Should I rent or buy my home?

Australian households collectively own assets of $16.7 trillion of which 56% or $9.4 trillion is invested in real estate.

Smart money move or dangerous national obsession? Let's find out.

Background

Buying your home – it's either the best investment you’ll ever make, according to the media or your most significant liability, according to Robert Kiyosaki, best-selling author of “Rich Dad, Poor Dad”.

Your house is not an asset. Rather it is a liability...Instead of putting money in your pocket; it takes money out of your pocket in the form of a mortgage, utility payments, taxes, maintenance, and more. That is the simple definition of a liability.

The truth is, it’s neither and both.

And Mr. Kiyosaki clearly wasn’t paying attention in accounting class the day they covered liabilities. Oh, that’s right, he doesn’t believe in college!

A better way of thinking about whether or not to buy your home is to treat it as a hedge.

Let me explain.

The golden rule is to buy property, not too much, only when the time is right for you.

As adults, we all need somewhere to live. We can choose to buy at the price available on the day by renting, or to fix the price by buying. By renting, we are exposed to the risk of fluctuating rental prices; by buying, we get the certainty of knowing the cost.

Regardless of what happens to rents or house prices, we have hedged (or eliminated) our risk of future increases in rents.

Over time rents tend to rise in line with wages without an excess supply of available properties. Even though you may be able to rent more cheaply than the cost of buying today, this won't always be true – your mortgage payment does not increase over time but rents will.

Real estate is also the only item we need to consume that maintains some value even when used. It might be more or less than you paid for it, but it still has a value.

This might seem like semantics – but it is essential in how we think about buying a home. If you treat it as an investment, there is the temptation to buy too much or compare it to investing in alternative assets like shares.

But looked at as a form of consumption, it reminds us that less is better. Every dollar we spend on our home is a dollar we can’t spend or invest elsewhere.

Most of the financial stress I see in my work arises from buying too much house or too much car.

Together these typically make up 40% of the average household budget and so are among the most important financial decisions any of us make.

The Cash Cost of renting is usually lower

In Australia, the cash cost of renting, at least in the short term, has almost always been lower than the ongoing cost of buying.

There are three main drivers of this:

There are significant transaction costs in buying and selling real estate. The main cost is stamp duty, which for example, would be $33,340 for a $850,000 property in NSW. This is the equivalent of 14 months’ rent.
The rental cost is usually less than the cost of borrowing the money required to buy the property, or the income that is forgone because this money could not be invested elsewhere. The rental yield (annual rent divided by the market value of the property) in Australian capital cities has historically been around 5%, (or roughly $1 per week for each $1,000 the property is worth). The rental yield fell over the past few decades as interest rates fell and remained low. Recently, these have started to increase again. Whether yields return to historic levels is open to debate, but right now, this can be as low as 3.4% in parts of Sydney. This means that a $850,000 property will rent for $556 a week.
It is possible to obtain a mortgage for owner occupied housing for around 5% right now. This has risen sharply over the past year, but is still below historic averages. The standard variable home loan interest rate over the past 20 years by way of comparison has averaged 5.64%.
Home owners incur a number of expenses that renters don’t. These include rates, maintenance, strata levies, building insurance and the fixed proportion of water charges.

Over time, however, inflation helps push up all of the costs other than the amount the owner has spent to purchase the property, so that at some point the renter’s cash cost starts to exceed the owner’s cash cost.

Over long enough a time period, buying will work out cheaper.

This phenomenon, whereby an initially higher cost to buy is slowly whittled away by inflation, means that given a long enough time period, buying will work out cheaper. How long that period will be is the great unknown. As the famous economist John Maynard Keynes said, ‘In the long run we are all dead.’

In practice, buying delivers certainty and a bunch of intangible benefits. The question for you then should be, ‘is now the right time for me to buy certainty at the expense of flexibility, knowing it will cost me a little more right now?’

There are some circumstances where the fixed option will almost always be more expensive. For example, if you need to move homes in a short period (usually any period less than five years). Here the transaction costs and the increased expenses almost always outweigh the benefits of fixing the costs of housing.

On the other hand, over any long period (often 15 years or more) over the past 50 years, the fixed option worked out cheaper.

But what about the gain (or loss) in the value of the property?

