“Rent never ends”
“Renting doesn’t build equity”
“Buying a house means at least something goes to equity”
“Buying a house ties you down”
These are all true statements. Though they sound good, they don’t capture the whole truth.
I’m going to go over every detail of the “own vs rent” argument and finally get to the bottom of it.
This is a pretty thorough article so you can jump ahead to any section you want by clicking the section below, though I do suggest you read every section at some point.
Go ahead and play with the calculator too. You’ll get an idea of where you stand before digging in.
- Why Buy instead of Rent
- Why Rent Instead of Own
- Cost of Ownership
- Opportunity Cost of Home Ownership
- Cost of Renting
- Rent Vs Own – Opportunity Costs
- Buy vs Rent – Low Money Down Loans
- Renting better than Owning?
- When Owning Makes Sense
I’m an economist at heart and studied it for more than 6 years first as an undergrad then as a graduate student. This education helped drive a passion on this topic and I ultimately left the PhD program to start as a real estate investor. You can read my bio here.
Since the amount of information in this article is more developed than most of what’s out there on the web, I suggest you download a copy of it to read on your unplugged time.
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Buying a House vs Renting
I’m sure I’m not the only one that thinks everyone seems to buy a house – my parents both own their houses, my grandparents do, and I know a lot of other friends and family do as well.
On the other hand, very Home ownership rates among millennials is at an historic low. There are a lot of reasons for it – massive student debt and required mobility for constantly changing jobs are just two of the major factors.
Everywhere I turn now, I find financial blogs and other gurus saying you should “rent where you live and own where you rent.” The problem: they don’t offer any solid evidence.
I currently rent while I rent out my former home. We moved to another state and chose to rent instead of buy because we are pretty mobile.
My personal reasons for renting aren’t based on any of the merits of home ownership vs renting, that is just my preference. We do own a ton of investment property, though, so this topic is pretty interesting to me.
Every month a little bit goes to my principal. Rent goes out the window. A little savings is better than nothing.
Home values only go up, so I’ll get a good return on my investment.
A house is my biggest asset and I want to accumulate assets.
Have you heard these reasons why people buy a home instead of rent? Perhaps you’ve even said them. I know I have used a couple in the past.
We’ll see if any of these arguments hold any water.
I need to be flexible for my job.
Places are too expensive where I want to live.
I’d rather invest my money.
The first two reasons to rent instead of own are obvious. If you need to be mobile, why would you buy? Of course, it’s better to rent and be mobile if that’s what your job or lifestyle requires.
A lot of younger people want to live where the action is – near downtown areas where there are a lot of amenities. These areas cost a lot to live in and cost even more to buy homes in.
Reason 3 catches me off guard. I thought the conventional wisdom was that buying a house is the path to wealth?
Well, I’ll discover the answers in this article. Is investing your money better than buying?
But first, let’s talk about owning your home.
The argument goes – if your rent and mortgage are nearly equal, then buying is better because some part of your payment goes back to equity.
Equity is something you build up over time and eventually you’ll have a lot of it when the house is paid off.
When the house appreciates, you earn that value as well.
Therefore, they say, buying is better than renting.
Seems pretty simple…
Understanding your mortgage payment
A mortgage is generally made up of the PITI (principal, interest, taxes, and insurance). The principal payment is what builds your equity while the interest, taxes, and insurance go to pay someone else. Over time, the P portion goes up and the I portion goes down. The taxes and insurance will likely go up as well.
Let’s take an example home worth $200,000 with 20% down payment, a loan of $160,000 at 5% interest for 30 years. Your mortgage payment will be roughly $1,150 per month. Let’s look at the amortization schedule.
The cost of buying a house.
I’d also like to point out that you need to put down $40,000 as a down payment to purchase the property. You can’t invest or touch that money once you do.
Assuming insurance and taxes don’t increase at all (not likely) you can see from the table that after 15 years you have paid off $51,386 of the loan (extra equity) and paid another $103,218.88 in interest and $52,500 in taxes and insurance for a grand total of $207,104.70!
