Should I Rent or Should I Buy?
I'm currently in the process of buying my first home and one of the key questions that I've had to ask myself in order to get here was whether it made more sense to keep renting or whether I should buy; I decided that for me, buying makes more sense. Many people believe that buying is always preferable to renting, but this is not always the case. There are a variety of factors to take into consideration when choosing whether to rent or buy. I will take you through the steps that you should consider along the way.
1. Start at the End
What I mean here is start by imagining yourself several decades in the future. You have made the decision to either rent or buy and you have stuck to it. You now continue living in your paid off house or you continue to rent. What happens next is critical. Many people believe that once their house is paid off that all expenses associated with owning the home stop. This is not true.
Even if you are living in a fully paid-off house, you will still incur costs that renters will never have to deal with. You will still pay for the cost of routine maintenance, somewhere around 1% - 2% of the property value per year, property taxes and homeowners insurance. If you own a condo, you will also pay condo fees. If these costs amount to more than the cost of renting, you should rent.
In situations like this, renting is always more cost effective because the cost of simply owning a property outright is more than the cost of renting. Now, this situation doesn't often happen, but if property values are extremely inflated and rents are relatively low in relation to property values, this situation can arise.
A Quick Example
Let's use a simple example to illustrate this point. Our two options are to buy a house for $200,000 or to rent the same house for $1,000 per month. Property taxes, maintenance and insurance come to $500 per month.
If you were to own the property outright and had paid off the loan, your monthly expenses would be $500 per month, compared to $1,000 per month to rent. Now, over a several decade period of time, rent will increase and inflation will discount the debt that you owe, but we will ignore this to keep things simple. In this case, owning the house has the potential to save you $500 per month over renting. Therefore you should proceed to step 2.
2. Determine Your Time Horizon
The next key determination that you should make is how long do you plan to own the property in question if you choose to buy. This is important because there is a significant cost associated with the actual transfer in ownership of a property. In order to buy or sell any home, you will likely need to factor in real estate agent fees, closing costs and other miscellaneous costs along the way. These costs vary based on the property and whether you are buying or selling, but will usually amount to at least several thousands of dollars. Some of these costs are paid by the sellers, while others are paid by the buyers; however, if you plan on buying and then quickly selling the same property, you will end up being responsible for the full gambit of costs over your period of ownership.
Let's move back to our example. You have decided that it's possible to purchase your property because it could save you $500 per month. Let's say that you have the cash to buy and don't need to take out a loan. We will now assume that the cost of buying or selling the home is $5,000.
Because you save $500 per month buying instead of renting, you would need to own the property for 20 months in order to break even. This is because if you were to buy and then sell, you would pay $10,000, $5,000 for each transaction. It would take 20 months to recoup this cost compared to renting. If you owned the property for fewer than 10 months, renting would save you $5,000 because you would not have paid the $10,000 in transaction costs if you were renting, but if you owned the property for 30 months, owning would save you $5,000 because of the accumulated 30 months of saving $500 minus the $10,000 transaction costs. Still following? Move on to step 3.
3. Calculate Accumulated Equity
This may sound confusing, but all I'm really saying is that you have to weigh the transaction costs of buying or selling, as well as the interest of a loan, against the gain in equity that you accrue while actually owning the property. One of the main financial reasons for buying rather than renting tends to be that over time, you can build up equity in your home. In order to simplify this idea, some people compare renting to paying someone else while buying a home as paying yourself by building equity as you pay down debt. This is based in truth, but the reality is much more complicated than this and can be explained through loan amortization.
Amortization is a principle that allows for fixed monthly payments, such as with a mortgage, where the portion of the payment allocated to principal increases over time. Basically, this means that when you first take out a home loan, your first few years of payments will be largely in the form of mortgage interest, but increasingly you will pay down the principal over time. Paying down the principal reduces the debt, thereby increasing your equity in the property; interest is an expense.
At this point, the time horizon question becomes more complex. A house that would have taken 20 months to break even with a cash sale will take longer once a loan is factored in. Let's assume that our loan on the $200,000 house carried a 5% interest rate and that the loan is for a 30 year period. How long would it take for the $500 potential monthly savings to allow you to break even?
Once you factor in the costs of the loan itself, it would actually take 11.7 years to break even between renting and buying (assuming that you paid only the minimum on the loan each month). This was calculated by taking the $500 maximum savings per month, subtracting the interest payment, adding in the principal payment and subtracting the $10,000 transaction costs. Basically this formula compares the cost of rent to the inherent savings of owning a home minus the costs of purchasing a home.
4. Make a Decision
One you have calculated the financial pros and cons of buying vs. renting it is actually time to make your decision! Of course, major life decisions such as this should not be based on money alone, but these tips should give you a solid place to start!