Rent-vs-Buy in a Total Cost and Total Risk Context

The decision to rent or buy a home is much more than just a financial decision.  After all, a home is not just a monetary investment but could be an investment in time or the future.  For example, someone may want to rent for the convenience and time-savings of not having to deal with maintenance or upkeep of a home.  On the other hand, another may decide to buy for the purpose of settling down and giving their children a stable environment to grow up in.  These types of decisions are highly personal, but the financials of rent-vs-buy can be effectively generalized and explored for a greater audience. 

When considering the financial part of the decision to buy a home, one must consider all the associated costs (including opportunity cost).  The cost of renting includes the rent, insurance, and utilities.  However, the cost of owning a home includes the following:

1. Initial purchase costs including: down payment, closing costs, agent fees, etc.
2. Recurring costs including: mortgage payment, HOA fees, insurance, taxes, utilities. 
3. Opportunity cost of the down payment + closing costs, etc.

Let’s take a closer look at the financials of rent-vs-buy in three comparison scenarios:

Scenario 1: Median House in USA vs Apartment

Let’s say that you want to purchase a $300k 3BR/2BA house with a $60k down payment to avoid paying PMI.  (According to zillow.com, in 2020 the median home price listing in the US is $282k.) The alternative is a 1 bedroom apartment for $1k per month in rent and $100/month in utilities and renter’s insurance.  A 30 year fixed mortgage payment on the $300k house with a 3% interest rate is about $1k per month.  Assume that HOA fees are $100/month, taxes are $200/month, insurance $100/month, and utilities $150/month.

So the total recurring cost of renting at the present time is $1100/month, while the purchased home will cost a total of $1550/month.  All of these recurring costs increase with inflation except for the mortgage payment.  Let’s look at the costs over time, say 30 years:

Rent, assuming a 2 percent inflation rate will cost a total of $535k nominally, and buying will cost a total of $696k nominally assuming 3% of the purchase price for closing costs and agent fees and the same 2% inflation rate.  Of course, the house looks to be the better deal here since after 30 years you now own the home free and clear and it is likely worth much more than $300,000.  In fact, at a 2% inflation rate it will be worth $543k after 30 years, making the home purchase look much more attractive than renting.  However, we still need to evaluate the opportunity cost of buying the home.  This amount is the $60k down payment (plus closing costs and agent fees, etc.) that could otherwise have been invested in the stock market at say, an 8% interest rate.  This will be worth some $600k after 30 years.  So at the end of 30 years, the renter’s net worth is $600k, while the home buyer’s net worth is only $543k, and the home buyer spent $696k to the renter’s $535k spent.  So in both cost and net worth, the renter came out ahead.  To be fair, this is just one example, and it really depends on the relative difference between the appreciation of housing prices vs. equity returns.  Historically, the stock market has returned 7% real (10% nominal) whereas real estate has more or less tracked overall inflation (CPI).       

Scenario 2: Apples to apples comparison rent vs buy in higher cost of living area

Consider a $460k house purchase vs renting the same house for $2200 a month.  Not including utilities, the monthly recurring cost of renting and buying is the same $2200.  For the buy option, this includes a $1530/month mortgage payment with a $90k down payment, $420/month in taxes, $150/month insurance, and $100/month HOA.  For the same 2% inflation applied to everything but the mortgage payment, the house will cost a total of $890,000 (unrecoverable, so not including down payment) and renting will cost a total of $1,070,000 (unrecoverable) over 30 years.  The value of the house after 30 years is $833k. The $90k down payment is worth $905k investing in equities for the renter.  In this scenario, the home buyer will come out slightly ahead after 30 years.  

After the mortgage is paid off in 30 years, the home buyer will drop the $1530 mortgage recurring cost, significantly reducing expenses compared to the renter.  However, the home buyer now has $800k in home equity, whereas the renter has $905k in stock investments.  Since we know that home appreciation is roughly consistent with inflation (about 2%) and stocks have returned about 10% nominally over the past 100 years, we can expect that the renter’s net worth will increase a net of 8% more than the home buyer (or $72k per year). The renter’s $72k per year extra income will help offset the $18k per year in savings for the home buyer with a paid off mortgage, even considering that the renting cost has inflated to $4400 a month after 30 years. 

