Renting against buying a home

Every way of living somewhere burns money. The question is never which one burns none. It is which one burns less over the years you actually stay.

For a renter the answer is short and complete: the whole rent is unrecoverable. Nothing is left at the end of the lease.

For an owner it is a mixture, and the mixture is the point. The part of a mortgage payment that repays principal is not spent, it is moved: cash becomes equity in the house. Everything else is spent for good.

The running example on this page is a $400,000 home bought with $80,000 down and a $320,000 loan at 6.5 percent over 30 years, set against renting the same home for $2,950 a month. In the first year those four costs come to $2,557.89 a month, and interest is about two thirds of it.

Every rate there is an illustration, not a current market reading. Property tax is charged on assessed value across most of the United States and varies by state and county; the United Kingdom charges council tax in bands, which does not scale with value the same way. Insurance is priced on what rebuilding would cost rather than on what you paid, so writing it as a percent of the price drifts wherever land is a large share of that price. One percent a year for maintenance is a rule of thumb, and an old roof has never heard of it.

One thing renters miss: a landlord meets every cost in that table, interest included if the place is mortgaged and the forgone return on the capital if it is not, and wants it back out of the rent. Whether the rent actually covers it is a question about the local market rather than about generosity, and in some markets it does not.

The usual version of this comparison puts the rent next to the mortgage payment. Here that reads as $2,950 against $2,022.62, and buying looks like the cheaper option outright. Both halves of that reading are wrong, in opposite directions.

The payment is too small, because it is only principal and interest. Property tax, insurance and upkeep add another 2.5 percent of the home's value every year here, and none of it is in the payment. In the United States a servicer usually collects tax and insurance alongside the payment and holds them in escrow, so the amount leaving the account is larger than the amount that repays the loan. Nobody collects for maintenance. It arrives as a boiler.

The payment is also too big, because part of it is not a cost at all. In month one, $1,733.33 of the $2,022.62 is interest and $289.28 reduces the debt. The interest is gone. The $289.28 is still yours, held as equity instead of cash. So the first payment is roughly 86 percent cost and 14 percent saving, and that split shifts in the owner's favour every month for 30 years. How amortisation works traces the whole schedule, and the loan payment calculator above will redo it for any price, rate and term.

Across the full 30 years this loan repays $728,142.36, of which $408,142.36 is interest: more than the $320,000 borrowed. That is the largest unrecoverable cost on the owning side, and comparing rent to a payment hides it completely.

Buying is charged twice, once on the way in and once on the way out. Take 2 percent of the price to buy and 6 percent to sell, and the round trip on a $400,000 house is $32,000 before anything else happens. Both percentages are illustrations. In the United States the seller has customarily paid both agents, though who pays the buyer's agent is no longer settled by convention and is now negotiated deal by deal; in England and Wales a buyer usually pays a banded transfer tax on top of legal fees, and it can be the largest item of the lot, while first-time buyer relief can take it to nothing.

That $32,000 is earned back out of the monthly gap, and nowhere else:

$$\text{months to break even} = \frac{\text{cost of buying and selling}}{\text{monthly rent} - \text{monthly unrecoverable cost of owning}}$$

• Cash costs only. Owning burns $2,557.89 a month against $2,950 of rent, a gap of $392.11. The round trip takes 81.6 months, so month 82 is the first one ahead: about six years and ten months.
• Charging for the tied-up capital. The $80,000 deposit could have been earning something: that is the opportunity cost of putting it into a house. Charge it 4 percent a year, a nominal rate to match a rent and costs that are also nominal, and owning costs $2,824.56 a month, the gap narrows to $125.44, and the round trip takes 255.1 months. Month 256 is the first ahead: over twenty-one years.

Same house, same rent, one assumption, and the answer moves by more than fourteen years.

That arithmetic freezes two figures that will not stay frozen, and the corrections do not all point the same way. Pulling the date earlier: the owner's interest falls as the loan amortises, and rents have generally risen in nominal terms over long periods. Pushing it later: property tax, insurance and maintenance rise with prices too, and the charge above sits on a static $80,000 while the capital actually tied up in the house grows every month that principal is repaid. Anyone showing you only the first pair is selling something. And the whole of it assumes the price never moves, which is the assumption that matters most. Notice too that the horizon is a division with a small number underneath: halve the gap and the wait doubles.

