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Renting vs. Buying a House: How to Evaluate

Jake - Author/Founder

Hi. I'm Jake, a frugal Canadian Engineer. I believe you can build a great life through frugal living and index investing.

Consider the decision to buy a home. Can you think of a more significant financial decision? I can’t. 

You may have heard, “renters throw money away.” This is true. But homeowners also throw money away on property tax, home maintenance, and mortgage interest. There is one other hidden cost that I will cover later in this post. 

You may also say, “the renter misses out on home appreciation.” Also true. But what if the renter invests in a stock index fund with expected annual returns of 8.3%  relative to the 4.3% for residential real estate (source)? 

When considering renting vs. buying, the real question is, what option results in throwing the least amount of money away?”

Based on my unique answer to this question, I’ve been renting and investing for eight years. It’s turned out fine. 

In 2023, it is possible to maximize wealth by renting and investing if your annual rent is less than 4% to 8% of the cost of your target home. 

Table of Contents

Ownership: A Colossal Decision

The average house price in my area (Ontario) is over $799,000 as of February 2023. That’s over 7.6 years of after-tax income for a household earning $150,000 annually. Buying a home is a big decision.

A decision, by definition, is the selection between alternatives. An informed decision requires that you understand two or more alternatives. One such alternative is to rent and invest.

Plus, a good decision accounts for risks associated with both alternatives. 

Mortgage Interest Rate Risk: Feb 2022 to Feb 2023

Homeowners face interest rate risk, housing market volatility, liquidity risk (it’s hard to sell a house) and maintenance risks such as foundation cracks. The plot below shows interest rate risk materializing through 2022.  

The option to rent and invest exposes you to eviction risks, rent price inflation and equity (stock) market risk. There is no “risk free” way to live. 

Unrecoverable Costs Of Homeownership: The True Cost Of Homeownership

There are four types of homeownership costs do not go towards the principle. These costs are “unrecoverable.” The money is “thrown away.” It does not stay in your pocket or contribute to your net-worth (wealth). 

The unrecoverable costs of homeownership are: 

  • Property Tax
  • Home Maintenance
  • Mortgage Interest
  • Opportunity Cost of Home Equity 

Overall, the total unrecoverable cost of owning a home is between 4% and 8% of the home value each year. By understanding these costs, you can make a good comparison between renting and owning. 

What option throws the least amount of money away? 

Credit for this approach belongs to Ben Felix from PWL Capital. He covers the topic well in the video. You can also check out the PWL Capital white paper titled “A Case for Renting“. 

1. Property Tax

Property tax costs an average of 1% of the home value per year. Your exact property tax rate depends on your municipality and the appraised value of your home.

You can find the exact rate through a quick google search. Your municipality should have a website. For example, the home I rent in Kingston is assessed at $334,000, and $4,270 was paid in property tax in 2022. 

With the home’s current market value ($670,000), the property tax rate is 0.72%. 

Property tax is a cost of homeownership, even when you are mortgage free. It can be expected to increase with inflation. 

2. Home Maintenance

As a rule of thumb, home maintenance costs about 2% of the home value per year. Read this post to understand this estimate further. 

Therefore, you can expect $5,000 in-home maintenance costs per year for a $500,000 home. Maintenance costs tend to come as large lump-sum expenses, like a roof replacement, rather than smooth annual expenses. 

This reminds me of a common misconception. Homes go up in value because the land appreciates. 

The building that sits on the land is a depreciating asset. To retain its value, you must throw money at the building in the form of home maintenance. 

To upkeep the value of the structure, you must:

  • Fix things that break. I call this “corrective” maintenance; 
  • Keep the house up to date with the times. I call this obsolescence maintenance. 

Corrective Maintenance

Some things need fixing. Roofs wear until they leak, foundations crack, furnaces fail and pipes burst.

Because these unplanned maintenance costs come as large lump sum expenses, homeowners need a more significant emergency fund held as cash.

