Elders preach that ownership is the top investment. Friends are buying homes, and explosive housing growth ignites a Fear of Missing Out (FOMO) 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 on property tax, home maintenance, and mortgage interest. There’s also a hidden cost on the money tied up in the house – we miss out on the opportunity to achieve higher returns in global stocks.
I‘ll show that between 4% and 6% of the home value is thrown away per year. This calculator provides a more detailed outline of ownership costs that disappear for good.
We will conduct a rational rent vs buy comparison for this giant financial decision to best maximize long-term wealth.
Ownership: A Huge Decision
The cheapest houses I can find in my area are around $400,000. And when I click the ad, I realize there is no house – only a vacant lot. A bit depressing.
The average house price in my area is over $890,000. That’s over 10 years of after-tax income for someone making $100,000 per year. I need to think deeply before making a decision this large. And I think you should too.
The Non-Recoverable Cost of Home Ownership
There are four unrecoverable costs of homeownership. Three of the 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 home value.
Let’s take a closer look at the four costs.
1. Property Tax
2. Home Maintenance
You don’t buy a roof every year, repave a driveway or replace a furnace every year. Maintenance costs come as large expenses that average out to roughly 1% per year.
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. This comes at an additional opportunity cost that won’t be covered here.
3. Cost of Debt (Mortgage Interest)
Mortgage interest, the cost of debt, is another unrecoverable cost. Gone.
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
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 (C .
The 4% difference is an opportunity cost. You miss the “opportunity” for higher returns by putting money into a house. Opportunity cost is a central concept in economics 101, and it helps you form a wealthy mindset around all spending decisions.
These returns above are inflation-adjusted. Access to the global market is simple and cheap with low-cost index funds such as XEQT or VEQT. You can check out the globally diversified index fund portfolios 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.
If you fully own your home, the unrecoverable cost comes in at 6% of the home value per year. The total ownership cost would be 4% of the home value per year if the home is 100% mortgaged at a 2% rate.
If that confuses you, don’t worry. I was confused at first too. 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; and
- Input house price and rent 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. Ouch.
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% real return in global stocks, instead of the 1.3% real return of real estate. You therefore incur a 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
Other Financial Considerations
Factors Favoring Home Ownership
- Investment returns are taxed unless sheltered in a TFSA. On the contrary, income from the appreciation of your primary residence is tax-free.
- A higher allocation to bonds will reduce returns, and your opportunity cost of home equity will go down. This will bring you closer to a 4% rule.
Factors Favouring Renting
- I didn’t factor in realtor fees or land transfer tax. These costs tilt in favor of renting.
- 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.
Factors Favouring Ownership
- A mortgage forces you to save. When renting, you need the discipline to consistently invest your money rather than splurging. If your not investing, the opportunity cost of equity doesn’t come to fruition.
- It is nice to know you own the roof over your head.
- Landscaping and custom home design are fiesable when you own the home.
- You need a stomach to handle the ups and downs of investing. Renting only makes sense if you use the excess cash to invest.
- You won’t get evicted.
Factors Favouring Renting
- There is no stress in dealing with house maintenance.
- Flexibility to move is 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.
- 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.
Renting is throwing money away. Homeownership is also throwing money away, just more indirectly. The question is which option results in throwing the least amount of money away? That option will maximize long-term wealth.
It makes more financial sense to rent if the annual rent is less than 4%-6% of the house price. To be super conservative you can use the 4% rule, or you can plug in actual data into the calculator.
– 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