The Eternal Question: Rent or Buy?

The following is an excerpt from Your Money: The Missing Manual , an excellent book written by JD Roth from Get Rich Slowly. Copyright 2010 O'Reilly Media, Inc. All rights reserved. Used with permission.

Deciding whether to rent or buy is a complicated financial and emotional decision. Real-estate agents like to say, "Renting is like throwing your money away." On its surface, this advice seems to make sense, so it gets repeated a lot in popular culture. But in a 2008 issue of Newsweek, Robert Shiller, a professor of economics at Yale University, wrote, "The popular argument that renting is equivalent to throwing money down the drain is really fallacious."

In some cases, it does make financial sense to buy a home. But in other situations, renting is the better choice. And often, there's not a lot of difference between the two, especially if you're smart and keep costs low. The decision usually comes down to personal preference. Let's take a brief look at the pros and cons of each.

Here are the advantages of owning your home:

• Stability. When you take out a mortgage, you know what your payments will be for years to come. There's no landlord to change the rules, and you don't need to worry about being kicked out at a moment's notice.

• Equity. As you make your mortgage payments, and as the property's value increases, you build equity, which is the difference between what you owe on your house and what you could sell it for. In other words, it's how much value you have stored in your home. For example, if your house is worth $225,000 and you owe $175,000, you've got $50,000 in equity.

• Freedom. You can do what you want with your home and yard, like plant a garden, paint the ceiling purple, or install a wet bar in the basement.

On the other hand, the advantages of renting include:

• Flexibility. With a rental, you don't have a long-term commitment. You can move on short notice, whether to get away from bad neighbors or to take advantage of lower rents elsewhere. There's also a wider range of rental options than homes for sale. It's difficult to buy a tiny house, for example, but you can easily find one- or two-room rentals.

• Lower costs. In the June 2007 issue of Kiplinger's Personal Finance, editor Knight Kiplinger wrote, "It often costs less to rent. The annual cost of owning a property, be it a house or a condo, is usually greater than the cost of renting, after taxes." True, you don't build equity when you rent, but you're not burdened with taxes, insurance, and maintenance costs either. You can use the money you save to travel or buy stocks.

• Lack of responsibility. When you rent, somebody else does the yard work and repairs the leaky showerhead. (Of course, this can be a disadvantage if your landlord is slow to respond to problems.) All you do is stick to the terms of your lease or rental agreement and someone else takes care of the rest.

Both sides of the rent vs. buy argument can trot out numbers and statistics to prove why they're right and the other side is wrong. The bottom line is that the decision isn't just a financial one, so it's hard to generalize. Yes, renting can save you money and it comes with far fewer hassles than owning. But owning your home can give you non-financial benefits.

The best way to decide is to think about your goals and figure out what makes sense for you. Ask yourself these questions:

• How long will you stay in one place? The longer you plan to stay put, the more sense it makes to buy a home. Buying lets you recover your costs and build equity.

• How do costs compare? Find a good rent-vs.-buy calculator and crunch the numbers. The New York Times has a nifty web-based calculator that can help you compare costs for renting vs. owning. The site lets you plug in numbers for your situation, and then shows you how long it would take to break even with buying.

• How would you spend the savings? When renting is cheaper, you can use the money you save to pursue other goals. Sure, you could spend the cash on purses and videogames, but you'll be better off in the long run if you use it to fund your retirement (see Chapter 13), budget for a new car—or even save for a down payment on a house.

• How do you feel about homeownership? For some, owning a home is a piece of the American Dream. For others, the chores and maintenance are a nightmare. Your feelings about homeownership are just as important as the financial stuff.

Note: Here's an excellent article from the New York Times that explains why the author—a long-time renter—decided to buy a home. It does a good job of laying out the pros and cons of each choice.

If you decide to buy, do it for the right reasons: because it fits your goals and will make you happy. Don't do it because you think it's a good investment. A mortgage is not a retirement plan—it won't make you rich. Instead, think of it as an investment in a certain lifestyle. If homeownership is a lifestyle you want and can afford, then buy; if not, rent.

