The math of “Rent vs. Buy” has changed

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Several changes to economic conditions and tax law over the last five years have added new variables to the big decision of whether it is more advantageous to rent or buy a place to live. I have updated and simplified a spreadsheet I have long used to teach this concept for you to download and plug in your own numbers. Your bottom line may surprise you.

The conventional wisdom has long been to get people into a purchased residence as early as possible and to stay there as long as possible. But several of the assumptions underlying that conventional wisdom have changed, and so for some individuals and families the advantages of home ownership over rental have declined. The question is by how much. Here are some key variables:

  1. The significant increase in the standard deduction for personal income taxes in the recent tax code changes means that millions of Americans can no longer find tax savings in their mortgage interest and property tax payments. The total value of this “tax expenditure” to the government, once one of the biggest tax deductions, has dropped completely off the list of the top 13 most costly tax breaks.
  2. Home prices first increased by double-digit percentages annually in many communities during the Covid pandemic, and now more recent action by the Federal Reserve to halt inflation has doubled mortgage interest rates, creating a “double whammy” for new buyers in the form of much higher monthly payments for newly purchased properties.
  3. Monthly rents also shot up in tight housing markets, but in many hot markets that trend may be leveling off. It is also common to see very different rental and house purchase inflation rates in the same community. One big new rental complex opening can still depress local competition.
  4. House insurance costs in some markets, especially in Florida where I live, have exploded.
  5. The costs of home and yard maintenance, especially if you are not performing these tasks yourself, have seen large percentage increases and shortages of workers in many markets.
  6. For elderly homeowners, “reverse mortgagers” and long-term care facilities have mastered the art of sucking the equity out of long-time homeowners, leaving them with nothing to pass on to heirs. Downsizing to a rental before the inevitable hits may provide more options for preserving your estate.
  7. In order to do an “apples to apples” comparison of renting and buying, you must consider the opportunity cost of your earned house equity, which could be doing other profitable things if you are renting.

The forgotten variable – opportunity cost

Opportunity cost is the money you lose by not investing an amount equal to your home equity somewhere else, whether in a safer, more diversified mutual fund or perhaps in a good growth fund, depending on your risk tolerance. While we have long touted real estate as the way to build a family’s net worth, people who found themselves “under water” after the 2008 real estate crash can attest that real estate is often a very risky, undiversified investment, the classic “all your eggs in one basket.” This is especially true in today’s market, where prices may be at their peak. Or may not be. That is the homeowner’s risky bet.

A similar amount of equity money invested even in “growth” mutual funds usually has far less investment risk than the typical house because of the careful diversification in most major funds. Certainly, the value of the house could continue to climb, but it could also stagnate, or even crash in value. We once stayed in a lovely beachfront vacation rental that had sold for $1.1 million in 2007, and then sold again for $400,000 after the 2008 real estate crash. That was a tragic investment by someone.

The vacation rental worth either $1.1 million or $400,000. Photo by the author.

The problem that most people have if they find renting to be less expensive than buying is that they spend that difference rather than invest it as if it were a growing pot of “house equity.” Likewise, homeowners that downsize into a rental often wind up spending their now-liquid equity rather than using its invested earnings to subsidize their rent, or, better yet, re-invest the earnings to make their estate grow.

As an example, if you net $200,000 of home equity by selling your property and going into a rental, and if you can invest those dollars safely earning a 4% annual return after tax, then you are earning a $667 “rent subsidy” every month you leave the equity in that investment. Whether you actually re-invest that money or not, this is a key factor in the “Rent versus Buy” decision to “compare apples to apples.”

The spreadsheet

You can download my “Total Cost of Ownership” Excel spreadsheet by right-clicking on the link below and selecting “Save As” to download it to your own computer. If you don’t have Excel, you can upload it into the free Google Sheets online spreadsheet program.

Total Cost of Ownership spreadsheet

The spreadsheet has three sections. You can enter values appropriate to your situation in the yellow boxes:

The first section captures most of the out-of-pocket costs of owning a home. If you are still able to take a deduction for your mortgage interest and property taxes, then reduce the amount you pay monthly by your marginal tax rate. If, for instance, that marginal rate is 25%, reduce the value by that percentage. In the “Other” category, think of things you will need to buy for a house that you may not need in a rental. For instance, needing to purchase lawn maintenance tools or furniture for extra rooms and outdoor spaces can significantly strain your budget. To calculate a comparable monthly cost, consider how much you would have to pay monthly if you bought these items on a time-payment plan.

The key here is to capture as many of the costs specific to owning that house as possible. The bottom line is the effective monthly out-of-pocket cost of owning that home.

The second section estimates your “opportunity cost,” the amount of money that you could be making from that amount of money in an outside investment. Enter your estimated house equity, or your saved down payment if you are still renting. Then enter what you think you could earn annually on that investment at your personal comfort level for risk. Then reduce that percentage by your marginal tax rate if you want to compare that amount to a “rent subsidy,” taken as current income annually.

Finally, detail as much as possible the cost of renting a place that is acceptable to your family. There may be costs here not found in home ownership, such as parking fees, but usually most of the other costs, such as insurance, are less for the renter than the owner. You are, in effect, paying for the property taxes and the owner’s mortgage payments in your monthly rental fee.

In my example the TCO, the “total cost of ownership,” and the total cost of renting are very close. If this is your case, the less tangible factors come into the decision, such as time commitment, location, and potential for equity growth over the period you expect to own the property.

Your two numbers are likely very different from mine, and from one another, and so this exercise gives you a feel for the size of that difference. Let reality set in here. Few people live in the same house for 30 years anymore. Short-term house equity gains, especially after closing costs and realtor fees, are often disappointing. Remember that “mortgage” is derived from the Old French “dead pledge.” It is a serious debt.

As one now in that “elderly” category, I can personally assert that we will all need to eventually face some hard realities about how long we can stay in a hard-to-maintain property that may be too big for our needs. Your children likely do not want much of your long-accumulated stuff. Getting your equity out of the “dead pledge” and into a well-managed investment gives you expanded options over a reverse mortgage should a health emergency hit.

If you choose to rent, your lease payment will likely rise over time, and so you can re-run your analysis for, say, three years out. Recognize, however, that house property taxes and insurance will also rise, complicating the “buy” decision even further. In the long run, purchasing a home is likely still more advantageous financially than renting, but the numbers in the short run may well be different on an “apples to apples” comparison.

In the end, the most appropriate reason for purchasing a house ought to be because you really want to own a house (or that house), not because the conventional wisdom says that you should be a homeowner. If you go through this TCO process, you will better understand the real costs of your choices. Maybe that is why they call it real estate.

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