It is one of the most important financial decisions in life: should we rent or buy a house? It is a complex topic that deserves a proper in-depth analysis.
- How long you want to live there
- Rental costs
- Mortgage interest
- Cost of ownership
- Future value of the property
- Transaction costs
I am big believer in making things as simple as possible. But there are certain issues that require a more detailed analysis. When deciding whether we should buy or rent a house, the simple rule of thumb is that we should buy if the annual rent is higher than 5% of the purchase price of the property. While this rule usually works well, it oversimplifies an important discussion.
Before we get into specifics, let me just tell you that, in case you have no money for the down payment yet, it is key to start making and saving money as soon as possible. That will allow you to pull the trigger on buying a house when the timing is right.
How long you want to live there
Before deciding if we should buy or rent a house, we must have an idea about how long we plan to live there. You do not have to know exactly how long. And just because you want to live in that house for a few years only, it does not mean you should not consider buying.
If you think you are going to be in that house for a good number of years, say more than 7, buying is usually the better option. Things are slightly different and more complicated if you plan to spend less time there.
But even if you were to only spend 2 or 3 years in that house, it might make sense to buy. That mainly depends on whether you want to keep that house as a rental property in the future.
You should analyze the decision of buying or renting as if it were an investment decision. Are you interested in owning that house for the long term because you believe in its potential? Would you still have liquidity for other projects in the future if you bought a house? If the answer to both questions is yes, you can consider buying.
Another important thing to consider is how much it costs to rent a house. And that cost must be compared against the value of the property. This will tell us if it is cheap or expensive to rent.
For example, if you live in a big city, and you pay a monthly rent of $2,000 for an apartment that has a purchase price of $600,000, the calculation would be as follows:
(12 * 2,000) / 600,000 = 4%
However, you may be living on the countryside and paying a monthly rent of $1,000 for a house that costs $150,000:
(12 x 1,000) / 150,000 = 8%
By that metric alone, and on a relative basis, renting the apartment in the city would be much cheaper than the house. Conversely, buying the apartment would be much more expensive than buying the house.
We should also know how much the mortgage payment would be if we bought the house. Comparing the mortgage payment with the monthly rent is useful but insufficient. Paying attention to the interest rate we pay is also important.
Mortgage payments can be broken down into interest and principal. The interest we pay is an irrecoverable cost. However, the principal payment lowers the outstanding mortgage debt, increasing our net wealth.
On the contrary, the entire mortgage payment is an irrecoverable cost. It might still be worth renting, but we should be aware of that.
And on the topic of interest costs, a factor to consider is what rate we would have to pay and whether we could refinance at any time. A 7% mortgage is much more expensive than a 4% one. But a more expensive mortgage is less of a problem if we can refinance at any time without having to pay a lot of fees.
Cost of ownership
Owning a house is never free. It costs money. And ownership costs should factor into your decision of buying vs renting.
In most cases, the most expensive cost is the general depreciation of the property. It will show up in the form of small repairs and big renovations down the line. Things like a new boiler, painting the walls, fixing doors or windows, updating the house, etc. As you can see, a house needs recurring investments in order to remain a desirable home. Most of these expenses come once every several years, but the cost may be substantial.
As a rule of thumb, it might be helpful to assume a 1% annual depreciation of the house. It means that, if the house is worth $300,000, you should factor in a cost of $3,000.
Another potential cost of owning a house are property taxes, regardless of how they are called in your country. It is what you have to pay to your state or council just for owning a house or apartment.
Property taxes can be moderate to high in the United States, relatively inexpensive in most European countries, and non-existent in other places.
Finally, if we are considering buying an apartment or a house that is part of an association, there will be fees to pay for the upkeep of communal areas. This can be in the form of a service charges, housing association fees, etc.
Future value of the property
This is the most difficult question to answer, as no one can really say. How much will that house be worth in the future?
That depends on things like inflation, the strength of the housing market, demographics and whether our area is becoming a more or less desirable place to live.
A remote town in a region from where people leave to seek better opportunities has less potential than a booming city attracting all sorts of companies and working people. The type of property is another important factor, especially with working from home becoming more popular.
As an example, we can use a long-term nominal price growth of 1% annually.
Buying a house usually means parting with a significant amount of money in the short term. Real estate is an illiquid asset. Buying a house carries many associated expenses (the topic we will discuss next) and selling it comes with even more expenses, taxes, and potentially long wait times.
For this reason, you should not buy a house if you might need to sell it soon. If you have a lot of liquid wealth, in the form of cash or stocks, this is not a problem.
But bear in mind that that money you put into a house is relatively trapped in the short term. A good rule of thumb is to use a 0.5% annual liquidity cost. It is not a real cost but puts into perspective the short-term unavailability of the money you had to put in.
By contrast, if we had that money invested in stocks, gold or bonds, liquidity would be almost immediate.
Finally, we must consider the transaction costs involved in buying a house. These are things such as stamp duties, real estate transaction taxes, mortgage origination fees, legal costs, inspections, etc.
These costs will depend greatly on where you live. They tend to be way higher in Europe, where they can easily end up being 10-12% of the purchase price of the property in certain countries. In the United States, they can be 2-4% of the transaction price.
Let us now use some example numbers to illustrate all the aspects we have analyzed so far:
- Rental costs: 5% of the value of the house annually
- Mortgage interest: 5%
- Cost of ownership: 1%
- Future price of the property: 1% annual increase
- Liquidity: 0.5%
- Transaction costs when buying: 5%
While renting would cost 5%, we can also calculate how much buying the house would cost
Mortgage interest + Cost of being an owner – Increase in the price of the property + Liquidity
Purchase cost = 5% + 1% – 1% + 0.5% = 5.5%
As we can see, the cost of buying a home (5.5%) would be higher in this case than the cost of renting (5%), so the optimal decision would be to rent, even before taking into account the one-off transaction costs.
It should be noted we may arrive at a different decision by using different assumptions. For example, if we assume that inflation will remain higher than that 1%, something we can apply to the cost of renting.
I am aware this is an incomplete analysis. It is almost impossible to take all things into consideration. But we should try to be as informed as possible when deciding whether we should buy or rent a house.
One thing to consider is that the macroeconomic landscape is very uncertain, and this can be interpreted in two completely different ways.
It might make us cautious if we think the economy will be softer in the future, something that would speak in favor of renting. But it can also lead to government and central banks creating inflation and lowering borrowing costs, which would speak in favor of buying.
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