Renting vs. Buying
A strong real estate market and a hot stock market combine for an interesting conundrum – should you keep renting or go ahead and buy that first home? Maybe you are near retirement and looking to downsize – should you move into a small house or ditch homeownership altogether? What do the numbers say?
Sure, the numbers are important, but it’s often a psychological decision, too. Your house is this weird asset that is both an investment and a form of consumption. It has aspects of a fun vacation in that you make memories in your house, but it also has features of a stock or mutual fund since its value fluctuates and generally increases over the long haul.
Ok, close the Zillow app now. We know you’re looking at it. Pay attention!
A common question we get asked at TFC is, “should I rent or buy?” Like all things in financial planning, “it depends.”
That’s never a popular answer, but it’s so true.
Your situation (like your employment, income, family, goals, dreams) matters the most. Many people place a high emphasis on that great feeling of working toward the American dream of homeownership – the white picket fence and golden retriever playing fetch in the front yard. So wholesome. But potentially costly.
Let’s talk about the factors that go into the rent vs. buy comparison.
Are you ready for an onslaught of questions that will reach deep into your soul? Let’s go for it.
- How much house do you want to buy? Bear in mind the median Michigan home price is a whisker shy of $200,000 right now, up more than 10% from a year ago[i]. Let’s say you want a little better than the average, so we’ll input $250,000.
- How long do you plan to stay? This is often a challenging question to answer since anything can happen in today’s economy. Jobs are quick to change, and the gig economy in a post-COVID world could lead to even more disruption. How about we call it about 13 years? That’s the median duration of homeownership according to the National Association of Realtors[ii].
- The mortgage details. Rates have been on the rise recently[iii], but remain near historic lows. Most families take out a 30-year mortgage and put down about 20%. Let’s marry all that together into our black box mortgage calculator… and what do we have? A 30-year fixed-rate $200,000 mortgage at 3.30% yields a monthly payment of $876 (this does not include property taxes, insurance, and HOA fees). We aren’t done by a long shot, though!
- Crystal ball details. We are going full bore on this analysis, so we must put on our economist hat. What does the future hold for your home’s price appreciation, the growth of rental rates, stock market returns, and inflation? So many variables! But you’ve come to the right place. TFC has a few numbers up our sleeve.
- Home price growth rate: This typically runs a little higher than inflation over the long run. Let’s say 3.0% per year.
- Rental growth rate: To be fair, we’ll assume the same 3% increase in rental prices.
- Stock market return: Wait, why are we talking about the stock market?? Glad you asked. When renting, you have the opportunity to take the money that would otherwise be tied up in a house and invest it in assets that can grow over time. Often, you can fork more money into tax-advantaged accounts like your 401(k), Health Savings Account, and Roth IRA. We have to consider this chance. Let’s assume you took that extra cash and parked it into the TFC 90/10 Aggressive portfolio and earned 6% per year.
- Inflation: Inflation has averaged 3.1% since 1913[iv], but just 1.8% since 2010. We’ll call it an even 2.0% going forward (though it will likely be higher than that in the next couple of years thanks to all that stimulus floating around).
- Property tax. You knew we’d talk taxes. Michigan’s average property tax rate is up there at 1.45% of the home’s value each year, above the national average of 1.07%[v]. Let’s plug that in.
- Your marginal tax rate. If you are one of the 10% of Americans itemizing deductions[vi], your marginal tax rate matters when valuing the mortgage-interest deduction. We’ll use a tax rate of 22% since that captures family income amounts between about $81,000 and $173,000. The next level is 24% for income between $173k-$330k[vii].
- Closing costs. The cost of buying a home might run you 4% in transaction fees while selling a home is slightly higher near 6%. Hopefully, technology and efficiency can bring down these lofty expenses over time.
- Extra maintenance and fees when owning. We know you love to watch HGTV. “Love It or List It” might be the favorite show among our clients. Those “renos” can add up quickly. It’s not just taking down a wall to put in a new kitchen; there are everyday maintenance items that creep up on homeowners.
- Maintenance/renovations: A rule of thumb is 1% of the home’s value per year of expense.
- Homeowner’s insurance: $1,139 is the average annual premium home insurance premium in Michigan[viii]. Since we are buying a little more than the average house, we shall assume it to be $1,150.