A high-interest savings account or a money market fund is a good place for an emergency fund. It should not be invested in stocks or long-duration bonds. 

This is money that you cannot use to invest. Therefore, this emergency fund has a small opportunity cost.

Obsolesence Maintenance

In addition to fixing broken things, homes must keep up with the times to retain value. I call this obsolescence maintenance. 

Preventing obsolescence can look like a new kitchen, new flooring, or updating the exterior. You can easily add another 1% of the home value to obsolescence maintenance. 

This brings total maintenance expenses to 2% of the home value annually. 

3. Cost of Debt (Mortgage Interest)

Mortgage interest is the price of debt. It’s another cost you cannot recover.

RateHub says mortgage interest rates are 5% for a 5-year fixed as of February 2023. Each year, you lose about 5% of the outstanding mortgage loan amount to interest payments. 

For example, let’s assume you buy a $600,000 home with 20% down on a 25 year mortgage at 5%. You, therefore, have a $480,000 mortgage loan.

In the first five years, you pay $167,500 in mortgage payments ($2,792/month). Of that $167,500, only $55,000 goes toward the principal of your home. The other $112,000 goes towards interest payments. 

In the first 5 years, annual mortgage interest payments represent 5.5% of the home’s value. 

It looks better over the rest of the 20-year mortgage period, and the mortgage loan gets smaller and more money goes towards the principal. Over the 25-year term, you pay $480,000 in principle and $357,511 in interest.

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4. Cost of Money Tied Up in Your House (Cost of Home Equity)

Imagine being mortgage free. You own your house 100%.The cost of mortgage interest no longer exists. Let’s also assume the home is worth $500,000. 

Does this mean the home is essentially free?  Unfortunately, no. There is a hidden opportunity cost of the money tied up in your home. 

By having money tied up in your home, you miss out on the opportunity to invest in assets like stocks that have higher expected returns. 

Over the past 122 years, a global stock index has grown by 8% annually while residential real estate in developed countries has grown by 4% annually. My data is pulled from the 2022 Credit Suisse Investment Returns Yearbook.

Global stocks can be expected to beat real-estate appreciation by 4% per year.  Therefore, the opportunity cost of home equity is 4% per year. Anyone can access global stock and bond indices with index investing. 

As discussed in my post on investment risk, stock returns are not guaranteed. Real-estate appreciation is also not guaranteed. 

 

Example: Opportuity Cost of $500,000 of Home Equity

Let’s look at the two options for $500,000 over a 25-year period: 

Option 1: The $500k in home equity earns a 4% annual return. After 25 years, the home is worth $1,357,000. 

Option 2:The $500k held in home equity earns an 8% annual return. After 25 years, the home is worth $3,670,088. 

By holding the money in home equity, you miss out on the excess returns provided by higher-returning assets. 

Homeownership: Total Money Thrown Away

To sum up the above, here is the total home ownership cost:

  • Home maintenance:  1% – 2%
  • Property tax: 1%
  • Mortgage interest: 5%

The total unrecoverable cost of ownership is up to 8% of the home value each year. 

As the mortgage gets paid down, the mortgage interest costs go away and are replaced by the opportunity cost of home equity. Once you are mortgage-free, you are left with the 4% opportunity cost of home equity. 

The calculator below provides a better breakdown that factors in your unique costs. 

Is Your Home An Investment?

Investments pay you cash flow rather than eating up cash flow. For example, stocks pay dividends, bonds pay interest, and rental properties pay a rental income. 

Your house eats up cash flow through property tax, home maintenance, mortgage interest and utilities. Land appreciation of 4% per year is not enough to compensate for the negative cashflows. Therefore, the home is best viewed as a “use asset”, not an investment asset.  

Rent vs Buy Calculator

calculator-4285211_640

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

Let’s crunch the numbers for a $670,000 home with a 20% down payment and a 5% mortgage interest rate.  

