Intro by JL’s Team
If you’re wondering if renting vs owning your house is a better choice for financial independence, you’re not alone. A lot of people struggle with this choice. With current interest rates on a 30-year fixed mortgage hovering between 6–7%, it’s more critical than ever to do the math.
In this post, JL breaks down the expenses of owning vs renting, opportunity costs, and gives a few frameworks you can use to plug in your own numbers.
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The saga of trying to sell our house in this unfavorable market continues. We have just lowered our price yet again. If it sells, I have a great degree of confidence we will have sold at the absolute bottom. We’d be thrilled with that. To see why, let’s play with some numbers.
Is my bias showing?
Rent v. Own But before we begin, we need clear the air on a few things. Owning a home is almost always a lousy investment. Relax. This doesn’t mean you should never own one.
It does mean you ought to be clear on your reasons and not let yourself be suckered into a false reality. It means you might want to run the numbers.
Some people love the sense of ownership and enjoy working on their property. Neither apply to us, but maybe that’s you. That’s fine. We can understand.
We’ve owned a couple ourselves over the years. Sometimes for schools and an environment for raising our daughter. Sometimes just because we liked the house. But never thinking we were making an investment, let alone a good one. That’s folly.
Other times we’ve rented and enjoyed the freedom and flexibly that lifestyle offers. Sometimes we’ve been both landlord and tenant at the same time, arguably the best of both worlds.
Now renting is the direction to which we are ready to return. But we’ve never made these choices without first considering the costs. You might want to do the same. Using our numbers, here’s how….
The apartment we’ve targeted will cost us about $2000 per month, $24,000 per year.* Built into that are a few extra expenses we’ll pick up not owning. Winter storage for my motorcycle and summer storage for the car’s snow tires, for example.
Our house is on the market for $355,000 and after commissions and fees we’ll net around $330,000. (This is lesson #1. Buying and selling houses is expensive. Unless you are sure you are ready to settle in for a number of years, rent. End of story.) We are mortgage free.
Opportunity Cost
With $330,000 equity tied up in the house the first and largest expense to consider is “opportunity cost.” That is, simply, what could this money be earning elsewhere? Right now it is locked up in the house and earning zero interest or dividends.
Here we need to select a proxy. In your own analysis, you might use whatever you plan to invest in. Or, if you are renting and considering a purchase, whatever you currently have your soon-to-be tied-up-in-the-house money invested in.
I choose VGSLX, which is the Vanguard REIT Index Fund, because I intend to move the money here to maintain my asset allocation in real estate once the house is sold. Since VGSLX pays a dividend of about 3.5% the opportunity cost is $11,555 (330k x 3.5%). That is, VGSLX would pay me $11,555 per year while the house pays nothing.
Capital Gains
Of course, the house might rise in value providing me with capital gains. But VGSLX has this same potential. In actual point of fact, the fund is the more conservative investment. Here’s why:
VGSLX is a broad based fund holding investments in numerous properties all across the country. The house is a far more focused holding: one property in one neighborhood in one town in one state. As such it could provide greater or lesser gains.
During 2011 VGSLX rose about 12% while my house value continued to slide. 2012? Who knows? Maybe the house will outperform.
Since this is unknowable, as predicting the future always is, and since the investments are both real estate, we can for this analysis treat the potential as equal. Clearly if you strongly believe your house or the alternative investment will do better you can factor this into your thinking.
Running the Numbers
$11,555 opportunity cost. This is the 3.5% dividend our 330k could be earning in VGSLX.
$18,000 in cash expenses comes from these:
- $2500 heating oil. Heat is included in the apartment rent.
- $7000 maintenance & repair & insurance (an average based on our actual records)
- $8500 real estate taxes
$29,555 total annual cost of owning and operating the home. Pretty shocking, no?
v. $24,000 rent =
$5,555 annual premium to live in the house.
Now looking closely you’ll notice, while the apartment saves us $5,555 per year, there is an $6,000 cash flow advantage to owning the house. It takes 24k in cash outlay to rent the apartment but only 18k cash to operate the house.
This is similar to the EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) for a business. Cash flow is critical in running a business or your household. But the ITD&A are all real costs that you need to consider in an accurate fiscal evaluation. So is opportunity cost.
Overall costs trump cash flow costs, simply because they are more complete.
There you have it, the most fiscally precise way to compare the real money costs. Just plug in your own numbers.
Running the Numbers another way
But wait, some will say, owning the house saves you $24,000 in rent. Isn’t that like an investment return? This is a bit clumsier, but sure, we can approach it from this direction.
