The most intense debate in personal finance might be the "rent vs. buy" debate. People want to know if it is a better financial decision to rent or buy a home?
There are two opposing views on this question.
The ownership crowd who believes that owning a home is better than renting. The central argument here is that paying rent is throwing your money away. You'll often hear arguments from this crowd like "paying rent is simply paying someone else's mortgage."
The renting crowd believes that renting a home is better than owning. The central argument here is that a house isn't really an investment. You'll often hear arguments from this crowd like, "a house costs you money, and therefore it should be treated like a liability rather than an asset."
So, the question remains, who is right in the rent vs. buy debate?
The answer is that both sides are (partially) right. Economists would describe your home as both an investment and a consumption good. It’s the only asset that fits that description and is the reason why housing is the most complex and controversial component of our personal finances.
Continue reading to learn:
The financial case for owning a home.
Why home equity amounts to financial "empty calories."
A rule of thumb to approach the rent vs. buy decision from a purely rational perspective.
The least-talked-about benefit of homeownership; the stability it provides.
The financial case for owning a home
There are three reasons buying a house can be a good financial decision.
You own the asset. Let's not overthink things too much; if you want to build wealth, you need to start acquiring assets, and if you're a first-time home-buyer, your house is probably the first significant asset you've acquired.
It creates forced savings. While many people are bad at actively saving money, they are amazing at making their mortgage payments. Every dollar of principal paid against the mortgage makes you a little bit wealthier. In that way, having a mortgage is like an automatic savings plan.
The value of your home might increase. You shouldn't bank on huge increases in the value of your home, but the fact is that over time, real estate prices tend to move up.
Why home equity amounts to financial "empty calories"
This get's to the heart of the matter of why there is so much disagreement on the rent vs. buy decision.
Owning a home creates a paradoxical situation where our home is often our largest asset and our greatest living expense.
As I mentioned at the beginning of this article, a house is both a consumption good and an investment. There is no other piece of our financial lives that behaves this way and is the reason nobody can agree whether owning a house is a good financial decision.
I own my own home, and I've it's more than doubled in value in the five years that I have lived in it. That has been a stroke of dumb luck, but I don't get too excited about it because home equity truly is the empty calories of wealth.
Here is how I look at it. The value of my home doubled, so my net worth has increased pretty fast.
But how does that make my life better?
To access that net worth, I need to sell my house. But that presents a new problem as I need somewhere to live. I could buy another house, but that doesn't work because if my house went up in value, so did the houses around me. I could rent, but now I have traded in a mortgage payment for rent.
If my house increased by enough, and I sold my house and invested the money wisely, it might make sense for me to sell and rent.
But how would I know when my house has increased enough in value that it would make sense to sell?
Let's talk about that.
A rule of thumb to approach the rent vs. buy decision from a purely rational perspective
In the past, I've written about the 5% rule, which is a financial rule of thumb that aims to provide a break-even point to where someone would be just as well off financially whether they decided to buy or rent a home.
If you want a full, detailed breakdown of the 5% rule, read this article.
Here is a general overview of how the 5% rule works.
Take 5% of the value of a home you are thinking of buying or renting.
Then, divide that number by 12.
The result is the financial breakeven rent.
For example, let's say you're thinking of buying a house valued at $600,000. 5% of $600,000 is $30,000. Divide $30,000 by 12, and you have $2,500. According to the 5% rule, if you could rent a comparable house for $2,500 per month, you could end up just as well off as if you bought the house for $600,000.
The major assumption in the 5% rule is that it assumes you take all of the money you would have used for a down payment and for other non-recoverable expenses of owning such as property taxes and invest it in the stock market. So, you are essentially slowly building up a stock portfolio that over time could be equal to the value of the house one day.
It's a massive over-simplification, and I would never make the 5% rule the centerpiece of my buy or rent decision, but it's a great way to change the mindset that renting is "throwing your money away."
From a financial perspective, all we are talking about is how to best deploy your capital. If renting opens up more capital to invest, then it could be a very viable option.
The least-talked-about benefit of homeownership
The greatest benefit of owning a home is that it provides stability.
First, it provides stability in your life because as long as you make the mortgage and property tax payments, nobody can tell you that you have to move. I know lots of people who were forced to leave rental homes that they love because the landlord was selling the home or wanted to move back in themselves. That does not happen to homeowners.
Second, it provides financial stability by essentially "locking in" my cost of living. I live in an insane real estate market (outside Toronto.)
In 2016, I bought my house for $375,000.
In 2021, I could sell this same house for anywhere between $750,000 and $800,000.
If I were a first-time home buyer and wanted to buy my house today, my mortgage payment would be double what it is today. While rents have not grown at the same pace as house prices, they are much higher than they were in 2016.
By buying my home at a price I can easily afford, I have been spared the rapid increase in housing costs that many renters in my real estate market have been forced to pay.
Where do you stand on the rent vs. buy debate, and why? Let me know in the comments.
If you want to keep up with my writing, you can sign up for my weekly newsletter here.
This article is for informational purposes only, and it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.