In my last article on the ‘Best Investment for you‘ I considered John Paulson’s advice for investors to buy a home. I focused a lot on how to value a house using rental yield to get an idea of whether or not you are overpaying for an asset. What I didn’t do was consider whether John Paulson’s advice was sensible or not and a lot of the discussion in the comments focused on house buying vs renting. So I’m going to rewind and address that question. The easiest way of doing this is to crunch the numbers – lucky for you I’ve tried to do as much of the hard work as possible and here is a model of buying vs renting costs with customizable inputs.
For those of you that want to delve in and see how it works you can download the spreadsheet above. Here is an overview of how I put the model together and where those default values came from.
The reality of buying
Let’s first consider the costs of buying – owning a house isn’t free. Firstly there are the upfront costs of paying a deposit (the size of which depends on banks lending criteria in your country) and also buying costs such as lawyer fees and tax. There are then the ongoing costs of maintenance and repairs for a house which will depend on construction quality, age and other things. Then you have the obvious cost of interest on the debt.
As John Paulson’s advice was from a US perspective I’ve used default figures relating to the USA. I used Zillow to find mortgage rates fixed for 30 years, for a house worth $200k and a 10% deposit. The lowest was 4.6% with initial cost of $1k. I add on another $2k for surveys and lawyers etc.
As for maintenance costs, this article suggests they are between 1% and 4% of the property’s value per year, I will use 2% as a middle ground and assume it also covers buildings insurance and taxes.
On the flip side, buying has the benefit that you own an asset which hopefully appreciates in value. Property in the US has historically increased in value by around 4% per annum. But this includes periods of high inflation and interest rates. Given our record low interest rates and how these inflate asset prices I believe 4% is a dangerous assumption. That’s why I’ve used 3% as default in the model.
The reality of renting
The beauty of renting is you are free from responsibility for general maintenance. Your outlay is limited to the rent each month and any additional costs from either being evicted/moving or contract arrangement fees from agents. I assumed these are modest at $100 a year.
You also don’t have the immediate outlay required to purchase a house so for a fair comparison we can assume you still have that deposit money and can earn investment returns on it. I’ve taken a baseline of 6% returns which should be achievable for an intelligent investor.
Monthly costs of buying vs renting
Finally, depending on whether per month renting was cheaper than buying, I had to decide what to do with the difference in those costs. To make it a fair comparison we have to assume that the person has access to the same money each month. So if renting is $800 and buying costs $1000 in total per month, the renter has $200 extra this month that they can invest and get returns on. Conversely if the rent is more than the mortgage then the buyer has extra money they can invest.
So in the model I have assumed that each month, the difference between buying vs renting costs is invested and so it adds to the assets at the end of the mortgage term.
My conclusions on buying vs renting
I have to say I was surprised just how close a call you can make buying vs renting by playing about with some of the values – particularly the investment returns on a deposit, because over a long period like 25-30 years this turns into a substantial amount of money on par with the house. Of course it all hinges on the investment returns assumption.
And in fact the whole model hinges on the initial assumptions, and like pretty much any model, you can make it say anything you want to. So is it much use? Well I think it is interesting to run scenarios through it. At the end of the day I think the renting vs buying decision will be affected a lot by the intangible benefits each option brings – ease of moving, stability of tenure etc. Still, for the financial side I hope people find this tool useful.