Rent or Buy? Enough Already!November 16, 2015
Tell me if you’ve heard this gem of financial advice:
If you’re renting, you’re throwing money away each month.
As renters, we’re regularly bombarded with quotes such as these, along with endless amounts of “expert” analysis telling us that buying a home is always in our best interest, regardless of our current financial situation. Here at SMD, we’re beyond ready to say “enough already!” and go on enjoying our lives as renters. After much deliberation based on the long-term impact and current housing market in our town, Mrs. Saver and I have concluded that buying a home simply isn’t a great idea for us at this stage in our lives.
If you’re a renter who’s made a similar conclusion, it can still be a burden to listen to friends, family or colleagues telling you that your decision to continue renting is a mistake. This may lead to a Fear of Missing Out when it comes to home ownership.
Filtering through common home ownership advice
Not too long ago, I received some unsolicited advice from a banker friend who, before gathering any information on our financial situation, declared that the best thing we could do with our money is go out the following day and buy ourselves a house with $0 down. Not only is this dreadful advice for us from a long term financial perspective, but in giving this advice, he failed to realize one simple truth about home ownership — there are as many reasons for buying/not buying a house as there are houses. Let’s break down some more of this home ownership advice and take a realistic look at each of them.
Advice: You should buy if your monthly mortgage payment is lower than a rental monthly payment.
Problem: Thinking of a home purchase simply in monthly-payment terms is terribly dangerous. It’s the same way most car dealerships lure you into buying a car that you can’t afford. Low monthly payments are very attractive, but this invariably means that you’re paying much more over the long term thanks to the accruing interest. This also glosses over the idea your monthly payment might only apply to a small portion of the principle of your mortgage.
Advice: Buying a house basically acts as a savings account.
Problem: I can see where this one is coming from (each payment applies to a portion to the principle of the mortgage, which translates into equity in your home), but in reality, that’s a miserable savings account. If you look at a typical mortgage amortization schedule, it’s common for your monthly payment to be applied primarily to the interest on the loan. Looking at this example from The Truth about Mortgage, if you have a $100,000 mortgage with a 6.5% interest rate (admittedly, this rate is a bit high compared to current rates) and made a $650/month payment, only about $90 would apply to the principle of the loan.
That example is a bit specific, but it should be noted that the above advice implies that you’re better off buying a house to save money than simply cutting back on a few bad money habits. In short, I can’t help but think this rationale for making the largest purchase of your life is a bit absurd, and those that are currently saving less than $100 each month (including retirement savings) are probably not prepared to buy a house in the first place.
Advice: You’re throwing away money by renting.
Problem: Barf. This one will be debated until the end of time, but it all comes down to a matter of perspective. For us, we love the many benefits that come with renting, such as freedom to move when we want, fewer responsibilities, and little to no maintenance costs. We’re still in our 20s, so the thought of buying a house and being confined to a specific place for several years doesn’t fit too well with us at this stage in our lives. We enjoy seeing different parts of the world, and our current career paths have the potential to lead us to some fresh new places every few years. For you, buying a home might just be right for the current stage of your life, and if you crave that stability, then yes, renting might seem like throwing money away.
From a financial standpoint, I’m not convinced that renting is always throwing money away. Buying a house comes with countless other expenses that simply aren’t present while renting. Closing costs, property taxes, Private Mortgage Insurance (if you don’t put down at least 20% down payment), and an unpredictable amount of maintenance costs all add up over time and could potentially cause you to lose money over the long term. This can be easy to overlook, as it involves carefully tracking your net worth over the course of your home ownership. Even if you sell your home and end up with a nice pile of cash, it often pales in comparison to the even bigger pile of cash you put into your home that you won’t get back. If you end up breaking even throughout this process of buying and selling, then congratulations, you just rented a home.
Additionally, it must be said that the pile-of-cash scenario above doesn’t take into account what you do with that money after you sell your house. Planning on upgrading to an even bigger house with that cash? You’re now starting at zero all over again! Repeat this cycle to successfully never own a home.
Unless you’re tracking your net worth and comparing it with renters who are doing the same in your neighborhood, then please, stop dispensing this “throwing away money” advice.
Advice: A house is a great investment.
Problem: This ties in closely with the above problem about throwing money away. I’m still not convinced, though there are some compelling arguments in favor of it being a solid investment. The real issue is that you’re probably doing it wrong.
Want to buy a house that’s below your budget and put in some good old fashion hard work to fix it up? You’re probably making a good investment.
Want to buy a house that quickly gets converted into a rental property as a source of income? Bravo. Great investment.
Want to buy a house with a minimal down payment and pay others to do the fixing up for you? Oh, and you want it move-in ready? Sorry friend, it’s probably not a great investment.
You see, houses can be superb investments, and like any great investment, it requires a certain amount of risk.