In year 1, you pay a total of $13,806 but only $2,360 goes toward your principal – just 17%. In other words, 83 cents of every dollar goes toward paying other people. By year 15 you have saved $52,000 but spent another $155,000 in other expenses.
So, you are actually saving about $200/month in the first year.
Now, of course, you’ll reach the “tipping point” eventually where your principal pays down more than the interest costs. In this example, it actually doesn’t happen until year 17 (which isn’t on my graph).
The key point is that in the first 15 years or so you will be paying a lot to interest, taxes, and insurance without building much equity.
However, this does not mean it is worse than renting; I’m just laying the groundwork.
Cost of Buying a House – adding inflation, appreciation, and maintenance
The analysis above is quite shallow as it doesn’t include some really important pieces of information.
The first thing I’ll go over is inflation and appreciation.
Before I go into it, let’s just quickly define inflation:
“Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling.” –Investopedia
Basically, over time your money buys less. That’s why you see the cost of milk, movies, cars, and houses constantly go up.
So, when we determine prices of a house, we need to “adjust for inflation.” If a house goes up 3% in price this year, but the economy saw a 3% inflation, your house actually didn’t go up in value at all.
You have more dollars, but those dollars buy less. That’s why you need to adjust.
I get excited talking about economics and economists, so hopefully I can keep things down to earth.
Two great economists Karl Case and Robert Shiller went back and analyzed the inflation adjusted housing prices back to 1890. They created the Case-Shiller index as well which I’ve provided an image of.
Case-Shiller Index and long term housing prices.
You’ll notice that for about 100 years US house prices hovered around 90-120 on the index. During the great depression up until the end of WWII, you can see it’s really low, and after 2000 it went really high.
But the point of their research is to show that there is actually no natural tendency for house prices to always go up. In fact, then tend to find their way back toward the long-term average.
Let’s look at some more evidence:
Since 1996, you actually see no real appreciation in housing prices. Housing is actually the closest item on the list to the inflation rate.
Even during the bubble, you can only see a tiny blip in its increase, and the crash was a very very small decline in prices compared to inflation.
So yes, housing prices do fluctuate and can be high or low for decades, but eventually, prices will correct.
Since their research shows housing prices are remarkably stable over the century, I will assume inflation and appreciation will balance each other over a 30 or 40-year period.
You read that correctly – your house doesn’t appreciate once adjusted for inflation.
Unlike cash, it’s a remarkable good hedge against inflation – Your property will probably not lose value over the long term due to the destructive effects of inflation.
But housing is going crazy in my area!
Sure, there are fluctuations in local markets. Some do well and some do poorly. This is really dependent upon very local changes based upon government regulations, industry, and demographic changes.
There is actually research that shows immigration being a major driver of local price fluctuations in housing.
So, you may benefit or suffer from local price fluctuations, but we can’t actually plan for increasing values since the evidence points against it.
Don’t forget about maintenance
Of course, the cost of maintenance depends on a million factors, but the average cost is going to range from 1-2% of the home’s value.
So your $200,000 house will have a 2-4,000 maintenance bill every year on average. It might seem high, but it averages in those expensive things like driveway repair, a roof, heating systems, and other major things that might break every 5 or 10 years.
So in 15 years, you can tack on an extra $30,000 in maintenance to the chart above.
I’ve talked a bit about opportunity cost on this website.
Opportunity cost is what you have to give up in order to get something else.
When you work an extra hour at work, you lose an hour with your family.
When you drop $40,000 into buying a house (remember the down payment I mentioned), you lose the ability to invest that money in the stock market or a new business (opportunity cost).
What if we invested that $40,000 in the stock market? I punched it into my handy dandy compound interest calculator – in 15 years it triples in value to about $127,000 (at 8% interest, the inflation adjusted growth of the S&P 500). A total earnings of about $87,000.
