Rent vs. buy: A gnarly calculation
A detailed walk through the decision to buy instead of rent
You’ve got a lifestyle in mind. Will you be financially better off renting or buying it? Let’s dive into all the moving parts.
We might have some intuition that because of the transaction costs of buying and selling (agent, lender, title, and numerous other fees), it’s better to rent if we’re only going to stay for a short time.
If we plan on staying longer, however, the advantages of homeownership can overcome the large upfront cost and can make buying a better financial decision than renting even when the monthly out-of-pocket costs are larger for the homeowner than a renter.
Figuring that out however, requires accounting for a lot of different and changing pieces: what’s the home’s price vs. rent for a similar one? What interest rate can you access for that price and the down payment you have? Can you save on transaction costs (without paying more to win the house)? How do you think the stock market will perform? What about home prices? Rent growth?
Even after scoping out those (big and tricky) pieces, you’d need to synthesize it together with upfront and recurring costs, and parse out the different tax treatments for your investment streams — an important part of the cost of turning that money into usable cash again.
Then, after you form those forecasts, what if you’re wrong? When time series look like they do these days, forecasts are HARD. Resilient decisions are those that work in most outcomes. So you’d really want to explore all the possible futures.
Doing all those calculations is a lot of work.
Luckily, I’ve coded it all up (read more below about our methodology) and visualized the results in Tableau.
By adding up all the costs and benefits over time associated with buying, and then doing the same for renting, we get the total accumulated net costs. After the costs associated with renting start to exceed those for the homeowner, the homeowner would have lived there long enough to make the purchase a good financial decision — though some would also be willing to accept the financial risk and/or cost of having to move earlier to follow a job, a partner, or family, for the other potential advantages of home owning not captured explicitly here.
(Thank you, tidyverse! FYI, Tomo Analytics is all python, so there’s plenty of good natured ribbing about my love of R.)
Benefits of owning (with a mortgage) included in the rent vs. buy tool
- Fixed monthly costs: A fixed-rate mortgage fixes the payment amount for a long time. A homeowner’s monthly costs then grow with property taxes (often slowed by local laws), insurance, and maintenance. This is a bigger advantage as pressure builds on single-family rents (up 13% year-over-year nationally in February 2022 according to Corelogic’s SFRI).
- Leverage: After only putting forward a fraction of the home price as down payment, the homeowner earns the appreciation on the full value of the house. The cost of leverage is the interest paid, so as rates increase, this benefit is muted.
- Debt pay down: Part of the out-of-pocket costs pays down your mortgage debt turning it into automatic savings. This happens faster when you have a shorter loan term since a larger share of your payment goes towards the principal right away.
- Asset price growth: Home price appreciation is often more stable than the stock market. While home price growth is expected to slow, it is not expected to fall nationally. Experts expected lower returns from the stock market over the next several years (the S & P 500 is down 185 since the end of last year, but has averaged 8.5% annually over the past 30 years).
- Capital gains exclusion: The profit from a home sale is tax free if under $500k when married and $250k when single. (We use $375k — “half married” — for this simulation.)
Benefits of owning NOT included in the rent vs. buy tool
- Extra satisfaction out of ownership or personalization: it’s important that you’re comparing the rent and price on a similar property if you want to isolate your decision to the way you access the lifestyle (rent it or buy it). But you could get satisfaction out of owning itself and the option value of personalization.
- Option value of refinance: U.S. homeowners are supported and protected by a massive housing finance apparatus. Forbearance and the option to refinance during an economic crisis — when rates are pushed down as a matter of policy support — was critical to homeowner resilience during the pandemic.
- Value of sweat equity: A skilled, tasteful person with construction chops who enjoys a project (or several) could break even more quickly.
- Option value of future rental income: Some buyers decide to become landlords, whether by renting out a room or by not selling and renting out the full property when they’re ready to move on. We didn’t put that in here.
Upfront costs
The most immediate way many approach the question of whether or not to buy a home is to confront the idea if they even can. While as a renter you should expect to pay a security deposit, first and last month’s rent, and an application fee, the buyer will need cash for a down payment and transaction costs.
While down payments for FHA and even some conventional products can go as low at 3.5%, the larger the down payment, the lower your risk of going underwater on the mortgage (owing more than the home can sell for) and the lower your interest rate. A smaller down payment increases your debt load and so your monthly payment. For some, this will push your debt-to-income ratio above what will qualify you for a mortgage.
There are increasingly more market innovations that further minimize the buyer’s upfront contribution to the home purchase (shared equity, lease-to-own), but these models also reduce the share of the investment benefit that goes to the homeowner.
