramatic difference in time commitment occurs in every phase: moving in, occupancy, moving out. Owners end up having invested hundreds to thousands more uncompensated hours. No one calculates this into their return on investment for real estate. While the owner is spending his weekend fighting crowds at Home Depot, the renter is on a bicycle ride (with fellow renters) or relaxing at the park. On and on. I have owned and I have rented. The lifestyle of the renter is far better.
All this talk of mortgages. You will probably own four houses. By time you are on your third, you will probably be a cash buyer. Most of what you read here applies only to your first home. Once you are a cash buyer, it is impossible to compare renting to buying.
This was an intriguing article and accolades for stressing the math over emotion. However, that being said this raised my hackles and my gut said WRONG!!! But why? Why do I feel that this is not right, after all the math is all here. So a couple observations:
– It doesn’t seem fair to rail against emotional arguments, admonish to “do the math” and then flippantly yet very entertainingly appeal to emotion. “Bullshit, Preposterous, Outlandish”… So I tried to ignore such decorations. But it is a little disingenuous to argue for rational discourse whilst at the same time partaking in the equivalent anti-cliches as to which you rail against.
– Most of the factual arguments are fine. However I sense a teensy bit of cherry-picking. For example, why do you use a much more marginal (for buy) P/R of 15.5 if you state (and https://www.zillow.com/research/data/ confirms), a very solid “buy” P/R of 11.95 or 11.27 is normal? Sure you are allowed, on your own blog, to cherry pick any hypothetical snowflakien example, but you must know that your scenario results will be read 100 times for every time someone notices that this is pretty unusual.
– If we corrected the example to a P/R of 11.27 (median/normal, as it has been very close to this from at least 2010-2018), then you have Rachel paying $3295 not $2500 for the equivalent house. Apples-to-apples.
– Who pays HOA fees? Not I. Not your landlord. If you do that let’s not count that into home ownership costs but put it into luxury indulgences (because it YOUR job to run the neighborhood CORRECTLY). So Owen, if he were wise, would not be paying $2500, but more like $2200 for the same house. To be fair, Rachel is also renting the “same” house, so it’s unlikely a savy investor would buy an investment property with a $300 HOA to rent to her for either.
– That’s now more than $1000.00 per month difference. With exponential growth, over 10 years, that’s a LOT. So it’s easy to tweak a couple numbers and change the debate a lot. Moreover I think the numbers I put up are much more average. So yes, every snowflake is different, but painting such an abnormal picture without clearly pointing that out seems a little fast-and-loose. And that’s about a 150-200K advantage to Owen for buying which is hardly insignificant.
– My own unscientific experience is that more like 0.5% not 1% is usual for maintenance. Less even on your primary residence if you can do anything at all yourself. Yes you can make very bad equity decisions (pool, granite kitchen) as a homeowner. Good news, renters don’t get to choose.
– “Hope is not a plan”. Totally agree. But pretending that you can’t tell that 2009 was a time to buy and 2006 wasn’t isn’t is not true. You shouldn’t micro-mange any investment, but “out of control” it isn’t. You can definitely decide when is good and bad for buyers and sellers, especially since the real-estate market moves fairly slowly. Months not minutes. Manage don’t day-trade.
– I think it is another article, but I don’t think there is a black/white line between renting and buying. For example, do you have your own well or use city water? HOA vs. not? As you move from very rural 100% ownership with very low taxes, no services to an urban condo with HOA, maintenance, high tax burden with supposedly high services, there is a big continuum. At the extreme, there is almost no difference between “owning” a condo and renting an apartment in my eyes. But there is a big difference between an apartment and when you own and maintain your own roads, wells, septic, house, acreage, etc. I have my own brush fire pump truck and road grader, for example. And guess what? Given the “efficiency” of government, I do all that for a LOT cheaper than rent and high taxes of that “turn-key” urban environment. I do not have to be all things to all people. I just handle what I need for me.
– And I rent to suckers in that urban environment for bookoo profit. But NO HOAs or PMI or high P/R. 😉
– High P/R is a bubble. It isn’t good for anyone and signals something is really wrong. But it does favor renters because they are temporary and can jump ship quickly. But who wants to live there? Can you do a study on Rent or Own vs. Salary in those places? High salary but Ultra-Ultra-High costs. Yeah it isn’t good. I think it basically says you would be better off in Djibouti.
– You are saying “Buying isn’t that much better/worse because Owen is near Rachel after ten years”. But you are deliberately aren’t saying Owen lives in LA, but Rachel lives in New York/DC/San Jose and is therefore woefully underpaid per sq. ft rent OR buy. And that is millions or 10s of millions by the time they retire. There are much more important other factors. And Owen drives a 1987 Toyota vs. Rachel’s leased Tesla…
My conclusion: Nice article. Made me think. I don’t agree. I think the facts you provided say that for the “Average” (median) homebuyer, renting could be better, but is mostly (median) worse. Yes do the math. And if you are smart, active, independent and motivated renting is much worse because you are ACTIVE and will manage your investment, not pay property manager and landlord to do it for you and keep the profit.
I am doing the P/R calculation and you said to include the total acquisition costs which includes purchase price amongst other things. I am still learning about the cost of purchasing a home but there is the list price for the home plus the closing costs but ultimately if I have a mortgage then there is also interest. Does the “purchase price” in the calculation exclude or include the interest you will end up paying. Just trying to do the appropriate evaluation. Thanks.
It’s interesting to see your opinion on the rent vs. buy debate. I like how you said that renting is actually smart, if you don’t want to tie up cash in a home. I think my wife and I will be happy renting a townhouse, or something.
You used Dow Jones as an example of how it has grown. But did not adjust it for inflation. I have heard the DJIA gain, once adjusted, is 2.3% for the last 100 years
Some good arguments here but you miss a VERY important point: 100% of your mortgage interest and real estate taxes (up to a certain amount) are tax-deductible. For many homeowners, that deduction is enough to drop them to a much lower tax bracket which reduces their tax liability considerably. Yes, they’re ‘throwing money away’ on the front end but when you crunch the numbers on taxes and itemize all your deductions as a homeowner, your monthly taxes due can be low enough to offset your monthly payment — by several hundred dollars. Renters can’t do this and if they are investing in stocks, they might not get a solid return for years. When they do get a return, everything has to be reported as income which can push them into a higher tax bracket with NO deductions available, except maybe standard deductions. Crunch those numbers and the payout isn’t as high as you would hope.
It really is a case by case situation but there’s still some truth in the fact that renting is throwing money away. You’re not investing in anything and that money isn’t being put to work.