Q&A: How could renting be better than buying?

Question

When I think about rent VS buying I often think back to those dental students in [Ohio]. They bought condos, lived in them for a few years and then sold them. In most cases they sold them for a lot more than they paid because some of them made improvements to the property. Even the ones that didn’t were able to sell them for about 5-10k more than they paid. Rent would have to pretty low to make it better than buying from limited perspective. Please show me where my thinking is wrong on that. I’m going to be in a position to make the choice between buying and renting quite soon. I always thought buying was the answer, but now I’m confused.

Answer

Before reading on, you may want to reread the post that illicited this comment. It may also be useful to consider all the cash flows.

Don’t Rush

First off, do not think that I am trying to convince people not to buy a home. That’s not my point at all. Buying a home is a great way to build your wealth, and over the long term will almost certainly be better than renting. The point I am shooting for here is that people should not RUSH into buying a home just because REALTORs are advertising that renting is a waste of money. Rushing into any decision is a great way to make the wrong one. If you buy a home without considering every cost associated with buying a home, then you may find yourself overextended.

Homeownership is a great financial decision. But, it also happens to be the single biggest financial decision you will ever make. The reason that my posts seems in favor of renting is because there is no end to the people who are willing to promote homeownership, regardless of the cost to you. I think that buying a home is the best decision for most people. But it must be done under the right circumstances and at the right time, with a careful eye for the terms of the loan. More on the terms of the loan in a later post.

The problem with most people’s financial decision making process is that they limit their perspective. If you only look at the gain at the time of sale of the home, and ignore all other expenses and gains, then you will make a poor financial decision.

Consider all the costs

So what are the extra costs that people do not usually think about? First, closing costs. Closing costs typically will cost the buyer 3-7% of the amount of the loan. Next, selling costs. Selling costs vary a lot, and sometimes do not even exist, but if they do exist, then they will cut into your gains when you sell the home. Finally you have expenses that you incur while owning the home. These include property taxes, cost of maintenance and repairs, homeowner association fees, mortgage insurance, property and liability insurance, etc. Most experts agree that these costs usually amount to about 40% of mortgage payment.

An example

A hard, numbers-oriented example. Suppose a dental student buys a $150,000 condo, and lives in it for 5 years. He pays 9% interest on his mortgage. His condo appreciates at a rate of 6% per year. His monthly payment is $1,200, so his property taxes, condo fees, insurance premiums, and other expenses total $480 (40% * $1,200) each month. He has no selling costs. So, after 5 years, what did he gain? His condo’s appreciated value is $200,000, so he has gained $50,000 in only 5 years! If you ignore the costs, then you think, “Wow, he just got $50,000. I’m never renting again!” But what did he pay? He has paid $67,000 in interest, $29,000 in monthly expenses, and $4,500 in closing costs. So his total cost of owning the condo is $100,500 for those 5 years. So, did he make $50,000? Nope. He LOST $50,000.

But wait, we’re not done. You think, “$50,000 lost? I’m never buying a home!” But that’s not true. What would you have lost if you had rented? Suppose the student could have rented a comparable apartment for $1,200/month. So what did he gain? Nothing. No income. What did he spend? $72,000 ($1,200/month * 60 months). So the renter LOST $72,000.

So the student should buy, right? Well, if you limit your perspective to just that, then yeah, he would want to buy the condo. But there is a problem with this analysis. The problem is that the condo buyer has spent $1,680 a month (mortgage payment plus other expenses), while the renter has only spent $1,200 a month. Making a financial decision based upon different expenses like that is like comparing a motorcycle to a car on the basis of horsepower. A motorcycle will have less horsepower but be faster, right? The difference is in the weight of the vehicle.

Same thing here. So, what if the renter also spent $1,680? $1,200 in rent, and $480 to be saved. Even if his saved money earns no interest, he would have $29,000 in the bank. So, the renter would have lost $75,000 in rent, and gained $29,000 in savings, so his total loss would be $44,000. So, in this case, the renter would be better off than the condo owner.

But that only applies to THIS EXACT SITUATION. What if the appreciation of the condo were higher? Then buying is the better decision. What if the renter can earn a good interest rate on his savings? Then the renter wins. What if the monthly expenses of ownership are lower than 40% ? Then the buyer might be better off. This is why finance is a 4-year degree. This is why they offer masters and PHds in finance. Every situation is different. Every situation needs to be carefully analyzed. And it can get very complex, very quickly.

The Nutshell

You probably should buy if:

  • Real estate prices are appreciating at a high rate.
  • You can afford to pay more than the mortgage payment on the house (40% more).
  • You plan to be in the home at least 5 years.

You should probably rent if:

  • The mortgage payment is barely affordable.
  • You have the opportunity to save your money at a decent interest rate.
  • Local real estate prices have historically risen slowly.

If your situation falls somewhere in between these two categories, then a more thorough analysis is needed to give an accurate decision. If you can do this yourself, then great. If you can’t, you could find someone trained in finance to help, or you could just eyeball it. Just remember to include all of the relevant benefits and costs and you should come out fairly close. Remember that 5 years is a typical time frame for buying to be profitable. If you don’t know anyone who can run the numbers, just let me know and I would be glad to help.

Lastly, remember a financial loss is sometimes worth the satisfaction of home ownership!

Posted on 9 Nov 2008