Extra-low down payments and untried financing models likely impact a hopeful buyer’s chances of winning a bid in a competitive market. So a typical buyer these days still gets a 30-year fixed rate loan with at least 10% down.
While the down payment gets a lot of attention, it’s not truly a cost. Like the renter’s security deposit, it’s something that will come back to you.
The painful upfront costs to the breakeven are all the little expenses that, when added up, can make up about 3% of the home price. Higher still is the ballpark estimate for the transaction costs at your eventual sale (8% of the home price; the seller generally pays the both agents’ commissions).
Reducing transaction costs is about continual process improvement and the application of tools and technology — something PropTech is only beginning to tackle in the mortgage industry (we’re on it).
Monthly costs
The next most immediate and tangible way that a consumer will tackle the question of whether to buy is to confront monthly costs.
For example, we commonly report the homeowner burden — the mortgage, insurance (assumes 0.5% of home price annually), and property taxes (assumes 1% annually) on the typical home — as a share of income. And, for good reason. Affordable monthly housing allows room for emergency, retirement, and rainy days savings — for financial resiliency.
In our rent vs. buy calculation, we add maintenance costs (1% annually) as well and incorporate some logic applying the mortgage interest deduction (but since the standard deduction doubled, and without knowing the buyer’s other itemized deductions, this is negligible in most markets).
The renter’s monthly out-of-pocket costs are rent (Corelogic’s median 3-bedroom, single-family rent) and renter’s insurance (15% of rent annually).
If owning is more affordable than renting on a monthly basis, then it’s probably a financial advantage over the longer run too. However, owning can be financially advantageous even when the renter’s monthly costs are lower. It has everything to do with the investment potential of each option and how long you stay.
Investment potential of renting vs. buying
The just-monthly picture leaves out the investment nature of the home buying decision. You are primarily paying for a place to live, yes, but the home will also be an appreciating asset.
To make a comparable decision to buying as a renter, we assume that the renter is fully investing the extra money that would have been used to buy and own a home. That includes any “savings” (the difference in monthly costs between buying and renting) each month. To keep it fair between the choices, the renter also has to take money out of their investments to cover the difference during periods where out-of-pocket renter’s costs are larger than the homeowner’s for a similar property.
But what return does the renter earn on their investment? As a default, we assume a constant 5% annual return. This is kinda like taking the average growth in the S&P over the past 30 years (about 8.5%) and docking with a risk penalty.
We also provide options for the very risk averse, who would only yield 2%, say in CD accounts, and the very risk loving and financially literate who might want to assume a 10% average return on their investments.
Expectations for the stock markets over the next 10 years are mixed. And it’s important to know that having to sell in a down market because of liquidity problems decimates a portfolio. If you can confidently hold for a long period of time because of other buffer wealth, 8.5% or more becomes a more reasonable average growth rate. Try all options to see how this assumption matters.
Setting the forecasts for home values and rents
There are many possible futures at this tumultuous stage in the U.S. economy. Mortgage rates are rising to an unpredictable level as the Federal Reserve pulls back its support; home prices exploded during the pandemic pushing price-to-income ratios beyond previous bubble-era peaks, and single-family rent likewise saw record growth.
Decisions at this uncertain time should be resilient ones, which is why we provide three potential forecasts to use for home price growth during the first year:
- Half of the momentum forecast: This takes a simple time series forecast capturing the current price momentum, and halves it. Given aggressive current price growth, this is generally the biggest forecast.
- Historic average (default): The average year-over-year for the available history before Jan 2020.
- Flat (0%): Exploring this option can ensure resilience to your home purchase decision.
You can choose two options for rent growth in the first year
- 3%: A rate more consistent with Federal Reserve inflationary targets
- 10%: A growth rate closer to the recent performance of single-family rents (+13% year-over-year in February; Corelogic SFRI).
At year six, no matter what option you chose for the first year, home prices will grow according to the historic average rate and single-family rents at 3% (long histories of the Corelogic SFRI are unavailable) .
Cost of liquidation
To enjoy your investment, you have to liquidate it.
- Renter’s liquidation: security deposit is returned and renter pays full capital gains taxes on their investment returns.
- Homeowner’s liquidation: sells the property with transaction costs (typically 8% of sale price) and only pays capital gains taxes on the profit above the primary residence exclusion, a whopping $500K when married, $250K when single.
Putting it all together:
Combining all the costs and benefits of each decision separately, we can estimate the total accumulated net costs of each decision. For the homeowner, this would be all the costs associated with buying (interest payments, insurance, maintenance, transactions costs, opportunity costs for the money you could have spent or invested elsewhere, etc), offset by the benefits (home equity, tax deductions, etc). For the renter, it’s the same (all the costs such as rent, insurance, the opportunity cost for the money you could have spent /invested elsewhere,) but with few explicit benefits beside low transaction costs making it easier to relocate.
