The Personal Financier: Is It Better to Buy or Rent?

Another look at this timeless question. Now better explained with a great tool by NY Times.

The NY Times has one of a few calculators that actually get the comparison between rent or buy right. I strongly recommend visiting Is it Better to Buy or Rent @ NY Times to get a feel of it.

This post is essentially an improved older post in which I've explained my approach to the buy or rent question, the same approach taken by this simulator.

There are many psychological aspects to the question of rent or buy. While these may be debated in length it is important to get the financial part of the question right (A deeper look into the psychological aspects is available related posts further down the page).

In this article I will examine the financial aspects of the decisions in the form of the alternative 'loss' in each option (Rent Vs. Buy). We are not always aware of the entire financial picture.

When addressing a financial question we should isolate those variables which can be measured and compared. We should regard a house as every other asset and ask ourselves which way to purchase the asset is most desirable financially.

In order to compare the two options we must first have a common basis for comparison. Evaluating rent or buy, financially can only be made by considering the same asset, of course. Thus, we shall look at two alternative paths to own a house in a certain period of time:

Option A: Buy the house today and live in it for that period: The Buy Option.

Option B: Rent the house today and buy it in the end of the period: The Rent Option.

Option A: The Buy Option

Let's assume our future home owner buys a house with the common combination of equity and mortgage. His 'losses' would include:

Interest paid on mortgage - The most obvious would be the interest paid monthly as a part of the mortgage payment. This is essentially 'throwing' money away much like rent.
ROI on equity - A bit less obvious would be the optional return on investment on his equity. Our home owner would have invested his money instead of using it as a down payment for the house. This alternative investment could have potentially yielded significant return which is lost when invested in a house (to be gained, possibly, by a rise in house prices)
Deal costs - The costs of deal itself that include taxes, real estate agent's commission, lawyers etc.
Home maintenance and improvement costs - House ownership often means maintenance and home improvements otherwise avoided.

What about potential gain? In the buy option our home owner has a great potential gain as his investment in the house is a leveraged investment (An investment made with a combination of equity and debt).

The possible gain extends to funds he didn't have in the first place. Here's an example: Our home owner has invested his equity of 100K US$ in a portfolio which yielded a 5% return of 5,000$. Assuming his house has yielded the same return (5%) but was purchased with the same combination of equity and mortgage (say another 100K US$) his return on investment is now 10,000 US$ (with some paid as mortgage interest but with a relatively low interest rate).

Notice the return on his house is gained also on the debt or mortgage part of it (Higher absolute return).It is important to note that this potential gain is also a source for potentially greater loss since in the case of loss on his investment our home owner is left with mortgage payments unaffected by the devaluation of his property.

Option B: The Rent Option

Let us now examine the 'losses' in the rent option:

The monthly rent - Self explanatory.
The potential gain on the house as an asset - While renting housing prices may rise significantly without any benefit for the one renting (the renter will eventually have to pay more).

The potential gains for the rent option are

Return on equity - Return on equity not invested in a house but alternatively invested in a portfolio.
Return on monthly savings - Not having to pay a mortgage leaves the renter with the ability and duty of saving the principal part of the monthly payment so that he or she may buy the house at the end of the period. These funds generate return on investment as well.

When comparing the two alternatives we should always compare them for the same asset and for a set period of time in order to achieve a true comparison.

After getting the financial part out of the way we must make room for the psychological aspects of house ownership vs. periodical rent. I'd like to dwell on one unique psychological aspect: The motivation to save. In the buy option our home owner is forced to save in the form of timely mortgage payments. In the rent option our home owner needs some discipline in order to save the money for future house ownership. As available money always has its uses the mandatory part of the mortgage is an excellent motivator for the less disciplined savers.

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