It looks like this: $24,000 rental savings (investment return) owning the house, minus:
- $2500 heating oil
- $7000 maintenance & repair & insurance
- $8500 taxes
$18,000 total cash expenses =
$6000 positive cash flow in house, minus
$11,555 opportunity cost =
-$5,555 annual investment deficit, i.e. cost of house over renting.
Cash flow cost also remains the same.
What about mortgage interest payments?
If you have a mortgage, and many do, you simply need to add an extra couple of numbers to the formula. Let’s take a look.
Suppose I had 20% equity ($66,000) in the house and an 80% mortgage of $264,000.
$2310 opportunity cost. This is the 3.5% dividend our $66k could be earning in VGSLX.
$23,795 in cash expenses comes from these:
- $2500 heating oil. Heat is included in the apartment rent.
- $7000 maintenance & repair & insurance
- $8500 real estate taxes
- $10,560 estimated interest on our mortgage loan @ 4% (note: the portion of your months payment that is applied to principle should not be included for this purpose although you will want to add it to calculate your cash flow number)
- -$4765 tax deduction savings. This assumes a 25% tax bracket and includes the real estate tax and mortgage interest above.
$26,105 total annual cost of owning and operating the home.
v. $24,000 rent =
$2105 annual premium to live in the house.
Because you have a mortgage your cash flow cost is now up to $23,795.
Bottom line.
So, even selling at the market bottom I come out ahead. I can handle the higher cash flow and that $5,555 in annual savings is real money in my pocket. Plus I get to step into the blissful renter’s life again.
BTW, while owning your own house is a lousy investment, investing in rental houses can be a whole other and very profitable thing. As alluded to above, at one time many years ago I was both a renter and a landlord at the same time.
These days investment real estate is too much like work for my tastes. But there is money to be made if you are willing to make the effort.
Post Script:
In the rent v. own analysis there are several formulas that provide some rough guidelines as to which is fiscally better. Here are two:
1. House price/Annual rent.
If the result is 21+ renting is better
Between 16-20 it’s a toss-up
less than 16 is a vote to buy
Using our number: $330,000/$24,000 = 13.75 This says we should buy, or in our case stay put.
2. Monthly rent x 110 = house price.
If the house costs more, rent. If less, buy.
$2000 x 110 = $220,000. This one says no question, rent.
So maybe these are not much help.
More useful, I think, is to look at actual numbers for a given situation as we did above.
“Life choices are not always about the money,
but you should always be clear about the money choice you are making.”
Addendum I:
Addendum II:
The Mad Fientist has a great post on his planned path to wealth. In it he has a compelling assessment of how renting will help smooth the way: http://www.madfientist.com/shortest-path-to-financial-independence/
Addendum III:
Here’s a real estate investor’s take: Renting is throwing money away…Right?
Addendum IV:
Podcast —Why your house is a terrible investment
Addendum V:
*Turns out I vastly over estimated the cost of our apartment. Rather than $2000/$24,000 per month/year, the number I used in the post scenarios, the actual rent is $1415 per month, $16,980 for the year. Since these numbers are only used as an example to illustrate the concepts, I don’t feel the need to recalculate them in the post. It is the technique that matters and in applying it you’ll want to use your own numbers anyway.
Addendum VI:
Thanks to Val in the comments below for this excellent video on the pros and cons of both renting and owning.
Addendum VII: Apples and Oranges
Some have observed that my examples above are not an Apples v. Apples comparison. Indeed they are not. But this only becomes an issue if you are looking at it as an academic exercise designed to prove a “winner” in comparing renting v. owning. I don’t.
In my opinion it is far more useful to compare two actual choices someone might be considering, and the framework I’ve provided here is designed to do just that. I’ve simply used our situation as the example.
You might be currently living in an apartment and considering buying a house. Or, like us, you might own a house and be considering renting again. Running your own number comparison will tell you what each option you are considering will really cost. You can even compare houses at different price points.
People make choices in the real world and running the numbers in the fashion I’ve offered lets them see precisely the financial implications of their choices. If they care to.
Having said that, should you be interested in what the numbers look like if we compare owning v. renting my specific house, check out my February 26, 2012 conversation with Executioner in the comments below. In my reply I run those exact numbers and you can see the same framework used in a direct apple v. apple comparison, again using our house as the example. It works either way.
The point is not that you should rent. Or that you should own. The point is, it is worth understanding the financial ramifications of your choices. Doing so positions you to make a more informed decision.
Once you have a sound handle on the numbers, you are also in a better position to evaluate the various lifestyle issues, deciding what such things are worth to you.
