Renting vs. Buying

Home-ownership is one of the pillars of the American Dream.  Being such, one would think that the home-ownership rate in America is high.  However, the United States is only ranked 41st in the world (1).  Good luck guessing which country is number one — the answer will come later.

Typically, home-ownership is associated with (whether correctly or not) a sense of pride, accomplishment, and self-worth.  In fact, the majority of houses purchased are based on these emotions rather than the actual financial numbers.  Contrary to popular belief, for some Americans renting may be financially a better decision than buying and there is nothing wrong with that.

We’ve all heard people say, in regards to renting, “You are throwing away your money.”  Usually it is taken to be a fact, a golden rule of financial decisions.  However, neither buying nor renting is inherently good or bad.  Whether to buy or rent depends on the surrounding circumstances.  Below are some benefits of buying, benefits of renting, and a break-even example between buying and renting.     

Purchasing a home with a mortgage can be a great tool to help build wealth.  A mortgage turns a portion of monthly housing costs into equity.  Over time, the value of your home should appreciate.  Both examples will increase your net worth.  Owning a home will also set your monthly housing payments on a fixed schedule that will not increase over time.  Some tax benefits can make owning a home more affordable also.  Under the right circumstances, owning a home will drastically increase your net worth.   

However, there is a reason people say, “Oh, the joys of home ownership.” Being your own landlord means you must cover all of the maintenance and repair expenses.  A good practice is to estimate about 1% of the home’s total value towards repairs and maintenance annually.  That is $2,000 annually for a $200,000 house.  Repair bills can add up, and having a sufficient emergency fund is crucial when those expenses pop up.  With renting, there is no need to worry– just call the landlord!

Renting, if appropriate, can create flexibility, have lower unexpected housing costs, and require less responsibility / risk.  Life happens, jobs change, desires change, dynamics change and having the flexibility to adapt is important.  By renting, it is much easier to pack up and move than having to sell a home.  Having flexibility is usually overlooked in life and should not be undervalued.  If you are planning on moving in four years or less, or would like the option to, renting may make more sense.  However, the downside of renting includes: no tax incentives, no monthly equity being built, and not having a fixed monthly payment (as prices can increase).  

Typically, the most important consideration in the buying vs renting decision is one’s time-frame.  If a home is sold within a few years, closing costs, maintenance, and realtor fees may actually create a loss.  Typically, the longer the time-frame, the better it is to buy.  As a general rule of thumb, owning a home usually make more sense for time-frames of 4+ years in the same location.  Living in a home for one, two, or three years can open the door for unnecessary financial risk and headache.  

Why one’s time-frame is so important is because the majority of monthly mortgage payments in the first few years go towards paying interest rather than principal.  An amortization schedule is the breakdown of a mortgage detailing how much money goes towards principal and interest each month.  For a $200,000 home with a $160,00 loan at 4.0%, only $2,817 goes towards principal out of the total $9,165 payment in the first year. 

Also, many websites and calculators will quote a monthly payment just of principal and interest payments.  Doing so is a great injustice as it ignores taxes, HOA fees, and insurance which could be as much as $300 extra per month (assuming a $200,000 home). When calculating how much house you can afford, make sure to include all the expenses and not just principal and interest.  

Below is a three year breakdown of expenses and increases in equity for a $200,000 home (20% down) with a $160,000 mortgage at 4.0%.  (Other assumptions: 7% selling/realtor fees, 1% maintenance/repairs annually, and the home appreciates 2% annually.)  

After three years, $21,041 of equity was built in the home ($8,800 via mortgage payments and $12,241 in appreciation.  When the house was sold, the closing fees and annual maintenance/ repairs totaled $20,976.  Meaning the homeowner was positive $65 and barely broke even.

The monthly payment for principal and interest, insurance, taxes, and HOA totaled $1,050.  Tack on an extra $170 monthly for maintenance and repairs for a total of $1,220 monthly.  In this example, renting for a similar price of $1,220 would have been a better financial decision, increasing flexibility and decreasing risk.  However, if the time-frame increased to seven years or fifteen years, the numbers change drastically as the homeowner would be positive $55,000 (seven years) and $113,000 (fifteen) instead of $65.  

Until there is more certainty over location, time-frame, or cash flow, renting can be a great option!  Many times buyers get caught up in the American dream of home-ownership when renting is the better decision for them.  However, when the time is right and a buyer’s time-frame is long enough, owning a home can be a powerful tool in creating financial independence.   

And lastly, I did not forget!  For those who stuck with this article just to get to the interesting fact of which country has the highest home-ownership rate… wait no further — as the answer is Romania with 96.4%.

Please contact me for more information or if you have questions,

Evan Werckenthien, CFP©

Evan@EWwealth.com

Work: 317-587-0858

Cell: 317-627-2529

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