To buy or rent?

At some stage in life most people are faced with a choice of whether they should buy or continue renting. The easier option is to maintain the status quo and continue renting; after all it gives flexibility and more money in your pocket each week.  There are advantages and disadvantages with each option that need to be carefully considered. From a financial point of view, over the long term, buying a home is generally the best option. Buying a home builds wealth through forced savings by paying off your mortgage, and the capital growth in the property.

The main problem with renting is that it entrenches behaviour that does not lead to long term financial security, as when you rent you generally pay less each fortnight than if you are buying a home.  This leads to a false sense of security in that you have more money in your pocket each week, which inevitably is not used for investment, but rather for the day-to-day temptations of life.  The lower the rent, the greater the difference.

A school friend of mine lived in a share house with 3 others in the mid 1990s, paying $80 per week as his contribution to the rent. He was earning a substantial salary, but guess what? – he was not saving anything  with his salary being used to pay a car loan, overseas holidays and the latest designer wardrobe.  After discussing the options with him when he came around for dinner one night, I suggested he should look at buying the house where he lived and maintain the status quo.  After doing his calculations he agreed and purchased the property for $145,000, getting a gift from his parents as the deposit and borrowing $140,000 from a bank.  The interest rate on the loan was 7.50% and he took the loan over a 25 year period. His mortgage re-payments were $478 per fortnight.  After taking into account the rent he received, buying the house cost him an extra $158 per fortnight.  The price of the house was obviously a lot lower than it is now, but so was the rent.  The rent that you pay now is a lot more than you paid at that time.  You will be pleased to hear that 15 years on he no longer lives in a “men behaving badly” type environment, and has now renovated the house and lives in it with his wife and 2 young children.

The advantages of buying are:

  • You do not need to move house each year, a process which gets more costly and difficult as we accumulate more and more possessions
  • Gives you a sense of security and stability
  • Builds your wealth over time
  • You can make alterations to the property or garden as and when you like
  • You are not at the mercy of the landlord and you cannot be evicted from your own home, providing you continue to make your mortgage repayments

The advantages of renting are:

  • You do not need to spend any money on maintaining the property
  • You remain flexible and can move easily to an alternative location if needed
  • You generally have a higher discretionary cash flow

To assess which option is more attractive for you, this can be illustrated in the table below, which shows the cost comparison between a tenant and a property owner over a 7 year period:

  • A tenant pays $1200 per month on rent with annual rent increases of 5%
  • The homeowner purchases a property for $300,000 and has a mortgage of $250,000 with an interest rate of 7%. The monthly mortgage repayment is $1,766.95
Year Rent Payment Mortgage Payment Yearly Difference
1 $14,400 $21,203 $6,803
2 $15,120 $21,203 $6,083
3 $15,876 $21,203 $5,327
4 $16,670 $21,203 $4,533
5 $17,503 $21,203 $3,700
6 $18,378 $21,203 $2,825
7 $19,297 $21,203 $1,906

 

From the table above you can see that initially, from a cash flow point of view, you are better off renting. Over the long term you will only be better off renting providing that you invest the difference (i.e. that you save  $597 per month) and get a greater return from this investment than the home.

When comparing the returns it is necessary to take into account the borrowing costs associated with the home loan. For example if your home appreciates at 5% let’s look at what happened:

Year Property Value Loan Balance Net Position
Start $300,000 $250,000 $50,000
1 $315,000 $246,297 $68,703
2 $330,750 $242,335 $88,415
3 $347,288 $238,095 $109,913
4 $364,652 $233,559 $131,093
5 $382,884 $228,705 $154,179
6 $402,029 $223,511 $178,518

 

If on the other hand, instead of buying a property, you invested your savings of $50,000 and obtain an identical return with the accumulated rental savings:

Year Value of  initial investment Value of accumulated savings by renting Growth Net Position
Start $50,000 $7,164 $2,858 $60,022
1 $60,022 $6,084 $3,305 $69,411
2 $69,411 $5,328 $3,737 $78,476
3 $78,476 $4,536 $4,150 $87,162
4 $87,162 $3,696 $4,543 $95,401
5 $95,401 $2,820 $4,911 $103,132
6 $103,132 $1,908 $5,252 $110,292

 

From these tables you will note that if the returns are identical, you will be better off buying a home over the long term.  In any event, renting over the long term you often end up in a worse financial position than that outlined above.  The reason is that most people do not have the discipline to invest the difference they save by renting versus buying.

As a general rule the property owner will be better off on the long term.

If you have any questions please don’t hesitate to contact Main Street Financial Solutions, we would love to help you.

 

Summary
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To buy or rent?
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The main problem with renting is that it entrenches behaviour that does not lead to long term financial security, as when you rent you generally pay less each fortnight than if you are buying a home.
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Main Street Financial Solutions
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