Buying a home is often the biggest financial commitment a person makes in their lifetime. Despite this, many people make the decision to purchase a house without the level of financial due diligence that should go in to a decision of this magnitude. Some even make the decision to buy with a strong emotional influence that flat out ignores logic.
I want to preface this by saying that The New York Times Rent or Buy calculator is by far the best I’ve seen. It’s comprehensive in that it builds in a lot of variables that go along with choosing to own a home or rent. Definitely check it out for an indication of what might be best for you.
Like all calculators however, it neglects one thing- the level of risk one is willing to tolerate. A term known as ‘Risk Appetite’.
I will explore risk appetite and what might be the right level for you in another post, however suffice to say for now that stems from the idea that every investment carries a risk. That risk is based on the uncertainty of future conditions.
There are two primary risks related to owning your own home:
1.) The risk that the market value of your home will decrease
2.) The risk that the costs to service your mortgage increase. This is primarily driven (but not limited to) your interest rate.
There are many factors that influence the rent vs. buy decision; however these two considerations are the most significant in making the correct choice.
Mortgages are generally held for a term of around 30 years. Think of how the world has changed in the last ten years alone and then think about just how difficult it would be to predict what the market is going to do in the next few decades. We live in a time of generally low interest rates which usually follows a recession like the GFC, but who’s to say interests rates will stay this low for the next decade? In the late 2000’s it’s estimated that six million homes were foreclosed in the US alone. Who’s to say that a situation like this would not occur again?
This is something that no one can tell you, particularly not a calculator.
Your risk appetite is a personal decision you make based on your ability to tolerate a given level of risk. The appropriate appetite depends on a lot of variables, however typically someone without a lot of resources to absorb any downturn in market values, or rise in interest rates should have a low risk appetite, for example:
- Someone with an unsecure or unsteady income
- Someone who doesn’t intend to be in the workforce or earning money for much longer
- Someone with a very low emergency fund or no support from others such as family
This isn’t to say that people matching this description shouldn’t be buying a house, just that they should consider what would happen if things went wrong. The ability to ride out the ups and downs in market conditions is critical to making any sound investment decision.
Which is “best” renting or buying?
In order to answer this question, we need to understand what “best” means. In accounting, there are five separate buckets that everything can be classified into. These are:
These are summarised and put in the context of homeownership/renting in the following diagram:
The first thing that you might notice is that renting only appears in one of these classifications. Understanding how much it will cost to rent over a period of time is a very straightforward calculation; you simply add the expense over the applicable period.
Homeownership on the other hand, appears in all five classifications and is not straightforward to evaluate. An asset is the physical home itself. If the market value falls or increases, you will have an expense or income equal to the amount between your purchase price and the current value. When I say ‘Expense’ and ‘Income’, I don’t mean that there will be any immediate movement in your bank account as these types of gains and losses are known as “unrealised”. Unrealised gains and losses will only be ‘realised’ when the home is actually sold and the gained or lost value is translated into the amount you receive on the sale.
The liability is of course the resulting mortgage that comes from obtaining finance to purchase a house as it represents future outgoings of cash. Every time you make a mortgage payment you pay an amount of principal (the original value of the loan, representing the cost price of the house) and interest (the expense charged by the bank for providing the loan). The interest rate is charged as a percentage of the loan balance and therefore in the early years of a mortgage the interest expense is higher. As the mortgage goes on, more principal is paid back and as such the proportion of the mortgage payment that goes toward interest is less.
There are other income and expenses too. Home ownership comes with additional taxes and maintenance costs. Rental income can also be earned.
In order to determine which is best, we need to consider which option results in the lowest expense (or highest income) over the life of the investment.
The life of the investment is how long we plan on holding the house for before (if ever) selling it.
We take the incomes related to owning a home:
- Rental income
- If the value of the house has increased, the amount of the gain
And take away the expenses:
- Interest expense
- If the value of the house has decreased, the amount of the loss
- Any other expense such as taxes, maintenance etc.
We compare the sum of these amounts (either a negative expense or a positive income) to the amount of rent that would be paid in the same period:
Rent x Length of Investment
Whichever has the lowest net expense or income is the logical “best” choice. In theory it is this simple, however in reality it is not.
Homeownership and Variable Expenses
We can easily define the formula above, however it is hard to put accurate figures on each element because the incomes and expenses will occur in the future which is uncertain. We could witness another global downturn which could wipe huge amounts of value off of homes again, or we could witness interest rates soar, driving mortgage payments sky high. The opposite could also be true. We can’t research the market in the present, but 30 years is a long time to forecast and we truly don’t have any way of knowing what the future holds.
The answer to the question: “Which is better? Renting or buying?
In order to know this, you’ll have to:
- Do your research: While we can’t predict the distant future, we might be able to understand some indicators about the near future. Remember, interest rate risk (the risk that the interest rate goes up) is higher in the first few years of the loan when you are paying interest on a higher principal. This risk is steadily reduced over time as the principal balance decreases. There might also be some evidence about where the future values of house prices are going, although this is usually unpredictable in the very long term.
- Consider your Risk Appetite:
How much risk do you want to be exposed to? How much variability in interest expense can you tolerate before going under? How much can house prices fall before you want to get out of the market?
After you’ve done the above, there’s only one thing you can do to truly know which option is best:
Wait and see.