Elders preach home ownership as the best investment. Friends are buying homes, and explosive housing growth ignites a Fear of Missing Out (FOMO), especially for young buyers in Canada.
To add to these pressures, we are told that renting is throwing money away. But homeowners also throw money away.
Property tax, home maintenance, and mortgage interest are examples. Then there is the hidden cost of the money tied up in the house (home equity). We miss out on the opportunity to achieve higher returns in the stock market.
The question to answer is “what option results in throwing the least amount of money away?”
I’ll show that between 4% and 6% home value evaporates every year for homeowners. I made this calculator to provide a more detailed outline of home ownership costs.
Understanding the rent vs buy comparison will help you make this giant financial decision in a way that maximizes your long-term wealth.
Ownership: A Huge Decision
The average house price in my area (Ontario) is over $890,000. That’s over 12 years of after-tax income for someone making $100,000 per year. I find this to be a tad depressing.
I believe we should all think deeply and do our research before we dedicate over years of salary towards a purchase.
The Non-Recoverable Cost of Home Ownership
There are four costs of homeownership that you never get back. Three of these costs are easy to see, but one is a hidden, implicit cost.
Together, the annual cost of home ownership – money “thrown away” – is between 4% and 6% of the home value.
Let’s take a closer look at the four costs of home ownership.
1. Property Tax
2. Home Maintenance
You replace a roof, repave a driveway or replace a furnace every year. Maintenance costs often come as large lump sum expenses. These expenses average out to be roughly 1% of the home value per year.
So you can expect $5,000 in-home maintenance costs per year for a $500,000 home.
That means you also need a bigger emergency fund, which is money that you cannot use to invest. Instead, its value erodes to inflation until a large expense comes due. The large emergency fund has an opportunity cost, however, I won’t capture that in this post.
3. Cost of Debt (Mortgage Interest)
Mortgage interest, the cost of debt, is another unrecoverable cost. Once the interest is paid you never get it back.
I quick look at RateHub.ca shows interest rates at 3%. So, I will assume
I’ll assume a 2% mortgage rate in our low-rate stimulated environment. You pay a 2% free to “rent out” the mortgage. Assuming a 20% down payment, you’ll have to loan out 80% of the home value, and you’ll pay a 2% fee on this amount.
4. Cost of Money Tied Up in Your House (Cost of Home Equity)
Money put down on a house is money that you can’t use to purchase assets with higher returns.
Global stocks have historically beat real estate appreciation over the past 122 years, returning 5.3% annually versus a 1.3% for residential real estate (source).
You miss the “opportunity” for higher returns by putting money into a house. I estimate the opportunity cost of equity at 4%.
Opportunity cost is a central concept in economics 101 and personal finance. It can help you form a strong mindset around all spending decisions.
All returns above are inflation-adjusted. You can access the global stock market at low cost with index funds. Canadians can use low-cost one-fund ETFs such as XEQT or VEQT. You can check out the globally diversified index fund portfolios for Canadians on Canadian Couch Potato or the Rational Reminder blogs.
Adding Them Up
Home maintenance and property tax add up to a 2% cost. Next, we have to take the weighted average of the 2% cost of mortgage debt and the 4% cost on the home equity amount. This brings the total unrecoverable cost of ownership between 4% and 6% of the home value.
This can be confusing, especially the split between home equity and mortgage interest. You can assume 3% for the combined cost of the mortgage and equity opportunity cost. This leaves you with the 5% rule of thumb. The example below should clear things up.
Or you can use the calculator to view the breakdown and achieve higher accuracy.
Rent vs Buy Calculator
The calculator performs the comparison more accurately:
- Fine-tune by entering mortgage rates, home equity, and property tax rates.
- Input house price and rental price for comparison.
A Rent vs Buy Example
Now that we have the four unrecoverable costs, lets crunch the numbers for an $890,000 home, the average home price in Ontario.
The 20% down payment of $178,000, leaves you with $712,000 in mortgage debt. The 2% mortgage interest on this amount costs you $14,240 per year.
While the $178,000 tied up in the house could have instead been used to gain a 5.3% inflation adjusted return in global stocks, instead of the 1.3% inflation adjusted return of real estate. You therefore incur an opportunity cost of 4% on your $178,000 or $7,120.
Annual Unrecoverable Cost
[% of home value]
Annual Unrecoverable Cost: $890,000 House
Monthly Unrecoverable Cost: $890,000 House
Cost of Tied Up Money (Equity)
Rent vs. Buy: Other Financial Considerations
Factors Favoring Home Ownership
- Capital gains income from the appreciation of your primary residence is tax-free.
- The RRSP home buyers’ plan allows first-time home-buyers to withdraw up to $35k tax-free from their RRSP to put down on a house. It must be paid back within 15 years.
- A higher allocation to bonds will reduce returns and decrease the opportunity cost of home equity. A large fraction of bonds in a portfolio will bring you closer to a 4% rule.
Factors Favouring Renting
- I didn’t factor in realtor fees, legal fees and land transfer tax. These costs can approach 5% of the home value when you sell. Renting avoids this cost.
- Frequent moves increase risk associated with house price volatility. Risk on housing is enhanced by mortgage leverage. The only thing worse than losing your own money is losing borrowed money.
- Crazy bidding wars make it stressful to buy. In these wars, you may not be able to get a house inspection. When you buy “as is” you risk buying a disaster.
Rent vs. Buy: Behavioral Considerations
Behavioral Factors Favoring Ownership
- A mortgage forces you to save by paying the mortgage. Renters must implement an alternate forced savings system to invest instead of splurging.
- Owners have more freedom to landscape, renovate and do interior design.
- Renters need a tough stomach to handle the short-term ups and downs of investing in equities (stocks).
- You won’t get evicted.
- Owning your home fulfills human need for security.
Behavioral Factors Favoring Renting
- You don’t need to deal with the costs, stress and time of home maintenance.
- You can have a smaller emergency fund.
- Shelter costs are easy to quantify, simplifying financial planning.
- You have more flexibility to move, offering a form of freedom.
- There exists cultural pressure (and a group of real estate agents) advocating ownership. This imposes a confirmation bias in favor of ownership.
- People often state their home is their best investment. That’s because a home is the only investment many people make.
- The opportunity cost of ownership is hidden and non-intuitive, imposing a bias towards ownership. It’s easy to ignore what you can’t see.
- Seeing home prices skyrocket elicits FOMO. It’s logical to expect future appreciation similar to the long-term historical average of 1.3%, after inflation.
Both renters and homeowners “throw money away”. The amount thrown away is just more difficult to measure for homeowners.
The question is “which option results in throwing the least amount of money away?” That option will maximize your long-term wealth.
It makes more financial sense to rent if the annual rent is less than 4%-6% of the house price. You can plug your specific data in to the rent vs buy calculator, or you can keep it simple and assume a 5% rule.
You are unique, and the best option for you will be unique. Perhaps owning your home is extremely important. Or maybe you move alot.
– Benjamin Felix, Associate Portfolio Manager PWL Capital Inc. “The Case for Renting”. https://www.pwlcapital.com/resources/the-case-for-renting/
– Credit Suisse (2021). Global Investment Returns Yearbook 2021. https://www.credit-suisse.com/about-us/en/reports-research/studies-publications.html