Comments

[Manny]

This is why a thorough thought process should always be practiced when finally deciding to purchase a home. It is not simply a financial decision as others would like to think.

For people who say that owning a home is a good investment, better think again. I guess the recent turmoil in the real estate market just proved this point.

[bubbajoe]

one thing left out of the article is true home ownership.
no mortgage.
owning a home with no mortgage does wonders for your cash flow.
with renting there is zero chance you can get to
a zero monthly residence cost (with home ownership
there are still property taxes and home owners
insurance)

[KH]

I rented for years and years before I bought a house.

My main problems with renting are the low quality/maintenance of rental properties and the fact that most of them are located in bad areas with lousy neighbors.

[Eugene Krabs]

Heh. If I didn't know better, FMF, I would say you actually make a point to bring out powder-keg issues. :D But that's a good thing and this is a good one to chew on.

I don't have much to add though. I think this is a pretty good entry that summarizes the pros and cons of the issue. The bottom line is that it's far from clear cut, and often times comes down to crunching the numbers

[sasper]

KH -- I agree with the typical low quality & maintenance issues with rental properties, but it really depends on the rental market you are living in. Here in Chicago, you can find top of the line rentals in the best parts of the city. Sure, you're paying more than a typical mortgage per month, but they're still available if you don't want to be tied down to one area with a purchase.

All of my rentals in the city have been in incredible neighborhoods with great neighbors. There would be no other way I could afford to purchase a house or condo in these areas. Entry costs are greater than $350,000 for a condo to start! Instead, I rent the worst apartment/house in the neighborhood, and have room mates, so I end up spending $400/month in rent!

[Tyler]

The New York Times has a great 'buy vs rent' chart with a number of variables that can be adjusted. The bottom line: without major appreciation above inflation, renting tends to be a better financial choice. (Home ownership is rarely as simple as a financial choice.) Play with the numbers ... its fun!

http://www.nytimes.com/interactive/business/buy-rent-calculator.html

(google New York Times Buy vs Rent if the link doesnt work)

[Jackie]

Like just about everything, the answer to the rent vs buy question is a resounding "It depends".

When I bought my first place, buying (even with HOA fees, taxes, insurance, etc.) was less than renting, so it was a no brainer. Now though it might be a toss up in this area. In a HCOL area you're often better off renting, especially if it's an area that is also prone to disasters. Then there are the emotional factors...

Our plan at the moment is to get our current house paid off in the next couple of years, and then to possibly rent a summer home elsewhere. Or maybe rent permanently elsewhere, while renting our current house out.

[wanzman]

FMF - here is a situation I am currently in that relates to the question at hand...might make a good follow up "ask the readers post".

My wife and I currently own a home (have for about 3 years). The market where we live, and particularly in our neighborhood, is currently strong. We both really like our house, but since we are young, and its just the 2 of us, sometimes we wish we lived in a different area (downtown), and sometimes the responsibility of taking care of this place weighs on us (we are 25 and 24). It is also a little more space than we currently need.

We have dreams of owning our own business in the near future, and would like to save as much money as possible to make that a reality in 3-5 years.

We are considering selling our house, and renting something in a more trendy, enjoyable part of our city with more recreational opportunites. This will allow us to do the following:

1. Obviously, our mortgage will be paid off, since the house is sold.
2. Proceeds from the sale could retire all our other non mortgage debt, plus give us additional savings.
3. We'd have excess cash flow of about $2,000 per month, which would all be thrown into savings for a future business purchase.
4. We would have more flexibility to pursue business opportunities outside our immediate area, as the house is the main thing currently tying us down. Would also give us the freedom to relocated closer to family if a good opportunity came up.

We would have a chance to be completely debt free with about $100,000 in the bank within 4 years, with freedom to pursue opportunities for owning our own business.

What should we do?

[FMF]

wanzman --

I think it will. I'll post it next week for all to see and comment on.