And before you say it, no, buying more house than you can afford doesn’t count as the risk you should be making as an investor. That risk boils down to either losing your home or paying lots and lots of money for a house over the long term. Rather, it’s the bank taking a risk on you. They’re risking that you may/may not make your mortgage payments, and as a result, they could benefit from a healthy long-term return on their loan investment (equating to whatever your interest rate is). The simple truth is that banks employ thousands of people to find ways to make money off of you. Convincing you to buy more house is one of them.
Instead, by buying less house than you can afford, putting in the work yourself to build equity, and working towards paying off that mortgage sooner rather than later, you tip the scales in your favor of seeing a nice return on your investment. Also, utilizing that house as a rental property is an excellent alternative and can provide a nice stream of passive income over the long term.
What’s the uniting factor in each of those “good investment” scenarios? They involve hard work. There’s a very fine line between buying a house as a luxury item and buying a house as an investment, and sadly, most people don’t know the difference. Simply put, your house won’t become a great investment if you’re making minimal mortgage payments and sitting on your ass all day.
Advice: Go out tomorrow, and buy a house with $0 down.
Problem: Please don’t do this. If you aren’t able to save even a penny in order to buy a house, you’re probably not financially ready to make the leap. Putting zero down means you’ll be forced to pay monthly Private Mortgage Insurance (PMI), which is definitely throwing money away. You get nothing out of paying PMI. This payment goes directly into the bank’s pocket as a means of insuring them if you happen to fail at paying your mortgage. It’s imperative that you take the time to save up at least 20% towards a home down payment. Not only will this show the banks that you’re reliable with your money, you’ll pay far less in interest over the life of the loan (and you’ll avoid paying PMI).
At this point, you might be saying, “what about the opportunity cost of not building equity today?”. Keep reading.
Advice: Don’t wait too long to buy a house. There are massive opportunity costs in waiting.
Problem: This is true, but the same can also be said for investing in general. This advice is regularly given to those who aren’t saving and investing money. There truly are massive opportunity costs by simply stuffing your money into a savings account. Thanks to our friend inflation, the value of your dollar continues to fall over time (-3% on average each year).
What this advice attempts to target is the ability of building equity as soon as possible. By not buying a house, a renter is putting their money into a property that yields them zero return and will give them nothing in return other than shelter. When we compare a home owner to a renter, then yes, the renter will lose all day long thanks to the equity being built up by the buyer. With the 20% down payment suggestion being thrown around by us, as well as many other financial bloggers and gurus out there, the idea of “waiting” and saving up that down payment can easily seem like a waste of time due to the opportunity costs. So how can we avoid this opportunity cost? Ding ding ding – by investing your cash in the market in the meantime.
Take a quote from a recent Money article when discussing the need for renters to become buyers as soon as possible:
“People say, well if you invested that money in mutual funds instead, it might earn a higher return,” says Smoke. “But in reality, renters aren’t setting aside and investing the money they would have spent on principal payments.”
Note that he doesn’t say that the mutual fund route isn’t true. What so many banks and financial institutions hope for is that you will not be a renter who also invests their money.
So what should you invest in?
First, it depends on your time horizon for your home purchase. For us, we plan to save up our 20% down payment and make a home purchase in the next five or more years. Due to the volatility of investing solely in stocks, we have a fund comprised of a index funds in a 55%/45% bond/stock mix. Sound a bit confusing? It doesn’t have to be. We use a Betterment goal fund for this. Here’s a look at the portfolio that Betterment set up for us based on our selected asset allocation (55/45):
We do this 45/55 split in order to minimize losses (bonds are ideal for this), while allowing for a moderate gain (with the help of the stocks).
If your time horizon is greater than ten years, you might even want to consider a more stock-heavy fund if you’re feeling adventurous. If your time horizon is less than five years, and you’re able to save the 20% in that time, I’d recommend a high-yield savings account to avoid potential short term losses.
When you invest your down payment savings, you’re effectively paying for that future house of yours right now. How? By investing those savings, you could see a moderate-to-high gain, which is potentially greater than that of your equity growth over time. Once you’ve saved that 20% down payment, you’re able to utilize that money by paying for 1/5th of your new house. At that point, the question becomes — do I want a house, or do I continue investing?
In short, when heavy investing enters the equation, the opportunity cost factor in buying a house becomes much less of an issue.
Do you want a home? Do you want to live in your current town for many years to come? Do you have the ability to save and invest your money properly in order to make your home purchase a worthwhile endeavor? These are the questions you should be asking yourself. And just because you’re renting doesn’t make you bad with your money. There are countless considerations that go into buying a home, and in the end, it all comes down to your own situation. For us, we’ll be taking Mr. Money Mustache’s advice on how to buy a house.