So, by buying a house, we have given up $87,000 in cash we could have earned.
If you take what you put down ($40,000) and what you paid down in principal ($51,385) you have saved $91,385 by buying a house.
By just investing the original $40,000 we would have $127,000. That doesn’t even include the extra amount saved each month going toward principal.
Renting seems to be winning this fight, so let’s talk about renting.
Renting is a bit easier to calculate.
We don’t have to worry about maintenance and other costs. We simply need to figure out what you’re going to pay for rent.
Fortunately, people study this stuff and I can just cite it. Take a look at this graph
Prices are a pretty constant 5% of housing prices. Source: http://www.lincolninst.edu/subcenters/land-values/rent-price-ratio.asp
As with everything, the numbers fluctuate, but it can be interpreted that the average yearly rent is roughly 5% of the average house price. After the year 2000 when housing prices shot up, you can see the ratio drops as renting becomes relatively cheap compared to buying a house.
As prices crashed, renting became comparatively expensive. You can see rents getting cheap again, though not as low as the bubble, still lower than any time in the last 5 decades.
Either way, the historical average is between 4.5% and 5.5% so I’ll use that.
So in theory, you can buy an average house for a certain price or you can rent an average apartment for 5% of that price per year.
If the average home costs $200,000, then the average rent costs around $10,000 per year or $833 per month.
So right now, the option is to have a mortgage for $1,150 per month or to have rent for $833 per month. Renting seems way cheaper and wins this round, but there are still some things we need to think about.
Remember above where I showed how inflation and appreciation balance out? Well, with renting you don’t have any appreciation for balancing the inflation. Rent just keeps going up and up.
Renting vs Owning – Can you save with rent or a mortgage?
Since we know rent prices seem to match housing prices, we can compare rents to a mortgage. Take a look at this chart.
First of all, it’s a huge misconception that mortgages don’t grow. Taxes and insurance are based on house prices, so, of course, your mortgage is going to go up as values go up.
So I’ve assumed house prices rise by 3% per year, which means your mortgage goes up slightly each year.
But rents go up a lot each year.
By year 12 you are going to be paying more in rent than if you had locked yourself into a house.
By year 30 you will be spending $11,000 more per year than if you had bought a house.
As you sock away more against the principal, you are starting to beat out renting more and more. Though your taxes, insurance, and maintenance keep going up, your interest keeps going down as you pay off principal.
Finally, buying a house wins a round.
But let’s sweeten the pot.
The mortgage ends after those 30 years and suddenly you aren’t paying any interest.
In year 31, the total payments will drop to $13,350 while rent will be $24,273. That’s a difference of almost $11,000.
Score one more for owning rather than renting.
If you think owning a house is better than renting, you should know by now that I’m not through yet.
I thought it would be interesting to see how a renter does if they save the money each year.
To answer this, let’s say that if the rent is less than the mortgage, they save that amount. If the rent is more than the mortgage, it comes out of the savings.
I won’t put up more charts, but based on the previous info, if invested at 8% return, after 30 years they will have a net savings of $22,442. They will have saved up a lot at the beginning, then as rents keep going up they will start losing out and dipping into the savings.
If they had bought a house that would have sacrificed that $22k.
But you can see that high rents will be digging into that savings. By year 33 those savings will have been completely depleted. It takes a while but owning a house beats out renting one.
That’s 3 points for owning a home. Can renting put some points back on the board?
Owning a house requires a down payment, renting doesn’t
Not quite done yet. We forgot about that $40,000 down payment.
Opportunity cost really affects the decision if you should rent or buy
Let’s say the renter socks that down payment away at 8% then also saves the extra earnings. In this scenario, owning a house never beats renting a home.
Look at the chart again. I’ve just highlighted a few years. You can see that your savings have skyrocketed to $638,215 by year 39.
Even though your rent is $18,000 more than your house payments, your interest is far exceeding those costs.