In some ways this is somewhat academic, because the value of any alternative property is likely to have risen (or fallen) by the same amount, so the increase in wealth can never be realised for so long as you need somewhere to live.

Similarly, any loss can be deferred, so long as you can keep up your mortgage payments and don’t need to move.

The wealth effect, whereby we feel richer because the value of our homes has gone up, can also encourage us to spend more of our incomes. This can secretly whittle away much of the advantage.

Oh, and don’t forget we could have invested the difference in cash cost between renting and buying, which could be worth more or less than the increase in the value of the property.

There are other benefits

Nevertheless, home ownership creates discipline around saving, it provides a store of wealth that can be accessed, is favourably treated by our tax and welfare systems, and improves your credit rating, which can lead to lower borrowing costs in future.

Either way, the homeowner gets the benefit of fixed housing costs and all of the psychological benefits of home ownership. These should not be underestimated. Ultimately this is a very personal decision. In my view, the key is buying the right amount of house with a cost that allows you to sit tight through thick and thin (see the 50/30/20 rule for budgeting). Oh and don’t move for a long time!

So how do the numbers stack up?

I'll use the example of a home that rents for $556 a week and costs $850,353 which equates to a rental yield of 3.4%. In other words, you need to spend just over 29 times the current year’s rent to buy the property.

Two individuals each have savings of $203,411 which they choose to either buy the property or invest while continuing to rent.

The initial cost of purchasing the property consists of a deposit. Traditionally this has been 20% ($170,071) plus stamp duty of $33,340 (in NSW). The balance is funded by a mortgage of $680,282 (over thirty years at 5.64%).

A deposit need not be a full 20% as I discuss in my article How to buy your first home but it avoids the cost of Lender's Mortgage Insurance. I have used 20% because it simplifies th emodelling and doesn't change the overall conclusion.

Harriet Home Owner

Scenario #1: Harriet Homeowner chooses to buy the property using all of her savings.

Each month she pays principal and interest repayments on her loan of $3,923. She must also pay for maintenance (I assume a typical 1% of the property value per annum), or an initial $708 a month. This cost rises annually with inflation). And of course, there are council rates of $125 which also rise with inflation each year.

Her total monthly cost is, therefore, $4,756.

I have allowed for property selling costs of 5% of the sale value to pay for agent’s fees, marketing and legal fees and an allowance for minor repairs and staging costs when assessing the value of her property.

Rachael Renter

Scenario #2: Rachael Renter chooses to rent and invests her savings in an investment portfolio.

Rachael pays an initial $556 a week (or $2,416 a month) in rent. Each year the rent rises in line with historic wages growth of general consumer inflation (CPI) + 1%.

Making the comparison

I have assumed CPI is 2.5% annually, the mid-point of the RBA target range. This means rent rises at 4%. I have also assumed that property prices rise at the same rate, keeping the rental yield constant at 3.4%.

I chose the Vanguard High Growth Index Fund as a benchmark for the potential return on Rachael's investment portfolio not because I particularly recommend it, but because it invests in a broad range of assets and I have 20 years of historical data to look back on. This period includes both the GFC (2008) and the COVID-19 period, and so spans a good mixture of the good and the bad.

Over the 20 years since inception, this fund has delivered an average annual return (after fees, before taxes) of 8.11% (before tax, after fees), made up of 5.51% income distributed each year and 2.6% capital growth.

The split matters because the annual income return is taxed when received at Rachael’s marginal tax rate of 34.5% including Medicare. In contrast, she only pays tax on the capital return when she actually sells and will benefit from the capital gains tax discount, meaning she only pays tax on half her gain.

I have assumed that both Harriet Home Owner and Rachael Renter earn between $45,000 and $120,000 so that their marginal tax rate is 34.5%. As we will see later, this has a material impact on the outcome.

So how does our duo fare over time?

There are two ways to compare Rachel's and Harriet's financial position.

How much they spend each month
What the net value of their assets is at any time.

Cash Flow of Buying vs Renting

Rachael Renter's monthly cost (the teal line) is initially the lowest and she adds the difference to her savings. But as rent inflation increases her monthly outgoings, over time, the gap narrows and a crossover occurs where Rachael's monthly outgoings exceed Harriet's (the yellow line).

How long this takes depends on inflation and the relationship between the rental yield and the home loan interest rate.