[Bad_Brad]

Well, someone might look at my $3000 mortgage and assume that the "cost" of owning my home is $3000. In reality, about $2000 of that is interest, and given that I'm at the 25% marginal tax bracket, that's a $500 federal tax savings right there (would be more than that if my state also had a state income tax). Also, about $300 of it goes to pay my property taxes via escrow, so there's another $75 federal income tax savings. And about $600 of it goes to equity which in the long-term is wealth and therefore not a true cost in my book. So the real cost of the mortgage is about $1825. And it goes down over time, because my marginal income tax rate has and will continue to go up, and because the amount of my payment that knocks down the principal and becomes equity will continue to go up.

Now, some will say, "Yeah, but think of all the repair costs, etc, associated with owning a house. True enough, those are significant. But take a look at a typical renter's contract any more. How much of that stuff does a landlord really cover these days? My last rental contract included a provision that I had to pay 100% of any routine maintenance costs up to $500 and 50% of any routine maintenance costs after that. "Routine maintenance" was also very broadly defined. I basically paid for a new hot water heater and a new in-sink disposal for my landlord during the two years that I rented from him.

As a homeowner you also have the freedom to do whatever you want with your home. As a renter, I needed an act of Congress to poke holes in the wall to hang pictures. The landlord also was free to nickel and dime me for things. After my first six month contract was up, the next contract included a $50 per month fee for each of my two cats. The next contract six months after that added an $80 per month charge for my parking space ($150 if I wanted covered parking, which you definitely want where I live).

You are also at risk as a renter of your landlord deciding he/she does not want that property any longer. Once it is sold, you can be kicked out of the place you call home just because someone else wants it.

Renting is overrated.

[Budgeting in the Fun Stuff]

I think renting vs buying depends a bunch on location. In Houston, you can easily get a mortgage payment that is the same or less than renting.

If we had gotten a 30 year mortgage, our payments would have been $520 a month. We were paying $730 in rent that was going up 5-10% every year.

We ended up with a 15 year mortgage with $740 monthly payments. We spend an extra $2200 a year for property taxes, $800 a year for homeowner's insurance, and less than $300 in repairs over the last 3 years. I'd say that it's been more than worth it for us.

If we lived somewhere way more expensive or we moved every couple of years, I'd still want to rent.

[Troy]

I can't stand the position that "renting is cheaper than buying"

No it isn't. Ever. on comparible properties

Renting a smaller, or less desirable place may be cheaper, and of course many rentals are apartments, small homes, etc and that tends to skew the numbers.

But take two identical homes. Both (at the same time) valued and sold at $200K. one to an owner occupied, one to an investor to rent. The renter will pay more. Why? Common sense. Someone has to own the rental, and that landlord likes profit. They also paid $200K for it...just like the "buyer"

The landlord, regardless of how he acuired the funds, through a loan or through assets rents at market. And market is always more than ownership, otherwise no one would ever own rentals.

Why would someone buy or own a rental if they couldn't obtain market rent? They wouldn't They have a profit motive, aside for the tax breaks.

Remember, every home is owned by someone. Sometimes the occupant, sometimes not. But all properties are owned. Because owning is always cheaper.

Now renting is many times the better decision. But not because it is "cheaper"

[LotharBot]

"Rent" actually does include taxes-maintenance-insurance costs, they're just hidden under the hood. After all, your landlord has to pay those things, and they get the money to do it from you.

People make the mistake of comparing "rent" to "mortgage payment" and then adding taxes, maintenance, and insurance on top. The right thing to do is to compare "total costs" to "total costs", including rent/mortgage payment, insurance, taxes, maintenance, extra fees, packaged utilities, and anything else you can think of.

[Mark]

@Troy: I almost agree with you except for a couple of points.
1. Market rent may NOT be profitable for the landlord - at least in the short term.

First, simple over-supply may drive rents down.

Second - many individual landlords don't know how to calculate their costs correctly. I have often heard people proudly state that the rent covers their mortgage! Even if they do try to factor in maintenance, they under-estimate it, especially long-term or one-off items like a new roof. And if the place is partly paid-off, they don't factor in the return they could get on thier money if it was in some other investment. If these people are your competition, and are happily renting at below-cost rates, you are forced to follow.