Strip the example down and the comparison is one percentage against another. Rent costs a percentage of the home's price each year. So do the owner's unrecoverable costs. The smaller one wins, before any price change at all.

The running example sits at 11.3, so renting burns 8.9 percent of the price a year. Owning burns 7.7 percent counting cash costs, or 8.5 percent once the deposit is charged 4 percent. Owning is the smaller number on both readings, which is why buying gets ahead either way once the round trip is paid off. What the deposit charge changes is not the winner but the wait: it cuts owning's yearly advantage from 1.2 points of the price to 0.4, and that is what stretched the horizon from under seven years to over twenty-one.

Now move the same house to a city where it sells for 25 times its yearly rent. Renting burns 4.0 percent while owning still burns near 7.7 percent, and no holding period repairs that: buying costs more every year, and only a rising price can rescue it. Move it to a market at 10 and the reverse is true, decisively.

The mortgage rate works from the other end, since interest is about two thirds of the owner's burn here. One percentage point on the rate moves the owner's yearly cost by about 0.8 percent of the home's price at this loan size, which is roughly eight tenths of a point of rental yield: enough on its own to swallow two thirds of the 1.2 point advantage owning has here. A market that made buying obvious at one rate can make it a poor deal at another, with no house and no rent having changed.

That is the honest shape of the question. There is no general answer, because the price-to-rent ratio and the mortgage rate are local, the return you would otherwise have earned is yours to set honestly, and how long you stay is your own plan.

Bought with 20 percent down, this house is not an $80,000 investment. It is a $400,000 position funded with $320,000 of someone else's money, and the ratios say so plainly: debt to equity of 4 to 1, debt at 80 percent of assets, an equity multiplier of 5.

That multiplier runs in both directions and it runs on the whole price, not on your share of it. If the house falls 10 percent, the debt does not fall at all, so the equity absorbs the entire loss: $80,000 becomes $40,000, a 50 percent hit. A 10 percent rise adds the same 50 percent. Neither is realised until you sell, which is part of why housing feels calmer than a share price, and is not the same as being safer. A fall deep enough to leave the loan above the value of the house does something a paper loss does not: it stops you moving, because a sale would not clear the debt.

Three more features come with the asset. None are hidden charges. They are simply its shape.

• It is one asset on one street. Diversification is the rare thing in finance that lowers the risk specific to one holding without lowering expected return, and a single house is the opposite of it. It does nothing about a fall that hits every house at once, and the local job market that sets your income tends to set your house price too, so the two can go wrong together.
• It cannot be sold quickly, or in pieces. A sale takes months, costs a percentage, and cannot be done halfway when you need part of the money. That is what illiquidity means in practice.
• It pays a dividend you consume. You live in it. No share does that, and it is the reason a home is not only an investment and should not be judged only as one.

Everything above holds the house price still. Nothing in the real decision does.

Four inputs decide it and nobody has them: what this house does next, what rents do next, how long you actually stay, and what the money would have earned elsewhere. Job moves, relationships and redundancies settle the third far more often than spreadsheets do, and a stay cut short by life is exactly the case where transaction costs bite hardest.

Tax changes the sums and it is entirely local. In the United States, mortgage interest can be deductible for a filer who itemises rather than taking the standard deduction, and only up to a cap on the loan size; the deduction for state and local taxes, property tax included, is capped as well; gains on a main home get their own treatment on sale; and the rent an owner implicitly pays themselves is not taxed at all, which is a real and often unnoticed advantage. In the United Kingdom an owner-occupier gets no relief on mortgage interest and meets a transfer tax on purchase instead. A handful of countries do tax imputed rent, so even that is not universal. Every one of those thresholds moves with legislation, so look up the ones in force rather than the ones printed in any article, this one included. Whatever applies where you live belongs in the calculation as an adjustment to the rates above, not as a bonus assumed at the end.

Two effects sit outside the arithmetic and pull in opposite directions. A fixed-rate mortgage fixes the interest, about two thirds of the owner's burn in this example, while tax, insurance and upkeep still float and rents move with prices. That is worth something real over a long stay, though how long a rate can be fixed for varies by country and a thirty-year fix is not on offer in most of the world. Against that, a renter keeps the deposit invested, pays nothing to leave, and can take a better job in another city next month.

Put your own price, rent, rate and expected stay into the calculator above and read the gap. That is the comparison. The verdict is yours, and there is no reason it should match your neighbour's.