- Utilities: This is one both owners and renters face. For our Ph.D.-level analysis, we will only include the extra utility costs a homeowner faces that a renter would not – ballpark it at $100 per month.
- HOA: The group we all love to dunk on, but they do good things too. Their hearts are in the right place – trying to keep up the value of our home. But getting that nasty gram in your mailbox is never fun. Let’s assume $30 per month in an HOA fee as a homeowner.
- Extra renting costs. The renters out there weren’t going to get off easy. There are additional expenses you folks face, too.
- Security deposit: You’ll get this back if you play by the rules, but you never know. We’ll assume about $925.
- Renter’s insurance: $180 per year is the average renter’s insurance in the country[ix].
- Broker’s fee: You might even pay someone to hook you up with a quality rental unit. It’s more common in big cities like New York. Let’s leave it at zero.
Perspective and Methodology
What a list of things to consider! And maybe you have a few more that you think we missed. We’d love to hear em! The bottom line is that we have to consider several items related to buying, owning, and selling a house such as initial costs of buying, ongoing costs of homeownership, the opportunity cost of missing out on stock market gains over the long run (after taxes), and finally net proceeds on the sale of your house.
As for renting, we must factor in upfront expenses like the security deposit and possible broker’s fee, the recurring cost of rent and insurance, the opportunity cost described above, and the puny return of the security deposit when you exit.
What’s The Verdict? And Who Are You?
Based on all those mathematical inputs, if you can rent a similar home for less than $924 per month, then renting is better. That’s the ‘spreadsheet answer’, as we like to say. It might be wildly different than your answer. Your preferences matter. If you desire to own that all-American house, raise a family, and make memories, then that future can be invaluable. Of course, you have to be able to pay the bills, too.
Perhaps you are a retiree looking to downsize. You want to determine if owning a small home or condo is better than renting.
Maybe you are an astute young buck in college looking to pounce on the real estate market – you must analyze all the numbers as we did above. Do not forget the often-overlooked costs such as transaction costs of buying and selling a house, the opportunity cost of missing out on equity market growth compounding (particularly if done in a tax-smart way), and significant ongoing maintenance expenses associated with owning a property.
The Mortgage & Other Tips
Maybe you are wondering what the mortgage payment is on the hypothetical house based on the above estimates – it’s just shy of $1,300 per month of principal & interest, taxes, insurance, and HOA. Keep in mind that when you pay down a mortgage, your first payments go primarily toward interest. It’s only after many years do you begin building serious equity.
Tip: consider a 15-year mortgage since that rate is often about 0.5% less than the standard 30-year fixed-rate mortgage. You will have a larger monthly payment, but you will build equity faster and become an actual homeowner much sooner.
Tip: if you are a retiree, consider paying off your mortgage since it’s almost like earning a risk-free return equal to your mortgage rate. With the bond market earning only about 1.6% right now, 3.3% tax-free is a heck of a lot better than 1.6% taxable! Be careful not to become house-rich and cash-poor, however.
Enough tips. Enough data.
Yes, the numbers are important, but your wishes & dreams matter. Sit down with us at TFC to help determine what you should do when it comes to buying versus renting. It is a big decision, but we can get you to your destination with confidence!
Have a great week!
Source: NYT Rent vs. Buy calculator
[i] https://www.zillow.com/mi/home-values/
[ii] https://www.nar.realtor/blogs/economists-outlook/how-long-do-homeowners-stay-in-their-homes#:~:text=As%20of%202018%2C%20the%20median,varies%20from%20area%20to%20area.
[iii] http://www.freddiemac.com/pmms/
[iv] https://inflationdata.com/Inflation/Inflation/DecadeInflation.asp
[v] https://smartasset.com/taxes/michigan-property-tax-calculator
[vi] https://www.taxpolicycenter.org/briefing-book/what-standard-deduction#:~:text=The%20Urban%2DBrookings%20Tax%20Policy,itemizing%20their%20deductions%20in%202018.
[vii] https://www.kiplinger.com/taxes/tax-brackets/602222/what-are-the-income-tax-brackets-for-2021-vs-2020
[viii] https://www.bankrate.com/insurance/homeowners-insurance/in-michigan/
[ix] https://www.policygenius.com/renters-insurance/learn/how-much-is-renters-insurance/
Photo by Francesca Tosolini on Unsplash