I just ran the numbers on a condo comples where the units sell for almost exactly $100K, property tax is over $2K per year, and HOA is over $300 per month. Rents are typically $1000 per month - $12K per year. If we assume a fair rate of return on investment is 5% (approx. cost of a mortgage, or approx return on investment os similar risk), then they should expect $5K per year for cost of money. These costs total $10,600 ($5K + $2K + $3.6K). I assume they also pay some insurance (say $400 per year), so their excess return is less than $1000 per year, out of which they have to cover all maintenance, vacant months (yes - tenants sometimes move out), plus any marketing or other costs.

In this scenario, the hassle associated with being a landlord can only be justified if you anticipate price appreciation.

2. Economy of scale: Often, a landlord can get a better price for maintenance costs, etc. (I'm talking about large-scale landlords - let's say 100 apartments.) For example, how much does he pay PER UNIT for landscaping, pool service, roof-replacement, etc.

Not a strictly economic cost by your definition - the opportunity cost of ownership: Real estate transaction costs are pretty high, so once you buy, you are pretty committed to stay for a while. You are giving up the posisbility of moving easily.

In case you think I am a spoilsport: I own the home I live in, and I now also own a condo I rent out. It sounds really cool to quote the REVENUE from the condo, but the PROFIT is not so impressive.

[jim]

Brad said : "My last rental contract included a provision that I had to pay 100% of any routine maintenance costs up to $500 and 50% of any routine maintenance costs after that."

I've never heard of such a provision in a rental lease. Are those really common where you live? What area of the country is that? I'm a bit surprised that renters would accept such terms.

[Budgeting in the Fun Stuff]

I also would like to know where Brad lives...a rental contract like that would not fly here. It takes forever to get things fixed when you rent, but it isn't on the renter's dime either.

[Troy]

Mark:

I agree about oversupply, but generally that short term situation evens itself out. If too many rentals exist, some of them will go for sale...to buyers who may turn them into other rentals or occupy.

And regarding the Condo examply my guess is the majority of the profit is in the tax breaks. Depreciation is a large part of that ($3500).

I am all for renting if the situation demands it. Short term. Uncertain. going to college, or whatever. There are lots of reasons. But being less expensive on average isn't one of them.

[Mark]

Troy: The tax breaks help in the short term, but people don't understand the long-term implications. If you sell, you pay tax on the profit, and the claimed depreciation over the years has reduced the tax basis, so you pay tax on all that. So you have shifted the tax to the future, with all the risk and uncertainty that entails.

I have talked to too many landlords who simply don't know their own true costs.

[Tyler]

Bad_Brad-

So lets say your loan payment is $1,825 (as you stated this is only debt service not principle) which means your debt when purchased was about $340,000. (assumes 5% 30 yr fixed) I live in a top 25 city by population that has been one of the lest affected by the economic crisis, and I promise you I can rent a place that would cost 350k for a lot less than your debt payment. Since getting your true mortgage debt requires me to add back the $600 principle you claim isn’t a cost, the real debt is $452,000- I get to use that $600 per month to purchase stocks, bonds, etc so I too earn a rate of return with a liquidity kicker.

Most places, even with the correction in housing prices, still do not cash flow positive when compared to their ability to receive rental income. Most cities, when comparing rental rates to ownership costs do not currently have an advantageous ratio. This changes all the time.

Use craigslist in your city to see what people are asking for rent and compare that to the estimated cost of the home. I think you’ll find that most homes would not cash flow positive if you purchased them today. If this weren’t true, I’d own a lot more real estate.

I currently rent my primary residence. There are a number of reasons for this decision that aren’t worth going into, but one of them, is that for now, it is cheaper to rent in my city than it is to buy. When this changes, I too will consider changing. Oh, and I’ve made all kinds of changes to my apartment… should the land lord have an issue, they can keep my deposit.

Troy-

Your logic is so flawed. There are a ton of people who own rental properties that don’t cash flow positive when assessing all the costs. They assume their upside is when the property value appreciates. Owning something doesn’t mean you make money off it and the purchaser is not always rational or intelligent. Play with the chart I posted earlier and you will find owning is not always cheaper.

