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How to work out if you're better off renting or buying a place to live
Wednesday, 12 July 2006
It's a decision we all face sooner or later: Should I rent or buy? We all need a roof over our heads - somewhere to have some privacy and bring up a family. If you're at that point in your life, pull out a piece of paper and a calculator. I'm going to show you which factors to consider when making the choice.
Things not to concern yourself about too much
What's going to happen to house prices in your area? What's going to happen to rents? Are we in a boom or a bust?
Speculation about the property market is always rife. Probably only the stock market exceeds it in terms of punditry. And even that's arguable.
One thing to make peace with early in the buy vs rent decision is that you're going to be acting on imperfect information. Despite all the clever-sounding analysis you read in magazines and newspapers, nobody really has any idea what the long-term outlook for property is in any market. And if they did, they're the owner of a very valuable piece of information and highly unlikely to tell you about it.
Houses in your area could boom or they could plummet - and the long-term factors that would affect them are generally unknown. The economy could go up a lot, the local business environment may tank, previously unknown contamination may be found on your land, it could be re-zoned to become more valuable, immigrants could flock to your area, and so on.
It's fun to speculate about these types of things, but nobody really knows what's going to happen. You'll have to make up your mind without this information, just like everybody else.
The role of interest rates
The interest rates set by central banks have a definite impact on the housing market. When rates go down, house prices generally go up, and vica-versa.
Because of this, most home-owners have a preoccupation with the decisions of central banks. But once again, what's going to happen with rates during the ownership of your house is strictly in the realms of speculation. They could go way up or they could go way down. If your loan is for thirty years, nobody has any kind of clue what interest rate environment you'll be facing over that time.
The level of interest rates probably shouldn't have as much of an impact on people's decisions as it does. It's the total amount you pay over the lifetime of your mortgage that matters, not this month's payments.
If you have to pay a high price for your house because rates are low, are you really better off than someone who pays less but gets hit with high interest? You can work out the various scenarios in a spreadsheet if you like, but often they're pretty similar.
People also often ignore the impact of inflation on their ability to repay a loan. Inflation, if you don't know, is the general rise in prices. For example, a loaf of bread is probably more expensive this year than it was last, along with the price of most other goods.
The main role of central banks is usually targeting inflation. If inflation is high, they'll raise interest rates to fight it. If it's low, they'll drop rates. So times of high inflation are broadly associated with high interest rates.
What generally happens when inflation is high is people get big yearly pay rises. Because prices are rising fast, workers demand bigger salaries to cover their living costs. So even though people may be paying a lot of interest on their loans when rates are high, they're also getting big pay rises to compensate.
Once again, this all comes out to mean that the level interest rates are at when you take out a loan doesn't make as much difference as most people think.
What you can afford to pay for accommodation
Now we're starting to get into what really does matter - and one of the most important factors is what you can afford to pay for accommodation. Remembering that you need money to pay for food, clothing, entertainment, retirement savings and all sorts of other expenses, how much should you put towards housing?
This decision is up to the individual, but a good rule of thumb is to pay no more than 30% of your after-tax income. This should give you a comfortable buffer for if things go wrong such as losing your job or having a big medical bill.
What the cost of renting a house is compared to buying it
After what you can afford, this is the second most important factor. You may have heard of price-earnings ratios which are used for calculating whether a stock is worth buying at the current price. The price to rent comparison is the closest thing in property. This is an easy way to work out if it's cheaper to buy or rent. And cheaper is generally better.
Let's look at a couple of scenarios to get the idea:
House number one
Price: $1,000,000
Rent: $31,285 per annum ($600 per week)
Current interest rate: 7%
Interest on $1,000,000 loan for one year: $70,000
In this example, buying the house costs over double what renting it does for a single year. A lot of factors would have to change before buying could be considered more financially attractive.
People say rent is money down the drain, but if that's true then so is interest. Whether you're giving it to the landlord or the bank doesn't matter - it's still money you'll never see again. Other factors such as maintenance costs and property taxes in your area have to be taken into account of course - but assuming those things don't have too big an impact, in this case the person is much better off renting on a purely monetary basis.
House number two
Price: $550,000
Rent: $33,893 per annum ($650 per week)
Current interest rate: 5%
Interest on $550,000 loan for one year: $27,500
In this example, once again assuming other factors such as tax and maintenance don't play a big part, the person seems as if they're better off buying.
You can use this technique to quickly work out which is cheaper in your area - renting or buying - at any particular time. Compare the price of a house to what it would cost to rent something similar.
The impact of opportunity cost
"Hang on a minute", I can hear a whole bunch of people complaining, "you haven't taken into account that I may have already paid off some of the house. If it's worth $1,000,000 and I've paid $500,000 then I have less interest."
I'm sorry, but it's not quite that simple.
That's because of the hidden opportunity cost of the money you've invested in your house. If you have $500,000 tied up in it, that's $500,000 that you can't use for something else.
You're effectively forgoing any other investment income from that money. So if, for example, banks are paying 10% on deposits at that particular time, the $500,000 you have in your house is costing you $50,000 a year.
Even someone who's living in a house they own, and owe no money on, is giving up income - simply because they could be renting it out to someone else. If your house could be rented for $30,000 a year, then that's what it's costing you to live in it. This is a cost just as surely as if you had no house but were paying $30,000 in rent.
Because of this, you have to take into account what else you could be doing with your money besides investing it in a house. And this includes money you may have made from the value of your house increasing.
A more detailed explanation of opportunity costs is available here.
The impact of risk
There's one investment saying that almost everyone knows: Don't put all your eggs into one basket.
Tying up your entire wealth in one property carries a big element of risk. If something goes wrong - such as flooding, contamination, job-loss, health problems, recession and so on - your house can end up costing you big-time.
We haven't heard many stories recently of people being forced to sell their houses at less than they paid for them, but trust me they'll be appearing sooner or later. Pretty much every real-estate market on the planet has problems at some stage. Before deciding to buy, make sure you're comfortable with accepting this risk.
There's also a liquidity risk associated with housing - in that it's more difficult to sell than most assets. If you own $500,000 worth of shares and you need $10,000 cash for some reason, you just log into your account and sell that many shares.
But you can't just sell your bathroom and keep the rest of your house. Even if you're going to sell the entire thing, you may have to wait months to find a buyer.
The emotional impact
Of course real-estate isn't like most other investments. Most people don't become emotionally attached to their share portfolios in the same way they do to their accommodation. You have to weigh up the emotional factors as well as the monetary ones.
Even if it's costing you more to buy, you may consider that price worth it. You generally can't make major structural changes to a rental property, or paint all the walls purple, for example. You could also be kicked out at any time and have to find somewhere else to live, if it suits your landlord.
On the flip side, if you decide to go and live overseas for a year or two, a rental property is relatively easy to get rid of - you just give your notice. If you own a house, you either have to sell it or arrange to have it rented out, which is often a big hassle.
So the decision can't be entirely hard-headed, although you should always take the numbers into account. Owning gives large numbers of people enormous pleasure in a way that renting simply can't provide.
So there you have it, my summary of factors to take into account when deciding if you should rent or buy. Ultimately, the decision is up to you. I hope this article has got you thinking before doing anything rash.
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