In Part 1 and Part 2 of this article series we looked at some of the financial and non-financial considerations for buying versus renting a home. In this Part 3, we wanted to explore the generally stated concept that renters are worse off than homeowners. Is this automatically the case?
To begin, let’s make a few assumptions:
- We have two individuals, one who wishes to buy, while the other wishes to rent
- Both have the same financial resources and can afford either option
- The renter will rent an identical home in the same location as the buyer
- Both have current cash savings of $125,000.00
- Taxes and inflation are ignored
Note the numbers below are sometimes rounded for easier reading.
As discussed in Part 2, homeowners have several costs that need to be paid upfront.
Let’s assume she wishes to purchase a home costing $1,000,000, with a 5% deposit ($50,000) for the mortgage loan. In addition to the deposit, she will need to pay transfer taxes (estimated $47,500), legal fees (estimated $5,000) and appraisal fees (estimated $5,000). In summary, total upfront costs of $107,500.
After paying these costs, her bank account will fall from $125,000 to $17,500.
The renter will not have any major upfront costs, but we’ll assume he makes a security deposit of $6,700, which is returned when he stops renting.
After making the deposit, his bank account will fall from $125,000 to $118,300.
Her major ongoing payment will of course be the mortgage payment. Let’s assume these terms and conditions:
- Mortgage loan = $950,000 ($1,000,000 less $50,000 deposit)
- Interest rate = 7%
- Loan term = 25 years
She will therefore have a monthly mortgage of $6,700.00 or $80,500 annually.
In addition, let’s estimate she will have the following annual expenses:
- Property taxes ($5,000)
- Property insurance ($10,000)
- Maintenance and repairs (estimated at 1.25% of the property value = $12,500)
In total, she will have annual expenses of $108,000. We are assuming she already has life insurance and does not require additional coverage for the mortgage loan.
It’s a little trickier to estimate monthly and annual rent, as it would be determined by the supply of properties, as well as location.
The objective of most landlords would likely be for rental income to pay for their mortgage, but circumstances would dictate if this a reasonable expectation. For example, if the target rental market is individuals who need short-term leases and are willing to pay a premium for it (longer-term leases should be comparatively cheaper), then depending on demand, rental income could cover the mortgage payments.
Ignoring demand and supply factors, it is a more valid expectation that rental income should be less than the mortgage payment because the landlord’s total return on the rental property is both rent and price appreciation. Under normal circumstances, if the renter is effectively paying the landlord’s mortgage, then they should stop renting and enter into a mortgage themselves.
Let’s assume monthly rent of $5,800 or annual rent of $70,000 (a 7% rent yield – see Part 2 for an explanation).
We have left out the cost of utilities from both the homeowner’s and renter’s costs; therefore, we are assuming annual rent of $70,000 is the renter’s only cost.
Based on these amounts, he is spending ($108,000 – $70,000 =) $38,000 less than the homeowner. But for the purposes of a proper comparison, we must assume that each person is putting out the same level of cash each year. So we have to assume he invests this surplus every year.
25 Years later
Remember, she has a starting bank account of $17,500 and pays annual expenses of $108,000. At the end of 25 years, she owns a property, which should have appreciated in value. If we assume 5% appreciation per year, in 25 years it will be worth $3,390,000.
Assuming she sells her property and pays agent’s commissions of 3% of the selling price (which amounts to $102,000), her net cash position at the end of 25 years would be approximately $600,000.
Remember, he has a starting bank account of $118,000, pays annual expenses of $70,000 and invests $38,000 each year. At the end of 25 years, his investment portfolio would be worth $2,220,000, assuming a 5% annual return (same as the homeowner’s house price appreciation).
Assuming a negligible cost to liquidate the portfolio, his net cash position at the end of 25 years would be approximately $592,000.
This is only marginally different from the homeowner’s ending position.
What the example indicates is that neither approach is necessarily an incorrect one because depending on the circumstances, the owner’s and renter’s future net worth could be very similar.
Of course, the assumptions used in this example could be challenged, for example:
- House price appreciation can differ from the appreciation in financial investments – our example assumed both were 5%
- Property is not a liquid asset, so there is no guarantee of a quick sale or even if it would sell at the appraised value. As we noted in Part 2, the price could also fall
- Making a house saleable usually requires some level of renovation to update it to current trends; we have ignored this cost in our example
- Future taxation policy could substantially change the result for either party
- Demand and supply for housing in particular areas could significantly alter both house and rent prices
- Our example did not factor in changes in interest rates for the mortgage loan or rental rate increases – our implicit assumption is they change at similar levels, but this may not necessarily be the case
- Individuals may not invest the surplus in a disciplined fashion
Ultimately, as we said in Part 1 of this article series, the “right” answer would vary by personal preference and a mix of financial and and emotional arguments. But it should now be clearer that renting is not necessarily the automatic worse option.
We hope you enjoyed reading the series, and we’d love to hear from you in comments below if you have questions or comments to share!