Many people find it odd that despite being financially retired, I don’t own a home.
When I try to explain how renting can actually make you richer than buying, I get funny looks.
Some common objections are:
- But aren’t you just paying someone else’s mortgage?
- Isn’t it smart to use the bank’s money to buy a house?
- Isn’t rent just wasted money?
The list goes on.
The reality is, the numbers don’t really support any of these arguments (at least in New Zealand).
We have some of the most expensive property in the world, the least favourable laws and rights for landlords, the least favourable terms for borrowers, yet property remains the most popular investment vehicle.
Why is that?
In this article, we’ll break down exactly what the numbers look like for renting versus buying. Are you actually better of being a homeowner?
Let’s start with a typical home an average Kiwi family would buy.
This is a house in Auckland, about 30 minutes out of the city centre, selling for just under a million, which is a little above average.
It’s not in an overly flashy area or anywhere special, so is selling right around its government valuation.
We can also see it rents for around $600 per week:
Let’s crunch some numbers.
Buy vs rent – How To Calculate?
The buy versus rent calculation has a lot of moving parts so it’s actually quite complicated.
Here are the things we need to account for:
- Difference between rent and mortgage payments
- Returns you can get from investing the difference
- Returns you can get from investing your downpayment
- House value appreciation
- Rent increases
- Homeowner expenses (and inflation)
- Costs of being a landlord
- Costs of being a tenant
- Cost of your time
Of course, this is nothing a sexy Excel spreadsheet cannot solve, so let’s figure it out.
What Are Our Two Options?
To buy this $950k property you’ll need a 20% downpayment, which comes to $190,000.
Before you settle on the property you’ll also need:
- Property inspection (~$500)
- Lawyer (~$1,500)
- Insurance (~$,1500)
This comes to an upfront cost of $193,500.
You’ll then borrow the remaining $760,000 from the bank.
Assuming a 30-year mortgage with a 5% average interest rate, that will come to a monthly mortgage payment of $4,080.
That’s the buy side of the equation.
The rent side of the equation is much simpler as it has fewer variables.
Instead of putting that $193,500 on a downpayment, we’re going to invest it in an index fund.
Our rent will come to $600 per week.
We might also want renters insurance, which is usually around $500 per year.
To simulate these two scenarios, we need to make some assumptions.
According to CEIC, house prices in New Zealand have appreciated 6% per year on average over the last 30 years.
The NZX 50 and S&P500 have both appreciated 10% on average over the last 30 years.
Rent generally increases in line with inflation and other costs, at about 3% per year.
Rates for this property are about 0.35% of the property value, or $3,325 per year.
Insurance for this property is around 0.15% of the property value, or $1,425 per year.
With these assumptions, we can estimate the cash inflows and outflows in both scenarios for the next 30 years, and see which option would leave us better off.
You will pay a $190,000 downpayment.
You will pay approximately $500 in inspection costs, $1,500 in legal fees and $1,425 in insurance.
You will pay $49,439 per month in mortgage repayments, of which $38,000 will be interest, and $11,439 will be principal.
During the year you will pay approximately $3,325 in repairs/maintenance/renovations, and $3,325 in rates.
The value of your home will increase 6%, or $57,000, from $950,000 to $1,007,000.
This will leave us with:
- Starting bank balance: $193,500
- Minus payments: -$249,514
- Ending bank balance: -$56,014
- House: $1,007,000 (6% increase)
- Mortgage owing: -$748,561
- Total net assets: $202,425
You start with $193,500, which you invest into the index.
You will pay $31,200 in rent.
You will pay $500 in renters insurance.
You will pay a $2,400 bond.
We will also save $21,914, since renting is cheaper than buying, which we can also invest in the index.
- Starting bank balance: $193,500
- Minus investment into index: -$193,500
- Minus additional investment into index: -$21,914
- Minus rent: -$31,200
- Minus renters insurance: -$500
- Minus bond: -$2,400
- Ending bank balance: -$56,014
This leaves us with:
- Ending bank balance: -$56,014
- Index fund: $212,850 (10% return)
- Additional savings invested into index fund: $21,914
- Total net assets: $178,750
Notice how the ending bank balances in both scenarios are the same.
This is how we get an apples-to-apples comparison.
In Year 1, being a homeowner required $249,514 of cash outflows.
Therefore, we calculate what our position as a renter would be with exactly the same amount of cash outflows.
If there’s a surplus, we invest it.
Then we simulate this over a 30 year period, and see which ones leaves us with a higher net worth.
Year 1 Summary
Your net assets after Year 1 will be significantly lower if you rent ($178,750) than if you buy ($202,750).
Why is this?
Firstly, it’s because you’ve taken out a loan to receive $950k of assets up front (the house).
This means you’re earning a 6% return on $950k, whereas in the rent scenario, you only have around $200k of assets producing a return.
Obviously, your $950k of assets will earn a higher return than your $200k of assets.
However, remember this loan needs to be paid back.
This means your cash outflows are going to be significantly higher as a homeowner than they will be as a renter.
Another thing to note on the rent side of the equation is; our net worth has actually gone down.
That’s because the return on our investments is not enough to pay for our rent (yet).
However, as you’ll see, due to the power of compounding this will quickly change as we continue to invest.
Let’s start with the buy side.
I know this is a lot of numbers, and if you’re a financial nerd it probably looks like Sanskrit.
However, it tells us everything we require if you know what you’re looking at.
The first 8 columns are self-explanatory. They show us the opening bank balance, minus all the things we need to pay for, then a closing bank balance.
As you go down the years, you’ll notice the expenses grow year-by-year, which is expected due to inflation and other factors.
For example, the repairs column shows about $3k in repairs per year on a $950k house.
