Building Wealth and Being Happy: An Excerpt
Should you rent or buy the place you live in? It’s a tough decision with a lot of variables you might not have considered before.
In the future, I hope to do some real-life rent vs. buy examples on this blog. In order to understand those examples, you’ll want a good background on things to consider in rent vs. buy scenarios. As such, I’ve decided to release this excerpt from my book Building Wealth and Being Happy. Here is everything you need to know about whether you should rent or buy the place you live in. Enjoy!
Real Estate as a Place to Live
You’re going to have to live somewhere. And isn’t rent just “paying someone else’s mortgage”? The truth is not quite that simple. Both owning and renting have their place at some point in most people’s lives. Real estate transactions will likely be the largest financial decisions that you are ever a part of, so you want to make sure you get it right. How does owning a home fit into your safe-withdrawal rate (SWR)?
Your personal living space does not generate any passive income for you. This means that you don’t get to add the value of your house to your stocks and bonds when calculating your SWR. However, owning a house could lower your annual expenses, and therefore your FI number as well, causing you to need less money to be financially independent. For this reason, we’re not going to think about buying a house to live in as ‘an investment’, per se, even though it is such a big part of your financial life. It’s hard to predict capital appreciation of real property, and growth in the value of your home is not something you should be banking on for your retirement. Instead, in the context of financial independence, it’s better to think of your housing needs as part of your ongoing expenses.
A Simple Rule of Thumb
There is a simple rule of thumb in the perpetual ‘rent vs. buy’ battle royale: if you’re going to stay in a place for less than 5 years, always rent. If you’re going to stay in a place for more than 10 years, always buy. Are you staying in-between 5 and 10 years? Well, it can get complicated. When in doubt, rent.
There are two main reasons why this rule holds true. The first is closing costs. Usually sellers pay commissions of around 6%, which comes from the cash they get from selling their house, to their agent, who splits that 50/50 with the buyer’s agent. Add on to that land transfer taxes for 1 or 2%, moving costs, and legal fees, and it’s easy to see how these expenses can add up to nearly half of your down payment. Even though these expenses come out of your pocket in the year you move into a new property, you can conceptually average them out over the number of years you live in that location. By staying in one house for as long as possible, you decrease the cost per year of these one-time expenses.
The second reason is interest. The way a mortgage works is that when you make a payment on it, a portion goes to the principal of the loan, which becomes your home equity, and a portion is interest, i.e. a fee paid for borrowing money that you’ll never get to see again. The interest, the part that is a non-recoverable expense, will always be higher at the beginning of the loan, especially during the first 5 years.
Rent or Buy?
We can illustrate this with math on a condo in Mississauga. Let’s imagine a $100,000 loan with monthly payments of $422, and an interest rate of 3% per year on a 30-year mortgage. When the first payment is made on this mortgage, the interest portion is the monthly interest rate [3% divided by 12] X $100,000 = $250. The portion of the $422 payment that is not interest [$422-$250 = $172] goes towards the $100,000 debt, reducing the amount you owe to the bank and therefore also reducing future interest payments.
When you make a payment of $422 in the 20th year of this mortgage, the portion that relates to interest will be much lower. By then, the remaining loan will be down to $40,000 and the monthly interest is calculated as [3% divided by 12] X $40,000 = only $100, down from $250 in the first year. Simply put, the percent of a mortgage payment that is “paying yourself” increases with every payment you make. It is truly in the later stages of a mortgage that the principal can be paid down quickly, building your home equity.
To fully analyze this Mississauga condo from a rent vs. buy perspective, we’d need to compare all the costs for renting a property versus owning a property over the time you expect to live there. We also need to take into account the opportunity cost of your down payment, which is the 7% or so that you could expect to earn if you rent and invest that down payment into the stock market. And we need to estimate the rent increases per year (say 2% per year, the maximum increase in many jurisdictions), the growth of the home’s market value (say 4% per year, including 2% inflation), and the interest rate of the mortgage over the time you’ll live there.
But there’s no need to re-invent the wheel here. There is an abundance of ‘rent vs. buy’ calculators available online, the most notable of which is from the New York Times. Canadians should keep in mind that your marginal tax rate isn’t applicable, as property tax and mortgage interest isn’t deductible in Canada, so you can go ahead and bring that down to zero. The calculator works by finding the total costs of ownership for the property that you’ve entered and giving you the break-even rent amount. This is the amount at which renting the property would cost the same as buying it. If you can rent it for less than that amount, you should rent. I input the assumptions we made about the Mississauga condo above into the New York Times calculator for a 10 year stay and the break-even point for rent was roughly $1,700 per month.
Another Rule of Thumb
Here’s another rule of thumb: condos are costly. Condos can be great for quality of life but don’t expect that buying one will be a beneficial financial move. The condo board maintenance fees can really add up, so you’ll need a ton—more than our estimated 4% per year—of growth in the value of the condo for it to be worth it. The Mississauga condo in question can be rented for $1,300 a month, meaning that owning it is about $400 more expensive per month than renting it; $48,000 more over 10 years.
It’s Not All About the Money
Buying can also tie you down to a geographical location and may make it more difficult for you to take a job that increases your earnings power. It’s hard to overstate how valuable mobility can be and renting grants you that flexibility. So, think about your future work prospects and job stability when making a decision. If you might be changing employers every couple of years, then it could make a lot of sense to rent and re-locate closer to your new workplace every few years. You’d even be able to cut down on commuting time and costs, which would allow you to save even more.
Psychologically, people often prefer to own a house because it feels more secure, like it is theirs and nobody else’s. They can do what they please and no one can kick them out! Of course, we know that’s not true. If you can’t pay your property tax, water, or mortgage bills, you will eventually get evicted. Having a hoard of investment money and living in a rental is just as much of a security measure as owning your own home.
A common, but ultimately indefensible, justification for buying is that a mortgage can act as retirement savings. Having equity in a house is great but paying tens to hundreds of thousands of dollars in interest to a bank for the privilege of being allowed to use your house like a piggy bank is a poor pretense that usually signals larger problems. If you have enough money to pay a mortgage but not enough to rent while putting away money for investments, you need to go back and re-visit the ‘rent vs. buy’ calculator or take control of your frivolous spending. Paying your mortgage and living paycheck to paycheck every month is easy but financial independence (FI) is about doing what makes sense rather than what’s easy.
Of course, there could be many reasons why owning a place might be the right decision for you, even if it isn’t the best financial decision to make. Owning real estate can be a real source of personal pride. And there are some things you just can’t do in a rental. Perhaps you want the freedom to renovate or landscape. Maybe you want a stable environment for your children with the guarantee that they’ll be able to stay at one school for their entire childhood. Or perhaps you’re willing to work a couple of extra years if it means being able to live close to your friends and family. It’s better to be happy and working than retired and miserable.
There are many places in the country where buying is the right financial decision. Even if it’s not, you can still justify it. Just make sure that you understand the impact that it will have on your FI.