Renting vs. Owning: Which is Better?
My wife and I recently became homeowners and we’ve been seeing SO many things that we want to fix or change. We need to buy curtains, a lawnmower, paint, lamps… the list goes on and on. And it’s costing a lot of money.
But even so, we figure that it’ll be cheaper for us to own our home in the long run when compared to renting. This makes intuitive sense because if you’re renting, you’re really just paying someone else to take care of the costs of your living space and paying a premium on top of that. Turns out it’s not as clear cut as that.
Home Values
You’ll often hear that your home is an investment. Many people will cite the fact that home prices have soared over the past few decades. If we look at the median price of new homes from the US Census Bureau, a home in 1973 only cost $32,500 while a home in 2010 cost $221,800. That’s an increase of over 580%! Annualized, that comes out to be just over 5.3%.
But those numbers don’t tell the whole story. For one, the numbers don’t include adjustments for inflation. During that same time period, the US experienced unusually high inflation. Although inflation over the past century has been around 3%, the period from 1973 to 2010 had an average annual inflation rate of 4.4%. Suddenly, our 5.3% annual increase in home value is cut down to a gain of just 0.9%.
Second, the numbers above are for new homes only. And the size of new homes has steadily increased over the years. The median size of a new home in 1973 was just above 1,500 square feet. In 2010, new homes were pushing almost 2,200 square feet. Bigger homes are naturally going to cost more. After accounting for the larger home size and inflation, homes didn’t gain any value at all.
The Census Bureau doesn’t provide much data on existing homes but they do provide information on price per square foot on new homes starting in 1992. Using this information, we find that home values only increased 2.2% annually from 1992 to 2010. After factoring in inflation, home values lost 0.7%! So homes really aren’t a good investment vehicle.
Cost Comparison
So if you’re not making money on your home’s value, how is owning a home better than renting? Your exact costs will depend heavily on the real estate market where you live but I’ll use the home and rental prices around me to see how much extra it costs to rent versus own.
Let’s look at a case study with our friend Tommy. She wants to see if it’s better for her to rent or own a 4 bedroom single family home. She knows she won’t live in the home forever. At the very least, she’ll move sometime in retirement. Tommy will have to pay utilities regardless of whether she rents or owns so we don’t need to look at those costs.
The only cost to Tommy if she rents would be her monthly rent payment. In my area, a typical 4 bedroom home rents for about $1,700 per month. With this option, Tommy can simply move when her lease is up after making her last payment.
When we look at the costs for Tommy to own, things get a little more complicated. One major cost to owning that Tommy wouldn’t have with renting is closing costs. When she buys a home, she’ll have closing costs for different services related to the home buying process. Those typically come to 3% of the sale price. Tommy could purchase a 4 bedroom home for about $250,000. That means she’ll pay about $7,500 in closing costs. We also need to plan for when Tommy eventually sells the house. Her house will appreciate a little so she’ll likely sell for higher than she paid but she’ll also have to pay closing costs again to realize any of those gains. When selling, she’ll have to pay the commission for her realtor (3%) and the buyer’s realtor (3%), and transaction/processing fees (3%). All those fees come to tens of thousands of dollars that Tommy will need to account for.
After the closing costs, let’s look at what would go into her monthly expenses. The most obvious is her mortgage. Her loan, and her monthly payment, would depend on the amount she puts for her down payment. Let’s say she puts down $10,000 and gets a 30 year fixed rate loan at 4.25%. This puts her monthly mortgage payments at $1,180.66. Since Tommy doesn’t have 20% of the purchase price for a down payment, she would have to purchase private mortgage insurance (PMI) which is an additional 1% of the loan amount annually, or $200 per month. She’ll have to pay PMI until she has 20% of the home’s initial purchase price in equity.
On top of her mortgage, she would have a few other items to take care of as a home owner that she wouldn’t need to worry about while renting. First she’ll need to pay annual property taxes. She’ll also have to take care of her own repairs and maintenance. Taxes and repairs/maintenance would each run about 1% of the value of the home annually. Finally, her mortgage lender will require her to get home owner’s insurance which costs about 0.35% of the purchase price.
If we consider all of the above, Tommy’s monthly cost to own would be $1,870 per month.
Wait, isn’t it supposed to be cheaper to own than rent?! Renting that same home only costs $1,700 per month. Why shouldn’t Tommy just rent?
At first glance, it seems like a no-brainer to rent instead of own. After all, Tommy wouldn’t have to pay any of the closing costs and her monthly payments would be $170 less.
But one of the major advantages with owning is the fact that Tommy’s monthly mortgage payment wouldn’t change. Her insurance, tax, and repair costs will keep up with inflation but the payment she makes to the bank stays constant. On the other hand, if Tommy were to rent, her monthly rent would increase with inflation every year. After 4 years, the total monthly payment for both options is about $1,900. In 30 years, her rent payments would be over $4,000 per month while her mortgage, maintenance, and insurance would be just under $2,400.
She’s also putting equity into her house while it’s appreciating. After 30 years, her $250,000 home would be worth about $480,000. After taking out her closing costs, she would profit $240,000. It doesn’t quite cover the costs she’s paid over the years for tax, maintenance, insurance, and interest but over the long term, it’s much cheaper to own than rent. After 30 years, Tommy’s total cost to own is about $293,000 while her total rental payments over that same period would be over $970,000.
As you can see, if Tommy were to only stay in her house for 1 year, the closing costs and higher initial payments would result in higher overall costs when owning so she would be better off renting. But if Tommy is going to stay for 2.5 years or longer, it ends up being cheaper to own since her mortgage is protected against inflation and the equity in her home helps to offset the costs.
Opportunity Costs and Investing
One final thing we need to consider is the opportunity costs related to owning or renting. For example, if Tommy decides to rent, she can invest the initial $17,500 she would have spent on closing costs and her down payment. Over a 30 year period, if she gets the market average 9% annual return, her $17,500 turns into over $230,000! On top of that, during the period when her rent payments would be lower than her owning costs, she could take that difference and invest it as well.
But the opportunity costs go both ways. Recall that while Tommy’s initial rent payment would be lower, after 4 years, her housing costs would be lower. At that point, if Tommy was owning, she could take the payments that would have gone to rent and invested them. There are opportunity costs on the front end when buying a home. But later on, your higher inflation-adjusted rent payment carries the opportunity costs.
The graph below shows what Tommy’s net worth would be in both scenarios, taking into account the investment returns and subtracting the cumulative costs we previously looked at.
If we take opportunity costs into account, we find that it’s not better for Tommy to own until she plans to stay in the house for at least 4 years. After 5 years, it’s much better to own as the lower monthly payments and equity of the house help her build her investment portfolio.
Rent or Own?
As you can see, from a financial perspective, the decision to rent or own isn’t as simple as it first seems. In general, over longer periods it’s better to own than to rent. If you plan on staying in a single place for the 5 years or more, it’s better to finance a home. If you enjoy living in new places every couple of years, then it’s best to continue renting as you won’t have enough time to experience the financial benefits of home-ownership.