You are literally living off your passive income now!
Buying a house just locks that money into the house and it doesn’t lose or gain any money. It’s well protected, but it’s also not earning any interest.
Based on the numbers, one might conclude that having no down payment could mean that renting is winning the argument. After all, there is no opportunity cost on money you don’t put into the house.
Since opportunity cost is clearly the driver in the argument, you might reasonably believe that buying a house without locking your money into it could tip the scales in favor of buying.
Perhaps, so let’s take a look at it.
You’re going to have a few competing forces here. First, you aren’t putting any money down (let’s assume it’s a VA loan) so you have no opportunity cost. Second, you will have higher payments because your loan will be larger.
Is buying better than renting when you have no money down?
When I crunch the numbers, the higher loan helps the homeowner by reducing the opportunity cost. The lack of any opportunity cost actually allows the renter to save only $247,842 more than the homeowner. This is a difference of roughly $400,000.
Even though the numbers aren’t as heavily in favor of renting, the renter still is better off than the homeowner.
In this example, I didn’t include the $40,000 because in both circumstances you would invest that. So the interest earned for both the renter and owner is the same. What I’m looking at is the difference.
Regardless how you slice it, renting makes more financial sense than buying a house.
Sure, if you can get into a house in a market with some crazy appreciation then you’ll make out better if you buy a house.
Since we know the housing market always corrects itself, you could also be the one who bought right before the bubble pops.
That’s why we can’t say that it’s a good decision – some people can make out, and some people can lose. The averages are what I use to analyze things and the facts show that on average, renting makes more sense.
Principal pay down is a terrible idea
Everyone wants to be debt free, so it makes sense to pay off a mortgage, right?
Do I even need to do the analysis for you? Just go back to what I said about your down payment and now think about it.
Does paying down the principal make sense?
NO, of course not.
You would just have locked up $200,000 earning no interest at all. It’s a little better than cash since it won’t lose value, but not much better.
If you are going to own a house, it seems it would be better to never pay it down. Instead, invest the money in something that pays interest.
Reasons to buy a house Revisited
Every month a little bit goes to my principal. Rent goes out the window. A little savings is better than nothing.
I’ve clearly covered this. Yes, a little goes toward principal each month, but that money essentially earns nothing. So, while the statement is true, it is misguided.
It is better to save the money and invest it in something that has a return
Home values only go up, so I’ll get a good return on my investment.
House prices do generally go up, but they are matched by inflation. So, even if your house went up 3%, it is likely that inflation was near that 3% number.
Prices vary up and down so you may find a decade or two with rising or falling prices. You also may find local markets that don’t follow the national trend.
So, you may be able to beat the averages for a while, it isn’t a guarantee in every market or for everybody.
Either way, there is no evidence that prices continually go up.
A house is my biggest asset and I want to accumulate assets.
This may be true…but you could have a larger asset if you had just invested the money in a simple S&P 500 fund. If you spend all your money on one thing, obviously that will be your biggest asset.
Think about it, if you spend $200,000 on a house, you will say it’s your biggest asset.
If you took that $200,000 and bought a…car, you’d say your car is your biggest asset.
Regardless of what you buy, if it’s the most expensive thing then you will say it’s your biggest asset.
So, just change what you put your money into and let something that earns interest be your biggest asset.
Does Buying a House Ever Make Sense?
Yes, of course.
It makes sense to buy a house when you aren’t interested in money.
Clearly, a home is not an investment. So, if you don’t care about money then get what you want.
Real Reason #1 to buy a house
You value stability. Renters may have to move from time to time which is less stable. If you want one place to live and raise children, then there is really only one option.
If stability is worth $200,000 to $600,000 to you, and your retirement account doesn’t need the money, then go for it.
Real Reason #2 to own a home
You find enjoyment in fixing/maintaining a house.
