The Rent vs. Buy Decision
The rent vs. buy decision is as old as the concept of financial planning itself. There are people who have very strong views on both sides of the spectrum. There are some people who believe that owning a home is always better and that renting a house is like throwing money away. At the same time, there are others that believe that renting is the way to go because of the less commitment and mobility that it provides.
Needless to say that this decision has a huge impact on the financial future of any individual. Firstly, housing expense is the single largest expense that any individual has. Even by the most conservative estimates, people spend around 25% to 33% of their income on their housing decision. Hence, it is important to be frugal about this decision as it sets the tone for the entire budget.
In this article, we will have a closer look at some of the financial and non-financial arguments which are made in the rent vs. buy debate.
Financial Aspects of the Rent vs. Buy Debate
Renting and buying are both different ways to stay in possession of a home. However, the expenses and benefits that arise from these different structures are quite different from one another.
Lets take a look at the true cost of renting and buying.
Case #1: Renting a House
When a person rents a house, they only have to make a couple of small financial payments.
- They are supposed to pay a security deposit to the owner of the house, which acts as a buffer to recover funds if the tenant damages the property. In most cases, this deposit is refundable as soon as the tenant decides to leave the house and move to a different one.
- It needs to be understood that the deposit figures are relatively larger amounts. They cost around 3 to 6 times the monthly rent. However, this money is given to the landlord interest-free. Hence, the interest cost of this money should also be included in the calculation as an opportunity cost.
- Then there is a monthly payment for the rent. This is the main payment when it comes to renting. This number is what is usually compared to the mortgage payment. Also, the rental payment typically goes up every year to keep up with inflation.
- Sometimes, people may have to pay a finders fee to a real estate consultant for bringing together the landlord and the tenant.
- In many parts of the world, some or all of the income pays towards making a house rent payment earns a tax deduction and lowers a tax bill.
- Lastly, it is important to note that the tenant does not gain anything if the price of the property appreciates. Since they do not have any ownership rights, they dont get any benefits. At the same time, the tenant does not have to pay for regular maintenance and upkeep of the house. This cost falls on the landlord.
- Renting a house also provides increased mobility. If people rent a house, they can simply move to another city when a different job opportunity comes along. Also, there are no commitments. If they lose their job, they can move to a smaller or a cheaper house to cut down on their expenses.
It is important for a person to consider all the costs and come up with a consolidated total cost of renting. Comparing only the rental cost with the ownership cost is incorrect. This number is expressed in relation to the value of the house in the form of a rental yield. This helps compare the rental costs amongst different properties and also to compare it to different investment options.
Case #2: Owning a Home
When it comes to owning a home, there are more payments that need to be made.
- Firstly, there is a down payment that needs to be made on the home value. This down payment is close to 20% of the value of the home. It is important to realize that this amount is also interest-free. Hence, the opportunity cost on this down payment needs to be included in the calculation.
- Then there are monthly payments, which are affected by the interest rate. The interest component of the monthly payment is what can be compared with the rental payment.
- There are closing costs such as brokerage and statutory costs, which are paid to the government. These costs are sunk costs. This is the reason that people cannot simply move houses if their jobs change. These costs can never be recovered. They can only be offset by the appreciation of the property.
- Also, there are maintenance and upkeep costs that need to be paid every year. This also includes the various types of property taxes that need to be paid in different parts of the world.
- However, the most important part is that any property appreciation belongs to the owner. Also, the mortgage payment does not change from year to year, but the rent does.
All this should be added up to reach at the total cost of ownership. In most parts of the world, ownership will be at a premium. However, the amounts need to be compared. For instance, if the cost of renting a property is about half of what it costs to own the property, one might be better off renting the property. On the other hand, if the property prices are appreciating rapidly in the vicinity, then buying may be a better option.
The bottom line is that there is no single answer to the rent vs. buy question. Hence, the method to make a comparison between the two options has been explained above. The decision can be made by the individual based on the outcome of their analysis.
|❮❮ Previous||Next ❯❯|
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
- Importance of Personal Finance
- Process of Financial Planning
- The Financial Life Cycle
- Three Types of Income
- Misconceptions about Personal Finance
- Macro-Economic Factors and their Effect on Personal Finance
- Going From Financial Goals to a Financial Plan
- Components of a Financial Plan
- Personal Financial Statements
- Advantages and Limitations of a Budget
- Ratio Analysis in Personal Finance
- Dollar-Cost Averaging
- Pitfalls of Dollar-Cost Averaging
- Value Averaging Method of Investment
- The Rent vs. Buy Decision
- Financing Your Home
- Fixed-Rate Mortgage vs. Adjustable Rate Mortgage
- The Phenomenon of House Poverty
- 5 Step Retirement Planning
- Retirement Basics: 401K Plan
- Retirement Basics: Roth IRA
- Auto Loans and Personal Finance
- Earnings Power in Personal Finance
- Personal Financial Planning For Small Businesses
- Common Pitfalls of Tax Planning
- Zero Based Budgeting System Using Envelopes
- The Concept of Financial Freedom
- The Financial Independence Retire Early (FIRE) Movement
- How Do People Save Large Percentages of Their Income?
- Rich Dad Poor Dad Philosophy
- The Pay Yourself First Principle
- Personal Finance Lessons from Rich Dad Poor Dad
- Estate Planning in Personal Finance
- 7 Personal Finance Mistakes to Avoid