Myth: Rent is a waste (revisited)

The Word on the Street

I still struggle to convince people that paying rent is not a purely wasteful practice. I have already done posts on this topic.

The Truth

Paying rent can be cheaper than getting a mortgage, and the difference in the cost can be invested to your ultimate gain. While I support the idea that most people would benefit from buying a home, I want to emphasize that no one should rush to buy simply because they don’t want to “waste” their money paying rent.

A Quick Distinction

First off, I want to make a quick point of clarification. Renting an apartment can be much cheaper than taking out a mortgage, but renting a full house may or may not be cheaper. Personally, I think renting a home is not a very good decision, and should only be approached under special circumstances or at necessity. Because of the square footage you are renting, the cost to you to rent a home cannot be much less than paying a mortgage, so if you are going to be paying that much, you may as well get some equity out of it.

That said, if your rent is less than what you would pay for a mortgage, then renting is a viable option that ought to be considered.

A Waste?

So, is paying rent a waste? People often ask, “I paid all this rent, and what did I get out of it? Nothing!” But is that really true? Do renters truly get nothing from their rent payments? To answer, let’s look at a similar situation.

Suppose your family pays $200/month for groceries. At the end of the grocery run, is your net worth increased? Nope. Your net worth has decreased because you now have less money in your checking account. So buying groceries is a waste, right? Please say no. For your money, you got food, and food is necessary to life, so you could argue that buying groceries is a fantastic investment ($200 invested and you get back a month of life for your family, how can you measure THAT return?)

So it is with rent. You may not be getting any DOLLARS back, but the need for shelter is as vital as the need for food. So, for your rent, you are purchasing shelter. So it’s not a complete waste, just as buying groceries is not a complete waste. It is simply a necessary purchase.

A New Perspective

In a very real way, you can think of your mortgage payment as consisting of two parts: one part covers the cost of providing shelter, the second part is an investment in real estate. The interest that you pay every month is exactly like paying rent, with only one significant difference (to be discussed later). The principal portion of your payment is exactly like depositing money into an investment, again with only one significant difference (also discussed later). So, if your interest is just like rent, and your principal is just like an investment, then why not pay rent and make an investment? In the end, the result would be very close to the same.

Examine the chart below for an illustration of what I mean:

Mortgage VS Investment

Notice the amount of interest paid versus the amount of rent paid. In the earler months of the mortgage, the interest is higher, leaving less to invest. But, over time, the interest expense decreases, thus freeing up more of your money to be invested in your home as equity. This is the fundamental difference between rent expense and interest expense. notice that it takes almost 7 years (83 months) for the interest expense to become less than the rent expense. So, for 7 years, you are “wasting” more money on interest than you would have on rent. After that point, the situation reverses. This is one reason why it is so important to keep a mortgage long-term; you need the late years to make up for the high expense of the early years.

So, if a portion of your mortgage is going towards an investment, what investment is it? It is your home. You are putting money into your home as equity. Simply put, you are investing in real estate.

Real Estate As An Investment

Have the historical returns on Real Estate Investment measured up to the confidence it has received?

The answer is a cautious yes. Between 1926 and 1996, the annual average rate of return on Real Estate was 11.1%. During the same period the rate of inflation was around 3%. So, it was obviously a better investment to buy Real Estate than to bury cash in jars in your backyard. However, the rate of return for small stocks checked in a bit higher at around 12% while the Dow Jones Industrial Average was a bit lower at 10%. These figures would suggest that Real Estate investments were right there at a par with Stock Market Investments.

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So, you can see that real estate investments enjoy similar returns to the stock market, so either investment would be a good choice. However, there are some differences between them. Perhaps most important is that real estate investments are not as easily converted into cash; this convertability is calledliquidity. If you have a large store of home equity, the only ways to access that is to sell the house or to take out a home equity loan (which would cost interest and thus reduce your net gain on the home). On the other hand, stocks (and bonds for that matter) are generally quite easy to convert into cash. The downside with stocks is that they experience a much higher degree of volatility in the short term. So they may be temporarily low in value when you have to cash them in. Both investments carry risk. The type risk each carries varies. Both investment types carry expenses. Again, the type and magnitude of these expenses can vary.

The important point to carry away is that both renting and home ownership present the opportunity to provide shelter, and that they both have room in them for you to save your investment in some kind of investment vehicle. Bear in mind also that the rent vs buy decision is not a decision that you make only once. At some point, renting may be better for you, but that may change next year or the year after. The key factor in the rent or buy decision is your time frame. If you are going to live in a place short-term, then renting is likely the better choice. If you are settling in for many years of living, then home ownership is likely the better choice.

Posted on 19 Dec 2008