If you enjoy gardening, fixing things around the house, having a beautiful landscape etc… you may find you need to own a home. Most landlords don’t want you messing around with their property and won’t appreciate when you are digging up half the yard to plant things.
Real Reason #3 to own instead of rent
Your specific market is out of whack with the rest of the country. Understand your market well before assuming this.
I made a lot of assumptions when writing this article. Assumptions are necessary in order to draw conclusions about averages…but sometimes they need to be taken with a grain of salt.
There’s a funny joke that some economists made up decades ago.
There is an Economist, a Physicist, and a Chemist stranded on a desert island with one can of food. They are trying to figure out how to open it.
The physicist starts by calculating force, estimating some distances, and devises a method to open the can by applying just the right force at the precise angle to open the can.
The chemist develops an elaborate system using the chemicals and naturally occurring ingredients available.
The economist says “you two are making this far too complicated. I’ll just create a model to solve this problem.” After thinking for a bit, he says “first, assuming we have one can opener….”
Perhaps only an economist will get the joke. The point is not all assumptions are realistic even though you need assumptions in order to model the economy.
Buy vs Rent is driven by Price to Rent Ratio
My biggest assumption was a 5% price to rent ratio. It’s currently far lower and sometimes it’s much higher.
As the price to rent ratio rises, the decision begins to move toward buying instead of renting. As the price to rent ratio drops, renting makes more sense.
I used the historical national average around 5%. You’ll notice right now the ratio is around 4% which really means you should rent.
Your particular area may be different, though. If you find the ratio in your area is up around 6% or higher, you may want to jump in and buy a house.
Using the example above, if the average home price is an area is around $200,000, the average rent may be around $666/month with a 4% ratio, but rent would be around $1000/month with a ratio of 6%
Your total mortgage is $1,150 per month for that house, so you can see how the math changes dramatically by changing the ratios.
You need to shop around and determine what the average rent is in your area and the average home price.
Remember, you need to compare similar properties. If you rent a 20th story penthouse but plan to buy a small single family ranch, then you aren’t really comparing similar properties.
The Case-Schiller Index is About the Long Term
Over the course of decades and centuries, house prices tend to go back to a mean value.
But you can see that in the last century there were 2 decades of low prices. This is half of an adult life back then. The life expectancy was about 60 years back then.
So, you may live your entire life in a bubble or with deflated prices. You don’t know when the market will correct even if it inevitably does.
The key is to keep an open mind and be able to adapt as things change.
Buying makes sense when you can add value
My friend “Mr. 1500” over at 1500days.com has made most of his money by what real estate guys like me call “house hacking” or what he calls the “live in flip.”
He found a way to turn something that isn’t an investment into something that creates wealth.
Basically, you find a house you can live in, but needs a bit of work. Over the course of a few years, you do the work.
After a few years, you sell the house and do it all over again.
The profits cover all the expenses (meaning you paid nothing to live) which puts money in your pocket tax-free (consult with your accountant). You can then invest the profit.
But What about all those real estate tycoons. Clearly buying beats renting
A lot of people make money in real estate. I have made a killing in it as well.
But I bought investments – I bought property that pays me rent and I did it with other people’s money.
When you are earning rent income, then it makes sense to buy property. When you buy investment property then real estate beats the stock market every time.
But, that’s not what we are talking about here. We are talking about buying a home. A home just doesn’t make sense financially (on average). It makes sense under certain circumstances and in certain areas. It also makes sense when you have certain goals.
Conclusion – You should probably rent instead of own
When I started research for this article, I really didn’t expect to see such overwhelming evidence against buying a home. I thought there might be some solid arguments for both sides, but the results would be inconclusive.
I actually crunched the numbers so many different ways trying to find reasons to buy a house. I was allowing my biases to dictate what I wanted to see for results.
But the numbers were so overwhelming, they wouldn’t point toward ownership in virtually any realistic scenario. So, I’ve concluded that:
The evidence is overwhelming: For the majority of Americans, it makes sense to rent instead of own.