Buying vs. Renting: Spelling Out the Cost Comparison.
The conventional wisdom states that paying rent is like throwing money away, whereas buying a home builds equity. Let’s re-examine this. One way to do this is to look at your expected annual cost and benefit of renting vs. owning the same home.
Let’s assume we are talking about a condominium listed for $300,000 to buy or also available for $1,200 per month to rent.
Cost of renting is easy to define, 12 monthly payments comes to $14,400 per year. It is a fixed cost, with no potential up-side, nor down-side. For example, if the roof leaks, it hurts the landlord’s wallet, not yours. The benefit of knowing your cost beforehand is that it aids your personal budgeting. You simply choose a rental home that fits your budget. The rest of your income should be spent wisely, i.e. mostly saved and invested.
As an alternative, you could buy the condo by putting 20%, or $60,000 down and taking out a mortgage for the balance of $240,000. With 5% interest, the annual interest charges will be $12,000. Interesting!
On the surface, since rent is higher than the interest payment, most tend to lean toward buying, especially as then, and only then, you would also have a claim on any expected appreciation (or depreciation) of the underlying value of the property.
But, the cost of owning the property is greater than just the cost of the interest on the financing. The real cost of owning includes accounting for your down payment, property tax, maintenance, repairs and investments to maintain the value of the house, while there is also a tax benefit (while it still is available) on the mortgage interest.
Why am I including down payment in the equation? Because if you were renting, you would be able to deploy that capital, in our example $60,000, elsewhere. For example, depending on your risk appetite, you could buy bonds yielding something around 3% or stocks with higher expected return (and risk!), or gold, or currency funds, or what ever your asset allocation process suggests. Therefore, we need to take into account the opportunity cost of no longer having the opportunity to gain income from this money. If you use bonds as the alternative investment choice, the 3% income lost on the down payment, results in an $1,800 annual cost.
Property tax, in our area, is about 1% of the purchase price, resulting in $3,000 annual cost. Maintenance, repairs and investments are hard to pin down, but you should expect to spend 1-3% of the home value per annum to keep its value. Some years you will spend significantly more (read kitchen remodel or new roof), other years significantly less (just clean the gutters, honey). The average 1-3% estimate comes to $3,000-9,000 per year.
The final piece of the cost analysis is the value of the tax benefit on the mortgage interest. Naturally, this will depend on what state you live in, as well as your personal tax bracket. Let’s give us the benefit of a high-tax state, like California, and use a tax rate of 40%. Then, the value of the tax benefit is 40% on the $12,000 interest payment, i.e. $4,800 that you can deduct from your income tax bill (assuming, of course, that your tax bill is greater than that, otherwise this is no benefit).
Tallying it all up we get the following annual cost for buying a $300,000 condo:
$12,000 interest payment for 80% mortgage at 5% interest
$1,800 opportunity cost of 20% down payment at 3% cost of capital
$3,000 property tax at 1% of purchase price
$3-$9,000 maintenance, repair, investments at 1-3% of purchase price
($4,800) tax benefit of 40% on interest payment
These add up to $15,000-$21,000 annual cost for owning the same property, depending on the maintenance costs, that you could rent for $14,400 per year. Naturally, you need to plug in your own location, property and income specific numbers to this equation to make the comparable calculation for yourself.
It appears to me that the decision between renting and buying rests squarely on your assessment of whether, and in what time-frame, the potential underlying value gain of the property makes up for the cost differential between buying and renting. I, for now, in my area, prefer to rent. I will let you know when I decide to buy.
This article was prepared by SustainableWealth.org and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward-looking statements expressed are subject to change without notice. This information does not constitute investment advise nor a solicitation or an offer to buy or sell any products or services. SustainableWealth.org is a trademark of Merk Investments, LLC.