This might sound high to some (or not), but in my experience, it’s very reasonable. For example, a tap breaks and you pay a plumber $300. A window breaks – that’s another $150. Very quickly this adds up over a year. Not to mention, over a 30-year period, almost everything will break or need fixing at some point. That means a $15k roof repair, $10k paint job, $5k to replace a fence, $5k to replace the carpet, $3k to replace the hot water cylinder, $5k to replace a rotting deck and so on and so on. Averaged out over 30 years, $3k per year is reasonable (or even conservative).
Rates also grow in line with property values, so $18k for rates in Year 30 might sound wild to you now, but if you ask people who owned homes in the 90s, rates were only a couple of hundred dollars. Things will look very different in 30 years (2055).
The column we’re really interested in is the final column.
This tells us, as a homeowner, how much our net worth will grow to after 30 years.
We can see from a starting net worth of $193,500 (which we had saved for our downpayment), after 30 years we will be debt-free with a net worth of $3.36 million.
Now let’s look at the rent equation.
This calculation is simpler, because there are fewer expenses.
Note that the “closing bank balance” is identical to that of the buying calculation (minus $2.12m).
Since we would spend around $2.12 million as a homeowner over 30 years, we need to compare it to a scenario where we also spend $2.12 million as a renter.
Whichever option is the cheaper option, we simply invest the surplus to equalise the amount of spending.
This is how we account for opportunity cost, which essentially is what this entire exercise is about.
The first interesting data point is in the far-right column. You can see our net worth falls in the initial years, as we discussed earlier. We start with a net worth of $193,500, and this falls to $163,000 by Year 4.
However, Year 5 is when compounding finally catches up and starts to work in our favour.
This is boosted by the additional $20k per year that we save by renting as opposed to buying, which gets invested into the index and compounds as well.
Interestingly, you will also notice that this $20k difference we get to invest gets lower each year.
This is because mortgage repayments stay the same (the mix of interest and principal changes, but the total amount stays the same). However, rent continues to increase every year with inflation. Therefore, the savings that we make as a renter slowly decline year-on-year.
However, even that is enough to make a difference, because as a homebuyer you’re in debt, and that means all your cash flow goes towards servicing that debt and paying interest. While your home will increase in value, after Year 1 you won’t acquire any new assets.
On the flipside, as a renter your cash flow isn’t fully committed, and since you’re debt-free, all your surplus cash can go towards buying more assets every year instead of paying interest.
By the end of Year 30, you will have a net worth of $4.9 million, almost $1.6 million more than if you had purchased the house instead.
In summary, in this particular scenario, renting is a far superior option to buying.
Other factors to consider
When I first started running these calculations, I was surprised how difficult it was to make a meaningful comparison.
There are many inputs, and 30-year forecasts are difficult by nature.
This is the first thing you should keep in mind – the model above is highly imperfect.
It requires many assumptions, and while they are all reasonable and based on historical data, they obviously may or may not eventuate in real life.
Secondly, there are many ways to perform this calculation, which all yield differing results.
As an example, people often rent because they cannot afford to buy. In our simulation, we saw that a homebuyer spent approximately $20k more than a renter each year, so we assumed a renter could just invest that difference. However, if you couldn’t afford to buy in the first place, obviously that $20k will not be available to you. You’d simply be struggling to pay rent and be living check-to-check.
This means the model is only applicable to people who can afford both options and have the ability to choose.
We also didn’t account for human behaviour, which is probably the most important.
If you commit all your earning power to buying a home, you are committed to paying off that home, and it’s highly illiquid. You can’t just sell a bit of your home to buy a new car or pay for a holiday. The nature of the investment means you’re quite likely to see the 30-year mortgage through, and end up with a house fully paid off.
However, as a renter, your primary asset is stocks or index funds, which are extremely liquid. You can sell a few hundred here or there with a swipe of your phone, and have the cash within 48 hours. Over a 30-year period, how likely are people to take a naughty dip into their investments to buy a new toy or a vacation?
Unsurprisingly, research shows it’s extremely common.
In fact, research shows many people don’t just take a “naughty dip”, they often blow the whole thing!
If you are not financially disciplined, it’s very possible as a renter, with highly liquid assets, you won’t end up with millions after 30 years. In fact, there’s a decent chance you might blow it all and end up with nothing.
This is one of the reasons Peter Lynch, the most successful fund manager in history, recommends the average person should always buy their home. Since the key to successful investing is waiting, homeowners generally outperform stock pickers, not because the housing market outperforms the stock market, but because stock investors can’t resist selling their shares to buy shiny things! Since you can’t just sell a piece of your house every time you want to buy a new iPhone, a house forces you into delayed gratification, meaning the success rate for making money on a home is much higher than on stocks.
Thirdly, we don’t account for the lifestyle factors.
Renting is flexible, but home-owning is not.
If rents in your area start rising, or you want to slash your rent expenses in half, you can easily pack up and move somewhere else. You even have the flexibility to move back in with parents, or a friend. You even have the flexibility to move overseas.
As a homeowner, you’re stuck with where you are and what you have.
Life is also easier (generally) as a tenant than a homeowner. If the hot water breaks, just call your landlord. However, if you own the home, you have to arrange the repairs yourself (and pay for them).
These are just some of the additional factors that one needs to consider when buying vs renting.
However, when it comes to purely the numbers, at least in New Zealand, the picture is quite clear. I’ve run this model many different ways and every time, renting comes out financially better off.
So Does This Mean You Should Always Rent!?
The purpose of this exercise was to show you that home ownership is not automatically a financially sound decision.
And, that the financial side of the equation is not the only side you need to consider.
When thinking of buying a home, always run the numbers, but also don’t forget to factor in all the pluses and minuses of being a homeowner and a tenant.
You might find that renting is actually the best decision for you.