A number of publically traded REITs have lost money… that means rents are less than their cost of ownership.

Type ‘Price to Rent Ratio’ into google and you will find home prices (purchase) in most cities are way about the historical relationships to rental income. This means rents are very low and or prices are still very high. Reversion to the mean tells us one of these will eventually change. But for now, renting, on a historical basis, is cheap.

As stated above, I can rent comparables for far less than it would cost to purchase them… and although I have zero appreciation up side, I also have zero down side.

Tax breaks- congratulations, you just paid 2k in interest to get a $500 tax break- quoting this as an advantaging is so incredibly silly. Mark is correct (unless you are rolling the capital gains into another home, which most ‘non investors’ are doing. Still a future tax delay.)

[Troy]

Tyler.

My logic is not flawed. Your assumptions are.

If a rental property does not cash flow...which is very possible, it is becasue the debt service exceeds the cash flow. That is because the debt was obtained BEFORE the market rent adjustment. That is not what this argument is about.

My example was two properties purchase vs rented at the exact same time. I know REIT's have lost money. Because they bought properties when market rents, and therefore prices were higher.

This discussion isn't about REIT's, or previously purchased investment property compared to current market rents.

It is about current rent or current buy. And I am right because it is simple economics. The houses that used to be $300K that you are using are now worth $200K which is what I am using. Just because an invester bought high, and is now losing money on current rents does not justify your argument. Becasue this argument isn't about being a landlord. It is about not being a tenant.

My point always has been that renting is never cheaper than owning over time because someone has to own the rental, and if renting was cheaper, no one would own rentals. The business would fold upon itself becaue there would be no profit. But it doesn't and we both know why. Because investment properties are profitable. I wonder why?

And as far as tax breaks...I didn't pay 2K in interest...my tenant did. And when I sell, I 1031 into a new investment property. I'll take the appreciation and roll it forward into LTCG.

[kitty]

@Troy "I can't stand the position that "renting is cheaper than buying"
No it isn't. Ever. on comparible properties"

I'd accept this with one exception. The renting may be cheaper during housing bubbles. In fact, the fact that renting equivalent(!) property is cheaper is the best indicator that real estate market is overvalued. This was the situation in many areas during this bubble.

[StL Pastor]

I think Kitty has it right-
In a rational market, Troy is correct-owning is better than renting. However, if you run the numbers, and renting is clearly cheaper in your situation, then the market isn't rational (most likely, it is presuming returns on housing well above inflation which are unsustainable), and you need to wait to buy until the bubble bursts.

[Tyler]

If I can rent a 250k home for $1100 per month with rent going up at the same rate as inflation and property values going up at the same rate as inflation, and earning less than historical market returns (5%), it is never better to own. regardless of debt or cash flows.

There have been very long periods of time throughout history where renting was a far better choice than buying.

Ive made zero assumptions. Purchasing today, at the ask, in most cities, is not better than renting from a purely financial position.

You have stated that it is "NEVER" better to rent because there wouldnt be any reason to buy a home if it was cheaper to rent. This is factually wrong and makes a number of assumptions.

People dont rent at what the purchaser wants, they rent at the market rate. If a buyer today bought a place and expects to rent it at 1k, but can only rent it for 750, then regardless of what he paid, that's what the market wants to rent the property for.

You make the bold assumption that a buyer knows exactly what the market rent will be, and will not purchase a property unless it makes sense from a pure rental perspective. The rental market is not 'always' more than owning. Get out of your vacuum and look at the real world.

Your arguments apply to any asset class/market. 'There's no reason to buy IBM because its properly valued at this price.' Renting is a way to sell short home ownership- ie homes cost more than their value. Someday, it will be far better to own than to rent.

I think you in particular would benefit by playing with the rent vs buy chart from the NYT. It can show you scenarios where it doesn't make sense to buy a home and is better to rent. Those scenarios have existed in the past and will likely exist at times in the future. Of all the markets to believe in efficiency, this housing market is probably the worst. (Emotional purchase, low volume, poor comps, high transaction costs, variable maintenance costs, high govt intervention/price fixing, etc)