My lease is expiring in a few months, and I was thinking about the decision to either rent or buy my next place. So, when I sat down to think through a rigorous analysis of which option makes the most sense for me, I realized others could save time and energy if I shared my entire thought process.
There are a few key components which most strongly influence if it is better to buy or rent for your personal situation. Some of these are straightforward, others tend to be overlooked, leading to sub-optimal decisions and money left on the table. This post will give you an exact methodology to determine if it is cheaper to rent or buy for you by holistically considering both options impacts on your wealth.
Why Don’t I Just Use a Rent or Buy Calculator?
There are plenty of rent or buy calculators out there, buy their methodologies often omit key factors that should impact your decision (more on this later).
Further, it is more important for you to understand the mechanics of how different factors impact what the correct decision for you will be. This way, you will understand how to think about making the right decision as new information about your situation is made available to you in real time.
Table stakes (what you must be comfortable with to buy)
- Do you have enough money for a down payment?
- Usually, you need to be able to put up around 20% of the list price of a house in order to be qualified for a loan and purchase a home.
- Ultimately if you do not have this amount saved up in liquid assets (ideally cash) there is no point in even considering this decision further. You need to either look for less expensive places to live or spend a bit more time increasing your savings.
- Are you prepared to take care of your residence?
- If you are at the point in your life where fixing a plumbing leak, or mowing your lawn once a week frightens you, you may consider sticking with renting for a little while longer until those thoughts no longer seem so scary. A massive benefit of renting is the piece of mind that someone else will take care of these annoyances for you.
- Are you planning on moving in the near term?
- As we will see in a second, generally the longer you plan to live in the same location the more buying your residence makes financial sense. If you know you are planning to live elsewhere in the near term, it is probably best to hold off until you are a bit more settled unless you plan to become a landlord.
The Million Dollar Question: Rent or Buy?
Now for the meat and potatoes. This is how I decide the million dollar question, should I rent or buy?
To begin, if you want to determine quantitatively if you should buy vs rent, there are three calculations you need to make (we will make these for you), which will tell you if renting or buying will have more of a negative impact on your wealth (i.e which will cost more in the long run).
First, you need to pay something for a roof over your head one way or another, but the fundamental question is the following: Which of these options will you have to “pay” more for, when considering both actual costs, and opportunity costs (i.e what would have happened to your wealth had you invested instead of used it to fund your roof over your head). This will make more sense in a bit!
For illustrative purposes, we will assume you are trying to make the decision between renting a place for $800 per month or purchasing a place for $200,000. Don’t worry about other assumptions related to this calculation just yet, those are coming.
The Three Key Questions
Question 1: If you rent, what will be the effect on your wealth?
The first part of answering this question is obvious, each year you pay your rent, your wealth decreases by an amount equal to your rent payments. But when thinking like an economist, we want to consider the opportunity cost of making these payments.
In other words, if you did not have to pay rent at all and instead you invested your rent money, how much would that amount be worth? This is a point that many people overlook.
|Year||Rent Paid in Year||Value of Rent Money if Invested|
This chart shows that in year 5, if you had not spent money on rent, and instead put your money in the stock market each year, you would have $63,700.
This is the negative impact that renting has on your wealth after 5 years. This is money that you would have had if not for making these rent payments (i.e if you chose to buy or chose to live with your parents or otherwise rent free).
Question 2: If you buy, what will be the effect on your wealth of the interest payments associated with your mortgage?
This one is easy, we can treat the portion of your mortgage payment that goes to interest exactly as we treated rent payments. This portion of your mortgage goes down the proverbial drain as soon as you make them just as rent payments do. You should treat these cash outflows the same as you do rent payments when determining the negative impact on your wealth.
Accumulating Equity in Your Home
But what about the portion of your mortgage payment that goes to equity in your house? Surely that is not wasted money, right? After all once you pay off your mortgage you are left with an asset of substantial value!
This is correct, and it should be counted as a positive factor in favor of purchasing a home. However, again we must consider the opportunity cost of putting your money towards equity in a home.
Question 3: What is the opportunity cost of contributing towards equity in your home versus investing it?
Nest, if you did not put your money into payments going towards equity in your home, what is the value of what you would have had, if you invested elsewhere?
The difference between the value of equity in your home and the value of what your money could have been worth if invested elsewhere is the opportunity cost of the equity portion of your mortgage payments. This is especially important to consider when making a down payment on a home which can often be a substantial sum of money.
PHEW. That was a lot but I hope you stuck with it because it is really worth understanding. Congrats on focusing this far! We are almost at our decision now!
TL;DR if you are putting your money into paying a mortgage and acquiring equity, you must account for what this money would have been worth if you did something else with it instead.
Making the Decision to Rent or Buy
We now have the three pieces of the puzzle we need. Combining the last two pieces gives us the value of the negative impact on your wealth of buying a house.
Impact on wealth of buying a house = Impact of interest payments (Question 2) + Opportunity cost of principal portion of mortgage payments (Question 3).
In the early years, it is likely that purchasing a home will have a higher negative impact on your wealth than renting, given the high opportunity cost associated with putting down 20% of the value of your home.
Each subsequent year however buying will look like a better and better option, given the increasing share of your payments going to equity in your home.
The Real Rent vs Buy Solution
Given the three questions we listed above the question becomes, how long must I continue to make mortgage payments on my home before buying makes more sense than renting? The answer to that question is the following: the year in which the negative impact on your wealth of buying is less than the negative impact on your wealth of renting.
See here for an example deciding between buying a home for $200,000 and renting a place for $800 per month. Here we assume a 4% interest rate on a 30-year loan, 20% down payment, 2.5% annual rent increases, 3% annual nominal home value appreciation, and an 8% opportunity cost (likely stock market return).
|Year||Interest||Principal||Rent Impact||Interest Impact||Principal Impact|
In each year, the running total cost of renting is less than the running total cost of buying until year 7. So, in this case, buying makes more sense if you are planning on being able to commit to making mortgage payments for at least 7 years. The negative impact on your wealth if renting comes directly from table 1.
What I Decided to Do!
Using this exact framework, I decided to buy my next place! I hope this gives you the same confidence that it gave me to go out and make the right decision for you.
If you want my entire spreadsheet that calculates all these components and recreates this analysis for your particular situation, go ahead and submit your email below and I will send it to you absolutely free.