Buying vs Renting – You Don’t Need To Own To Be Happy
Photo by Jonnelle Yankovich on Unsplash
In this article, I’m going to talk about buying a home versus continually renting. There are scenarios when buying is the right choice and when renting and investing your money in the stock market is the best decision.
Here’s how this article is broken down:
- How homeownership has become harder to attain for younger generations
- Why talk about buying vs renting?
- What are the pros and cons of buying a home?
- What are the pros and cons of renting long term?
- What should you do? – The 5% Rule
A quick note, I’m going to focus on the state of California and Michigan. I will use median household income numbers from a white household for the given year (for Hispanic and African American households, the median household incomes are lower).
How homeownership has become harder to attain for younger generations
If you’re a Millennial or younger, you may have been told if you go to college and work hard, you can eventually afford a nice home, have 2-3 kids, and have a nice backyard. This ideal has long been presented as the “American Dream” and the benchmark of success. With rising home costs and stagnating wages, however, this “American Dream” is no longer attainable for many younger adults.
Going back in time, a Baby Boomer born in the 1960s could expect a median home price in California of around $193,000 in the 1990s. The median household income in 1990 was $54,000, which means that if you were in your 30s in the 1990s and had an average education, which was just a high school diploma, and earned an average income, the price of a home would be 3.5 times your income.
Fast forward to today, the median home price in California is $700,000 and the median household income is around $78,000. The cost of a home just jumped from 3 times your yearly household income to almost 10 times! Now let’s say that both you and your spouse have advanced graduate degrees; if we ignore the gender pay gap your household income is now $130,000. Even with this level of income, the median home price is still 5.38 times your income. If we factor in a buying home in a good neighborhood with enough space for children, as well as debt from college tuitions, the prospect of owning a home becomes bleaker for younger adults. But if we think we Millenials have it bad, the future may hold worse situations for the generations to come.
Why talk about buying vs renting?
Despite younger adults being in a worse situation to buy a home, there is still a huge push to encourage people that buying a home is always the right decision. There are perpetual interests from real estate brokers and agents, banks, furniture stores, and other capitalist forces that try to persuade us that we need a home, but before deciding to purchase it’s important to objectively look at the two options, buying and renting, relative to your personal and financial situation.
The pros and cons of buying a home
Based on my experience as a homeowner, here’s a quick summary of the pros and cons of owning your own primary residence.
Pros
- More Space
- Depending on where you decide to live (large city, suburbs, or rural suburbs) you can get a lot more space for your money. This can be especially great if you have a large family and have multiple dogs. ($800,000 will get you a small 1-2 bedroom condo in California’s Bay Area, but you can get a 4-5 bedroom house in a good school district with an acre or two in your backyard for the same price in Michigan)
- Your money is leveraged
- This means that for every percent return in your property value, you get 5 times the return on your initial investment. When buying a primary residence property, you only need to put 20% down and the other 80% is given to you by a bank in the form of a mortgage. If your home is priced at $400K and you purchased it with an initial investment of $80k (20% down) when it goes up 10% to $440k your effective rate of return is 50% because you made 40K profit from an 80K initial investment
- Tax Benefits
- One of my favorite tax benefits of owning a home is if you have any appreciation for your primary residence, you don’t have to pay any taxes on the profits up to $250,000 for individuals and $500,000 for married couples.
- You can also deduct any mortgage interest for the first $750,000 of your loan. This will help reduce the income taxes you need to pay.
- Long Term Benefits
- If you plan to live in a city/state for a long time, once your house is paid off you won’t have to worry about paying for housing when you retire – this will leave more retirement income to spend on non-housing expenses.
- You can leave your home to your kids and help them not worry about home costs. In a world where things are getting more expensive every year, it’s great to help give your kids a better start than what you had.
Cons
- You will have to pay for all maintenance and repairs on your home, thus adding another expense to your yearly budget. Averaged over time, home upkeep and maintenance can run anywhere between 1-3% of your home’s price each year. From personal experience, you will have some years with high-cost repairs/upgrades, but most years will be smaller maintenance.
- If you live in a condo and have homeowner association (HOA) fees, this is money you pay every month that doesn’t go into building equity.
- The combined cost of maintenance, upkeep, HOA fees, property tax, home insurance, and mortgage principal and interest, may eat into a large percentage of your monthly savings, which you could have used to invest in the stock market for a higher rate of return on your money.
The pros and cons of renting
Before I purchased my own home, I had my ups and downs with renting. Here’s what I think are the pros and cons of renting
Pros
- You don’t have to worry about repairs
- If you have roommates or the rent costs are low, it can be very economical to rent and you could potentially save more money each month to invest
- You can live in a nicer neighborhood, or a better school district, for lower costs
- If you’re unsure of where to live long term, it’s easier to move from place to place when renting
Cons
- You’re not building equity. If you’re renting in an expensive area you’re throwing money away every month. When you buy a home, a portion of your housing expense is preserved in the equity of the home.
- Your roommates, or even other tenants who share a wall, could be annoying
- The management company may not be responsive to dealing with complaints or issues.
- You can’t upgrade or modify the space to your liking. For example, you won’t be able to remove a wall to open up more space for your kitchen, put in wood floors, or even change the paint colors.
What should you do?
The financial break-even point for when it’s better to buy a home rather than rent depends on factors such as:
- Cost of rent and rate of rent increase
- Mortgage rates and the cost of the home
- The stock market rate of return
- How long you plan on living in a purchased home
- Home appreciation rate
- Home maintenance costs
It is difficult to predict long-term market and property returns. In the past 10 years we’ve had an incredible bull market with the NASDAQ returning 13-15% average yearly returns, however, it’s difficult to conclude whether this return will continue forward 10, 15, or 20 years from now. Likewise, it’s also difficult to predict whether home prices will continue to have returns that parallel the S&P 500 or NASDAQ.
A very simple rule for determining whether you should continue to rent is the 5% rule explained in this very helpful video by Ben Felix. Essentially, the reason why you should rent over buying is that you can invest in the “unrecoverable costs”, such as interest, property tax, and maintenance in the stock market. The difference between market return and the home equity return after factoring in inflation, market growth rate, home equity growth rate, inflation, taxes, and home maintenance costs is around 4-5%. If you take the price of a home, multiply by 4% or 5%, then divide by 12 then that would give you a rough idea of the breakeven rent price.
| Home Price | Break-Even Rent Using 4% Rule | Break-Even Rent Using 5% Rule |
| $300,000 | $1,000 | $1,250 |
| $500,000 | $1,667 | $2,083 |
| $750,000 | $2,500 | $3,125 |
| $1,000,000 | $3,333 | $4,167 |
| $1,500,000 | $5,000 | $6,250 |
If you have a very aggressive portfolio, I would recommend using the 5% rule. If you have a more conservative portfolio I would use the 4% rule. Going off the 4% rule, if you’re considering a $1,000,000 home and you can rent a similar place for less than $3,333 then it’s better to continue renting.
At the end of the day, the decision to buy a home or rent is yours and it may depend on more than just the financials. I urge you to keep an open mind about both options, renting and buying, and weigh all the factors yourself before making a decision. Don’t feel pressured to buy a home, but don’t put it completely out of consideration. Create your own pro and con list and use the calculator to see what makes more sense financially.