During lunch yesterday my son Sam, who is getting married soon, asked if it would better for the new couple to rent or buy their first home? He had given considerable thought to the subject in recent months. As a renter since college, he felt like he was throwing his money away; money that might instead be applied toward equity in a home comparable to or better than the one he and his new wife might rent – increasing their wealth rather than draining it.
After agreeing with and complimenting his reasoning, I shared a few additional issues to consider. One of the most significant, but difficult to quantify before experiencing it, is the amount of financial stress that home ownership can place on the new couple. The mortgage payment alone is more often that not, near the max of what their budget can support. Unexpected expenses can weigh heavily on the couples’ finances and emotions.
Another issue is flexibility. Renting affords the ability to adapt to circumstances that are not knowable in advance, but are more more likely for young couples to experience, such as job/city changes, entrepreneurial inspiration, twins, or say, triplets! Buying a home and having to sell it after only a short period of time can be brutal on a couple’s finances. There are the obvious expenses of ownership, such as mortgage closing costs, property taxes, maintenance, painting, roofs, air conditioners, and transaction costs that argue against owning for just a few years. There are also the less obvious costs that come along like normal maintenance or improvements that can easily divert income from more fun things like eating out, weekend getaways, and new clothes.
First time homes are generally ‘fixer-uppers.’ They are found primarily in transitional neighborhoods which are dependent on the local economy and demographics for market appreciation. They are restricted in floor space and yard and most often require a move when the kids come along. Invariably they are older and are susceptible to major maintenance surprises.
In my desire to give my son and you, our readers, the best unbiased advice we could on the subject, I enlisted the expertise of my CFP® and CPA colleagues, Geoff Hall and Jared Korver to develop an objective analysis of the question. Thanks also to mortgage expert Robin Pike for her significant contributions to this effort.
Meet the Smiths and the Joneses. Both couples are in their late 20’s and employed with combined incomes of $80,000 each. The Smiths decide to rent their 1,500 square foot home at $1,300 per month. The Joneses decide to take the plunge and buy a similar home next door for $225,000. As first-time home buyers they considered going with a special first-time mortgage that would afford them them a down payment of only 5%, but they quickly dismissed it when they learned about the high PMI (primary mortgage insurance) that would be required. In fact the PMI remained with the mortgage throughout its life, even after equity in the home exceeded 20% of the mortgage value. This proved to be a very expensive option.
Both couples had $22,500 in savings. Our renting couple would continue saving while our buying couple would use their savings to make a 10% down payment on their home. The 10% down payment, their income, and their credit scores of 690 would qualify them for a $205,500 mortgage with a monthly payment of $1,213, including principal, interest, taxes, and pmi. The payment amounted to 20% of their gross annual income, well within FHA guidelines.
To fairly consider both options we assumed that the Smiths, our renting couple, would save, not spend, the portion of their discretionary income that would otherwise go toward home maintenance costs and any mortgage expenses exceeding their rent payment, as well as their existing savings of $22,500. We further assumed the Smiths would at some point in the next three to five years buy a home to raise their children. They would wisely be unwilling to take any market risk that might jeopardize their savings in such a short savings window. We applied an interest rate of 1.5% on their savings.
The table above is the result of many variables discussed by our team and calculations carefully prepared by Jared. Our spreadsheet is available for download and use via a link provided later in this article. The cash flows numbered on the left represent years with the corresponding net cash flows for both the Joneses (buyers) and the Smiths (renters). The “difference” column shows that for the first roughly 3.5 years the Smiths are ahead of the Joneses. But if they Smiths don’t move sometime soon afterwards, they will begin falling behind the Joneses – assuming the Joneses don’t have a major, or a series of minor unplanned replacements of some kind (AC, roof, foundation, mold, termites, etc).
The general findings may not be surprising to you, but there are some subtle takeaways from the study worth mentioning. One is you might be quite surprised to find how sensitive the numbers are to real-life uncertainties. We’ve made our spreadsheet available online so you can change the variables to match your own situation and expectations. For instance – what if you wanted to rent for a longer period and invest the savings in the capital markets? If you averaged an 8% return, your break-even compared to home ownership occurs in year 9.
Another takeaway is the cost of housing – for both options. The Joneses pay interest, taxes, and maintenance, while the Smiths pay an increasing (by inflation) rental expense. If there is growth in net worth, it accrues in the home of the owners and in the savings or investment accounts of the renters. Leverage and tax breaks afforded to homeowners (earning return on the total home value while investing relatively little as a down-payment) gives the homeowner the advantage for a few years, but the vastly superior return of the capital markets eventually favors the renter/investor because of the persistence of considerably higher capital market returns compared to inflation, generally regarded as the rate at which homes appreciate. From a purely economic standpoint it is better to rent – own – rent over our lives. But we are not purely economic creatures – are we?
We hope the exercise has been helpful. Have a good weekend.
Buy vs. Rent Spreadsheet Note: Clicking this link will download a copy of our spreadsheet into a browser you can edit and save for later use. In order to edit, you will need to click “Enable for Editing” at the top of your browser.
Disclaimer: Any information provided in this spreadsheet has been prepared from sources believed to be reliable, but it is not guaranteed by Beacon Wealthcare and is not a complete summary or statement of all available data necessary for making an investment decision. Past performance does not guarantee future results. Information provided here is intended only to inform and does not constitute a recommendation to buy or sell. Unless expressly stated, Beacon Wealthcare does not accept orders and/or instructions regarding your account by e-mail. The opinions expressed here reflect the judgment of the author as of this date and are subject to change without notice.