To Rent Or To Buy
Welcome to Saving Money with Andrew!
Just under two years ago, I received this thoughtful email from a family friend I hadn’t spoken to since the George W. Bush administration:
The email might have been ridiculous, but the sentiment was understandable. Take a look at home prices (adjusted for inflation), starting from the years in which the Baby Boomers bought their first home.
If anything, the chart above understates how great an investment a home has been over the past 45 years, because in addition to being an asset that (on average) has more than quintupled in value in that period, a home is something you can live in.
And yet…“You’re throwing your money away on rent”, something most people have heard from a well-meaning relative, is neither true nor particularly helpful advice. In fact, deciding whether it’s a better decision to continue renting (as we’ve done for over a decade) or to buy a home (as we did last week) requires weighing some key factors. I like to divide them into two groups - the soft factors and the hard numbers.
The Soft Factors
Availability
This is an easy one. In some places, particularly rural areas and some suburbs, rental inventory is very scarce, especially if you want to live in a house rather than an apartment. In other areas, particularly high-cost cities, there is far more inventory available for rent. In either of these situations, your choice is likely a fairly easy one.
Flexibility
Some people, such as those with children nearing school age, want to put down long-term roots, have a place to call their own, and not think about lease renewals every year. Others, such as recent graduates and singles, often prefer the flexibility of being able to move on relatively short notice. Simply buying or selling a home has significant one-time costs, both money (in our case as buyers, about 3% of the purchase price, not counting our broker’s commission which is shared with the selling broker) and time (I easily spent 250 hours on the home search and related work through closing). If you aren’t highly confident that you will stay in your home for several years, it is hard to justify expending these resources to buy a home.
Homeownership as a Life Goal
Many people view homeownership as a milestone in life—a sign of reaching true adulthood and a major achievement to be proud of. This is a legitimate feeling, but should be weighed alongside the other factors.
Cultural Concerns
In many families, there is an expectation that young adults will buy a house. In some cases, there is an expectation that adults will buy a house before taking other steps of adulthood, such as marrying and having kids.
I find this expectation deeply unfair. Housing is far more expensive, adjusted for inflation, than it was decades ago (just look at the chart). As a result, this norm implicitly forces younger generations to defer other life steps, and often to make suboptimal personal and financial decisions, to buy when they otherwise wouldn’t. But family expectations are strong, and can be hard (or impossible) to overcome.
The Hard Numbers
Relatively few people approach the decision of whether to rent or buy on a purely quantitative basis. But ultimately housing is almost everyone’s largest single expense (almost 50% in our case!) and to approach it without some objective analysis would be a mistake if you care about your personal finances.
An extremely useful exercise is simply to weigh the annual cost of renting versus the annual cost of ownership for a comparable home. Take your annual rental expenses (as well as any related expenses like renter’s insurance or a broker’s fee), and then compare it to the annual cost of owning a home. Some items to include:
Annual mortgage interest (do not include principal, as it reflects paying down debt) and mortgage insurance premiums, net of any tax savings.[1]
Property taxes
Homeowner’s insurance
Annual maintenance (as opposed to improvements that increase the value of the house). Make sure to include things like landscaping, pest control, replacing appliances, and the like.
Transaction costs for buying and selling your home, divided by the number of years you expect to live in it. For instance, if you spent $15,000 on closing costs buying your home, expect to live in it for 8 years, and then spent $25,000 in closing costs and broker’s fees to sell it, add $5,000 ($40,000 divided by 8) to your annual cost.
The NYT has a fantastic rent vs. buy calculator which is extremely useful in doing the math, and includes several other key factors to consider that are beyond the scope of this post.[2]
One thing you’ll notice, especially if you’ve lived in different cities, is that the math often skews heavily in favor of renting or buying, depending on the metro area. One useful metric is the “price to rent” ratio, which compares the average home price in the area to the average annual rent.
In areas in which this ratio is very high (particularly California, New York City and Seattle) the math often, though not always, favors renting. In areas where it’s quite low (such as Milwaukee, Memphis, and Detroit) the math often favors owning. Most of the country is in the middle and it will depend very much on your individual situation. There are many factors that cause these ratios to vary so much, but one reason is often the attractiveness of the city to foreign buyers, whose demand can often significantly affect (some might say “distort”) the real estate market.
For my family, our desire for flexibility, along with extremely skewed price to rent ratios for the cities in which we’ve lived, led us to be longtime renters. That changed last week, when we finally closed on our first home in the suburbs, away from the city in which we’d lived the past decade.
And now…Andrew’s pick of the week:
I’m a big fan of Janet Yellen, our incoming Secretary of the Treasury. She’s brilliant and just hit the trifecta of heading the Council of Economic Advisers (under Clinton), the Federal Reserve (under Obama), and now the Treasury. I love her inauguration fashion sense, and now she has a Hamilton-style rap track telling her story. Enjoy!
I hope this has been helpful. If you liked it, please share it on social media! Also, please send me your feedback, requests, and success stories. I’d love to hear about how you’ve thought about renting vs. buying in the past.
[1] Note that because of tax changes made during the Trump administration, most households now take the standard deduction and so a mortgage interest deduction is of limited value. Even if you itemize, your cumulative mortgage interest and property tax deduction may not be much more than what your standard deduction would be if you didn’t own a home.