Scenario 3:  Minimum downpayment higher cost of living area

The 20% down payment on a $460k house in Scenario 2 was at least $90k which is a grand sum of cash to come up with to purchase such a home.  As a result, many home buyers opt for a 10% down payment or even the minimum of 3.5%. For our example $460k house, this would be a $16k down payment.  Typically, if 20% is not put down on a home, mortgage insurance is required which can cost about 1% of the total cost of the loan per year.  This comes out to an extra $370 a month in PMI added onto the $2900 a month for the mortgage, taxes and insurance on 3.5% down.  This total monthly payment is about $1000 more per month than the payment in example 2. PMI is only an added cost for the first 8 years because, with a 30 year mortgage amortization, it takes about 8 years to get to 20% equity needed to call the bank to drop PMI.  In this scenario, the total unrecoverable cost of the house over 30 years is $1,200,000 while the rent total cost is still 1,070,000 assuming the 2 percent inflation rate across the board.  The other big difference from Scenario 2 is that the down payment is only $16k which the renter would have invested and grew to $160k over 30 years invested in equities. Compare this to the $833k value of the house after 30 years.  We can see that the buyer has $670k in higher net worth than the renter and only had to pay an extra $130k over 30 years.  

This is an example of the wealth creation power of highly leveraged investment with inflation.  The homebuyer only put down 3.5% on a total home value that is increasing at a 2% inflation rate, effectively generating a 65% return on investment.        

Risks of Renting and Buying     

We can play this game of long-term inflation assumptions and stock market returns all day but “past performance is no guarantee of future returns,” as the saying goes.  We need to look at this rent vs buy discussion in the context of risk.  From a financial standpoint, the principal risk of buying a home with a 20% down payment is the 5x leveraged investment.  In other words, if the house price increases by 2% a year, the down payment cash-on-cash return will be 10%.  However this process also works in reverse in a housing downturn where the cash on cash return for 2% decrease is a 10% loss on the down payment.  If the downturn is extreme enough (2008 mortgage crisis) homeowners can end up “under water” where they have a house that is worth less than they owe on it and the down payment (equity) is completely wiped out.  In this scenario, the homeowner may not be able to sell without risk of foreclosure.  

In the renting scenario, there is no leverage risk multiplier (unless you trade on margin) and the down payment can otherwise be invested in a well diversified index fund, lowering the risk further.  All of your eggs are not in one basket in the sense that all of your money is not in one thing (a house) in one neighborhood in one small geographic market.  Neighborhood values can rise and fall with available jobs, new local laws, zoning, and other external factors.  A stock index fund is invested in the broad market that is insulated against local downturns whereas a house investment cannot be protected from these downturns.      

Maintenance Costs of buying a home

The cost of maintenance for the home was not considered in the above scenarios.  Most estimates are that the recurring cost of maintenance for a home is about 1-2% per year of the home value, not including the potential time that you spend on maintenance.  This was not included due to the high variability of maintenance costs arising from factors such as age of the home, handiness of the homeowner, and home type.  For a real home purchase decision, maintenance costs should always be considered as they can often be high both money-wise and time-wise.    

So should I rent or buy?

There is no easy answer to the question of financial optimization of renting vs. buying, given the complicating unknown factors of time, interest rates, inflation, taxes, and long-term market performance.  One thing for sure is that renting is not simply throwing away money, as the financial implications are far more subtle.  Low down payments in strong long-term housing markets with low mortgage interest rates will undoubtedly favor the case for buying. On the other hand, expensive housing markets with relatively low rental costs during periods of high equity performance will surely present a compelling financial case for renting.  Lastly,  it is important to think beyond the financials and consider risks such as stock market volatility risks and leveraged investment risk in any rent vs buy comparison.