I bet you $100 that you’ve been trained to think that renting is throwing away money. Why pay rent when you could take out a mortgage with monthly payments equal to your rent and build equity in your home? Historically, buying a home is the thing to do – everyone has one and it is often viewed as a pillar of success. Oh - that person bought a home? They must have their s*** together.
The purpose of this blog post is not to shoot down the idea of buying a home, but rather reframe the conversation and help you determine whether buying a home is truly aligned with your values and goals. In some cases, buying a home makes perfect sense. In other cases, it does not, and this is the area that is not discussed enough.
I believe the rent vs. buy decision boils down to 3 key factors
- Financial opportunity cost
Financial opportunity cost
In order to build equity in your home, you need to put a lot more money into it. Every situation will be different, but you can typically take a ballpark guess at how much extra money you will need to put into a home compared to renting. The key word here is guess – you certainly won’t be right, but you can get close.
Let’s walk through an example. Let’s say you are married, earning a combined income of $200,000/year and currently paying rent of $2,500/month. You are considering buying a home for $500,000 and want to determine the impact it would have on your finances.
Rent @ $2,500/mo or buy $500,000 home?
One-Time Buying Costs
Annual Buying Costs
Annual Rent: $2,500 * 12 = $30,000
Renter's Insurance: $20 * 12 = $240
10% Down Payment = $50,000
3% Closing Costs = $15,000
Monthly Mortgage Payment: $2,150 * 12 = $25,800
Property Taxes = $5,380
Homeowner's Insurance = $1,500
Renovations / Projects = $1,000
Maintenance = $2,000
Total Annual Cost: $30,240
Total One-Time Cost: $65,000
Total Annual Cost: $35,680
First, calculate what your annual cost of renting is by adding your rent + your renter’s insurance. Assuming renter’s insurance costs $240/year, this equates to $30,240/year.
Next, calculate what your upfront one-time costs of owning are. Assuming a 10% down payment and 3% closing costs, this equates to $65,000.
Finally, calculate what your estimated annual costs are. Your mortgage, property taxes and homeowner’s insurance will be known, but the renovations, projections and maintenance are the wild cards. In this example, I used very conservative estimates for the wild cards. These costs are usually the unexpected costs that make home ownership much more expensive than anticipated. The annual costs are estimated to be $35,680/year – relatively similar to the cost of renting.
This is not a huge surprise for those who have gone through this exercise before. It often forms the basis of the “rent is throwing away money” argument. If your annual costs of renting vs. buying are relatively similar, why would you ever rent when you aren’t earning equity?
The key is the opportunity cost of that $65,000 one-time cost. What other opportunities could you pursue with that money? Here are some common options:
There isn’t a right or wrong answer here – it ties back to your values and goals. However, building home equity appreciation is often not one of the primary goals I hear from people. If renting allowed you the financial flexibility to travel to the places you’ve dreamed of, I’d argue that is more important.
Renting simply offers more flexibility. Think of renting as owning a sailboat vs. a cruise ship – you can make quick adjustments and change directions in a sailboat, but a cruise ship takes far more time and effort.
People from the Gen X and Gen Y generations value flexibility far more than other generations. Life can change quick and you don’t want to feel held back by a certain asset. You may want to live in a few places, change jobs, start a business, etc. Renting allows you to adjust your housing situation to directly accommodate changes in your financial situation. The bank is not going to say hey – you can start paying 20% less in mortgage payments so you can start a business. However, you could move to a new area or reduce your space to pay 20% less in rent so you can start that business.
This is very important to consider – there are simply important emotional factors when something is “yours”. When you buy a home, you have the peace of mind that a) you can never get kicked out (as long as you are paying the debts on time), b) your mortgage doesn’t increase and c) you can make whatever changes you want to the home.
This is important to think through and relate back to your values and goals. You may not be able to feel this security and travel around the world, so this forms an important basis of conversation about which is more important to you.
Once you have kids, this is even more important. You likely want your kids to grow up in a community and education system that fits your values. You can still accomplish this through renting, but that low possibility of getting kicked out of your home by the landlord becomes more front of mind.
Ask yourselves a few questions:
- What is it about owning a home that you cannot achieve through renting?
- How is owning a home directly in line with your core values?
- What would you do with the “opportunity cost” of the money you are putting towards a down payment and closing costs?
- What other goals do you have that may be impacted by buying a home?
Don’t assume renting is a poor financial choice. Challenge the societal norms around owning a home and think through how it ties back to your values and goals.
Additional assumptions used
- $450,000 30 year fixed mortgage at 4%
- Real estate taxes based upon Somerville, MA
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