In this example, home equity amounts to $134,000, and mortgage debt amounts to $536,000. I use a low value for property tax and home maintenance to give home ownership the benefit of the doubt.  

 

Note that the total unrecoverable cost of ownership is 6.5% per year is high. 

Below, I show the total annual cost for each of the four categories of unrecoverable costs. None of this money contributes to your net-worth, as it does not go toward the home’s principal. 

In my area, a $670,000 home rents for $2,750. Therefore, renting this home (and investing) would be expected to maximize net worth.

In addition, the renter may see other benefits, such as: 

  • Less time allocated to home upkeep
  • A smaller emergency fund
  • Saving 5% of the home value ($33,500) in closing costs upon a move

Top 8 Books To Grow Wealth

Rent vs. Buy: Other Financial Considerations

There are other financial considerations not covered above. Some benefit renters and many benefit home owners. Let’s go through them. 

Financial Factors Favoring Home Ownership

  • Capital gains income from the appreciation of your primary residence is tax-free. Gains from stocks are not tax free unless the stocks are held in a TFSA. 
  • The RRSP home buyers’ plan allows first-time home-buyers to withdraw up to $35k tax-free from their RRSP to put down on the 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. 
  • Renting and investing require a long-time horizon. Even a globally diverse index fund can be expected to crash by 50% and can take over five years to recover. A renter must be willing to rent for an extended period to endure market crashes.  
  • Homeowners can use leverage to increase the returns of real-estate appreciation (while taking on more risk). A renter who invests can also make use of leverage to invest if their risk tolerance is high enough. 

Financial Factors Favouring Renting

  • Selling a home comes with realtor and legal fees that can approach 5% of the home value when you sell (source). Renters don’t face this cost. They have more flexibility to move, and can perhaps find better paying work. 
  • Housing markets can be volatile, often due to interest rate risk (see below). Housing market downturns are enhanced by mortgage leverage. Losing borrowed money is the only thing worse than losing your own money. 
  • Interest rate risk. You can gauge the sensitivity of mortgage payments to interest rate changes using this mortgage calculator.  Interest rate risk is a double whammy. When rates rise, the mortgage payments increase on variable-rate mortgages and you can see a decline in home prices. 
  • Bidding wars can make it stressful to buy. In these wars, you may not be able to get a home inspection. When you buy “as is”, posing a risk of high maintenance costs. 

Rent vs. Buy: Behavioral Considerations

You are a human and not a robot. There are key rent vs. buy considerations that cannot be measured with money. 

Behavioral Factors Favoring Ownership

  • A mortgage forces you to save by paying the mortgage. Renters must implement an alternate forced savings system to invest, and this requires self-discipline. 
  • Owners have more freedom to landscape, renovate and do interior design. 
  • Homeowners don’t get evicted.
  • Owning your home can fulfill the human need for security.

Behavioral Factors Favoring Renting

  • You don’t need to deal with the costs, stress and time of home maintenance.
  • You will naturally spend less time and money on home improvements by renting. For more, see the endowment effect
  • 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.
  • You are exposed to rent price inflation in areas without rent caps

Biases In Favour of Home Ownership

  • Cultural pressure exists (amplified by banks, realtors and mortgage agents) advocating ownership. This imposes a confirmation bias in favour 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 4% before or 1.3% after inflation.

Conclusion

Both renters and homeowners “throw money away”. The amount thrown away is harder to measure for homeowners. 

The question is “which option results in throwing the least amount of money away?” That option maximizes long-term wealth. 

It makes more financial sense to rent if the annual rent is less than 4%-8% of the house price. You can plug your specific data into the rent vs buy calculator.

Finally, there are unique behavioural considerations to consider in the rent. vs. buy debate. The best option is unique to you. 

Jake out. 

Sources

 – Benjamin Felix, Associate Portfolio Manager PWL Capital Inc. “The Case for Renting“. 

 – Credit Suisse (2022). Global Investment Returns Yearbook 2022.