Sources and more methodology notes
Rents and prices
To capture comparable rents and prices for a typical home isn’t straight forward. We pair a Tomo Economics blended estimate of the typical value of a home (built from ZHVI, FHFA HPI, and 2019 5-year ACS) and the metro median 3-bedroom, single family rent from Corelogic. These measures are more correlated across metros than other options, a confirmation that built from different sources they are capturing similar pressure in the two highly related markets: the typical valued (not luxury!) for-sale market and single-family rentals.
Corelogic median market rate 3-bedroom, single-family rent should be a much more reliable comparison for a current rental seeker as we cannot easily isolate new leases (just recent movers) and remove non-arms-length landlords in census data.
Across the metros where the Corelogic measure is publicly available, the average lift over another, more readily available way of estimating the typical single-family rent is about 11%. (rents reported by recent movers to single-family rentals chained forward to the current month with ZORI from Zillow) is about 11%. We apply this premium to the more readily available rent estimate to recover breakeven estimates in the United States as a whole and for regions where the Corelogic data is not available.
Tomo Economics creates a dollar-denominated estimate for the “typical” home price across the nation and metro areas by combining two widely available home price indices (HPIs), the ZHVI and the FHFA HPI. The FHFA HPI is first dollar denominated by pegging the value on June 30th 2017 with the median reported home value drawn from the 2019 5-year ACS. See this post for the motivations behind creating this “wisdom-of-crowds” style estimate.
To estimate a pre-pandemic breakeven these prices are chained back from December 2021 (the last available data for our blended measure until the quarterly FHFA HPI update at the end of this month) to December 2019 with the corresponding index (Corelogic’s SFRI for rent and Tomo’s blended index for home values).
Home price forecasts
The user is given the typical home price for the metro, but able to choose three options for home price appreciation over the first year. Home price over time is then used in determining so many other streams such as home equity, property taxes, and even maintenance expenses. The options are flat (0% growth), half of a momentum forecast, and historical appreciation (the average year-over-year for the available history before Jan 2020).
The momentum forecast is a simple auto-SARIMA, so does not dynamically capture the influence of higher rates, but stands for the possibility that price growth remains elevated above historic averages but significantly slowed from the pace of price appreciation set during the pandemic.
After the first year, regardless of your selection, home price appreciation splines to the historical growth rate over a course of 6 years.
Rent forecasts
Because I only have year-over-year single family rent growth estimates for 20 metros from Corelogic’s public reporting, we feel less comfortable programmatically estimating metro or nation specific forecasts for rent growth so only provide two discrete options for the first year growth rate: 3% (more in line with normal times) and 10% (in line with current growth).
After the first year, regardless of your selection, rent growth splines to 3% over a course of 6 years.
Comments on other simplifying assumptions
- Uniform property taxes: 1% of home value. In a high tax district (layers and layers of local tax districts), breakeven will take longer (or could never happen).
- Uniform property insurance: 0.5% of home value or 15% of rent annually. In a flood plain? In a high fire risk area of CA? The breakeven will take longer or may never happen depending on the level of insurance needed for a fair and safe mortgage.
- Steadily setting aside 1% in the home’s value every year and spending it on home maintenance may be a serious underprovisioning to meet the fixer-upper needs of older homes.
- No HOA or condo fees. If you have condo or HOA fees, you would also want to assume that at least some of your home maintenance costs would be covered (or what is the organization for — just restricting your neighbors? Boo.) The more superfluous the charges, the more that option looks like the downsides of renting: your payments are spent and gone every month.
- No difference in utility payments between buying and renting: This is the same as assuming the landlord accounts for your utility use in your rent and you will use the house the same whether you own or rent.
Using the concept of opportunity cost to simplify the math
To make a comparable decision to buying as a renter, we assume that the renter is fully investing the money that would have been used to buy a home and that would include accounting for any savings or withdrawals (the difference in monthly costs between buying and renting) each month. That’s actually hard to code the way it would functionally work.
The easiest way to estimate that, and yield equivalent results, is to estimate what the buyer would have earned in interest in our simulated stock market with ALL the money they spent on housing. As if they just floated in the air and invested all that out of pocket money. That’s their full opportunity cost of buying. Then do the same thing for the renter. The amount the buyer’s opportunity cost exceeds the renter’s opportunity cost (and it nearly always does bc of the down payment and upfront cost) is then the individual’s full wealth trajectory minus what they could never have attained anyway because living takes lots of money!