In this example, though, it takes 21 years for Rachael’s monthly costs to exceed Harriet’s.

In almost any scenario you can construct, Harriet’s monthly costs will fall below Rachel's at some point given enough time. Moreover, at year thirty, Harriet's mortgage will be paid off and her monthly outgoings will dramatically fall.

Net Asset Position of buying vs renting

This comparison is a little more complex.

In order to equalise the cashflows, I assume that whoever has the lower monthly cashflows of the pair adds it to their savings.

Initially, Harriet is worse off because she had to pay the costs of buying her property (primarily stamp duty) and had to forgo the earnings on her savings used as their deposits.

Rachael can readily access her savings, but Harriet will need to meet the costs of selling, so this need to be deducted from the value of her property.

On the other hand, Rachael will need to pay Capital Gains Tax on her profits, Harriet will not. For Harriet, her higher monthly outgoings (which include principal repayments in her monthly loan repayment) in part reduce her debt to the bank, increasing her net assets.

Again, under most long enough scenarios, there will be a crossover point where Harriet will recoup her initial shortfall through debt reduction and property value growth while the tax due on Rachael’s investment growth reduces her profit. In this example, the crossover for Harriet also (coincidentally) takes 21 years. This period would be just 12 years if both were top rate tax payers (earning over $180,000).

Any time after this, Harriet's net assets will exceed Rachael’s.

After 30 years, when Harriet has paid off her mortgage, she is $696,000 better off than Rachael.

Lower inflation, lower rental yields, higher investment returns or higher mortgage rates would lengthen the time it takes to get the crossover period.

Moving Home too often can wipe out the benefit

The cost of moving house for home owners, is much more expensive than for those who rent. This cost includes stamp duty on the new purchase, agents fees and marketing costs for the sale of the old property, and usually some minor repairs and staging costs required to present the property in the best light and so maximise the sale proceeds.

The average Sydney homeowner moves every 12.3 years, so what impact does this have on the analysis?

I have analysed the case where Harriet moves house in years 5, 17 and 29. This mirrors the story of a young couple who buy a starter home. Five years later they have children and move to a larger property. As their children become teenagers they upgrade again (12 years later). Finally, they downsize when their kids leave home a further 12 years later.

For each move I have allowed for property selling costs of 3% of the sale value to pay for agent’s fees, marketing and legal fees and an allowance for minor repairs and staging costs when assessing the value of her property.

Harriet will also need to pay stamp duty on the new house purchase. For simplicity, I have assumed the price of the new home is the same as the old home at the time of the move (that is the additional space has been achieved by moving to a cheaper suburb).

This results in the breakeven period moving out to year 58. A long time for sure, but still within the life expectancy of at least one member of the average 36-year-old first home buyer couple.

If they both upgraded to a more expensive house, the breakeven periods would lengthen further.

Conclusion

Over most long enough periods buying your home will leave you better off than renting. But it’s not possible to predict ahead of time how long that period will be.

Moving home plays a big role in how long it will take to get ahead. A single move (say at year 5) will have only a minor impact, but regular moves accompanied by purchase of a much more expensive home will wipe out the benefit.

Home ownership is not just about the numbers for most people. Ownership comes with the security of tenure. You can’t be forced to move by a landlord. It also enables you to renovate and change your home to suit your needs. These things are important to our psyche.

Success with money is more about behaviour than maths. Few people who rent will have the discipline to consistently invest the difference in monthly cash flow in practice. A mortgage forces homeowners to save a portion of their repayments.

This does not mean that rent money is dead money. But if you know where you want to live long-term, it usually makes sense to buy rather than rent.

If you choose to rent, you need to save the difference and invest diligently not to be worse off than buying. Few people have the discipline to do this.

If you do buy, be careful how much you spend. Try to spend no more than 5-6 times your annual income.

And don’t be tempted to think that spending on home improvements is always an investment. Most such jobs do not add more than their cost to the value of your home. Do it if it gives you joy, but recognise it is a form of consumption, not a way to invest.

Seek advice from a mortgage broker and a financial planner (or better yet someone who is both) to see if buying a house is suitable for you will help ensure that you avoid any potential mishaps or buy the wrong house.

Whatever you do, don’t rush into buying just because your friends are doing it or your parents are badgering you.