Should I rent or buy my home?
Australian households collectively own $8.2 trillion of real estate. Smart money move or dangerous national obsession?
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.” Robert Kiyosaki
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 $31,207 for a $800,000 property in NSW. This is the equivalent of nine 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). Right now this can be as low as 3% in parts of Sydney. This means that a $800,000 property will usually rent for $500 a week or less.
- The standard variable home loan interest rate by way of comparison is around 3% right now – lower than it has been at any other time in the past 50 years and as a result closer to the cost of renting as it's ever been.
- 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 (usually 10 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.
Its not a one way bet
RPdata, a property researcher, tracks these things its ‘Pain and Gain Report’ series. The latest report shows that one in five resales are at a loss or a gain of less than 10%. These owners would have been financially better off renting. On the other hand four out of every five resales yielded a gain of 10% or more. The average hold period for those selling for a gain was eight to 13 years.
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 loan that rents for $500 a week and costs $812,500 which equates to a rental yield of 3.2%. In other words, you need to spend 31 times the current year’s rent to buy the property.
Three individuals have savings of $194,247 which they choose to either invest or use to buy the property.
The initial cost of purchasing the property consists of a 20% deposit ($162,500) plus stamp duty of $31,747 (in NSW). The balance is funded by a mortgage of $650,000 (over thirty years at 3.0%).
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 $2,740. She must also pay for maintenance (I assume a typical 1% of the property value per annum), or an initial $677 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, $3,542.
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.
Scenario #2: Rachael Renter chooses to rent and invests her savings in an investment portfolio.
Rachael pays an initial $500 a week (or $2,173 a month) in rent. Each year the rent rises in line with historic wages growth of general consumer inflation (CPI) + 1%.
I have assumed CPI is 3% annually, so this means rent rises at 4%. I have also assumed that property prices rise at the same rate, keeping the rental yield constant at 3.2%.
I chose the Vanguard High Growth Index Fund as a benchmark for the potential return because it invests in a diversified portfolio of assets at low cost, and I have a long history of returns available. Over the past 18 years since inception, the fund delivered an annual return of 8.42% (before tax, after fees), made up of 5.3% income distributed each year and 3.11% capital growth.
I have assumed that Rachael pays tax on the distribution each year (at her marginal tax rate of 34.5% including medicare) and reinvests the after-tax amount. The growth in the fund is taxed as a capital gain when finally sold.
Each month Rachael transfers to or withdraws from her investment an amount equal to the difference between the rent ($2,173 in the first year) and Harriet’s total ownership cost ($3,542 in the first year) to equalise their cashflow.
So how do our duo fare over time?
There are two ways to compare Rachel 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
Harriet’s monthly cost is initially higher and Rachel adds to her savings. But as rent inflation increases Rachel’s monthly outgoings, over time, the gap narrows and eventually, a crossover occurs where Harriet’s monthly outgoings become lower than Rachel’s.
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 16 years. Right now, with interest rates below the rental yield it is probably as long as it has ever been in history.
But in almost any scenario you can construct it will happen 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.
Initially, Harriet is much worse off because she has to pay the costs of buying her property (primarily stamp duty) and she has to forgo the earnings on her savings which she uses as her deposit.
Rachel can readily access her savings, but Harriet will need to meet the costs of selling her property, so these need to be deducted from the value of Harriet’s property.
On the other hand, Rachel will need to pay Capital Gains Tax on her profits, Harriet will not.
Each month until the crossover date, Rachel is adding to her investment the difference between Harriet’s higher outgoings and her lower rent.
For Harriet, some of her higher monthly outgoings reduce her debt to the bank, increasing her net assets.
Again under most long enough scenarios, there will be a crossover point where Harriet recoups her initial shortfall through debt reduction and property value growth while the tax due on Rachel’s investment growth reduces her advantage.
In this example, the crossover occurs at year seven. Any time after this, Harriet's net assets exceed Rachel’s.
Lower inflation, lower rental yields, higher investment returns or higher mortgage rates would lengthen the time it takes to get the crossover period.
Over most long enough periods buying your home will leave you better off than renting on a like for like basis. But it’s not possible to predict ahead of time how long that period will be.
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.
Either way, don’t rush into buying just because your friends are doing it or your parents are badgering you.