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Renting vs. Buying
- which is better over time?
The renting vs. buying decision attempts to answer a simple question: over the long run, is it better to rent a home or buy one on mortgage? What lodging option results in better returns?
Surprisingly, there's no simple answer. It depends strictly on your personal financial goals - including your risk appetite, time horizon and psychological needs. All in all, I would perhaps vote for buying a house - I bought one after moving to America. However, it is important to gain from the insight of others, and apply that to your personal situation. Here are some important things to keep in mind:
ARGUMENTS IN FAVOR OF RENTING
- Renting is clearly the 'cheaper' option on a monthly basis, for the same or similar space. When you rent, you are only paying for the month's shelter. When you buy, you are paying an interest + a portion of the principal + property taxes + capital goods insurance and maintenance. So if monthly outflow is an issue, opt for renting vs. buying (by the way, utilities is something you pay for in both cases).
- To get a mortgage on a home, you'll need to pay money upfront. These days, with banks being fairly stingy in their lending practices, many banks insist on a 20% down payment (10% is the bare minimum) on purchase price. This means that on a $300,000 house, you'll have to cough up at least $60,000 before a bank will give you a loan. Obviously, you can't think of buying until you have the down payment available. Renting, on the other hand, only requires a security deposit, usually no more than one to three months of rent.
- Buying a house involves more non-refundable transaction costs than renting. When you buy, you have to pay closing costs (e.g. transfer fees, title insurance, loan processing fees, government duties and taxes). All combined, these total to approximately 5% of purchase price. Similarly, when you eventually sell, you have to pay broker fees (in the US, buyers don't pay broker fees, sellers do). The fees is usually 6% of purchase price. That means the transaction cost of acquiring the house adds at least 11% to its price. The non-refundable transaction cost of renting a house is negligible. Consider that in your renting vs. buying decision.
- If you're not planning to stay in a given location for a length of time, don't buy. Real estate is an illiquid investment. It takes a while to sell off a house, especially in a tough market. If you get transferred to another city or country at short notice, and are unable to dispose of the property quickly enough, you might end up paying mortgage for several extra months.
- People will tell you buying property is a great investment. Home appreciation lets you invest a relatively small amount, use leverage (in the form of mortgage) and multiply your equity manifold. This may be true in high growth developing economies like India, China or East Europe. But in developed economies like America, home appreciation has, when averaged over several years, just about kept pace with inflation. No more, no less. So you're better off saving the down payment and monthly principal payback money, and investing in a stock market index fund. You'll likely make more money in the long run, at least in America.
- Real-estate is a long term investment. If you buy a house, you will see significant appreciation only in 5 to 7 years, if not more. Do not buy a house for investment, if your financial goals do not allow that much of a time horizon. Time is the single most important factor in the renting vs. buying decision.
ARGUMENTS IN FAVOR OF BUYING
- There's a lot of psychological comfort in 'owning' your house. Technically speaking, you don't really own the house till its paid off (till then, the mortgage lender does). But you do get the benefit of equity appreciation while living in the home('equity' refers to your monetary share in the home), and that constitutes an important asset in the making, to bequeath to your kids.
- If you itemize deductions while filing taxes in the US, you could get a decent tax benefit by buying a house. The interest you pay on a home is tax deductible, thereby reducing the overall tax liability on salary or other sources of income. If you're in the highest tax bracket, this is almost equivalent to getting one-third of your interest payment back.
- As of writing this section, capital gains tax in America on home appreciation profit is relatively low, and in fact zero, if you meet certain simple conditions. This factor is easy to miss in the renting vs. buying decision, but is important nonetheless.
- If you do have to move cities or countries in the course of your job, and if your home is not easy to sell quickly, you could rent it out, resulting in additional income to offset the mortgage on that home.
- If you're already invested in the stock market, real estate is a good diversifier and provides a hedge against inflation, even in a developed economy like America's.
In conclusion, define a time horizon, look at your current and future monetary situation, look at your personal preferences, and then take the plunge.
The internet has some excellent "renting vs. buying calculators". These allow you to define specific variables like purchase price, down payment, mortgage rate and time horizon and calculate if its cost-effective to rent or buy. The models are simplistic, but provide a good decision support tool. Try them!
Calculator 1 - NY Times
Calculator 2 - Ginnie Mae
Calculator 3 - Center for Economic & Policy Research
Return from Renting vs. Buying to the Lodging Guide
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