I received some interesting feedback after my last post on determining if something is a good rental investment. Basically, I was told that the math behind the 1% rule for rentals must be wrong (give the article a read here), otherwise everyone would rent rather than buying a home. Is there a clear winner when comparing renting versus buying a house?
I truly love feedback on my posts (regardless of whether it’s positive or negative) so please keep it coming! You can send questions/comments in the comment section at the bottom of each post, message me on instagram @moneygremlin, or send me a message using the “contact me” function at the top of this blog. In particular, negative feedback allows me to sit back and re-crunch numbers to see if I can explain things in a different way.
As much as I would love to take credit for the 1% rule, it’s not my own. If you google “1% rule real estate” you’ll get 232,000,000 hits today. However, the math works and I stand by it.
I’ve been trying to think of a different way to numerically explain how it could be true. So let’s look at it from the opposite side, and determine whether being the renter can make you rich.
Am I really claiming that when comparing renting versus buying a house, renting might win? Yep!
It’s a hard concept to accept since so many people claim owning a home is the way to eventual financial security. But are they right? To compare renting versus buying a house, let’s do a little case scenario!
First, let’s address one elephant in the room. It’s a fact that home owners typically have a higher net worth than renters. A MUCH higher net worth actually! (For an interesting assessment of net worth and why it matters, read this).
Every 4 years the Federal Reserve conducts their Survey of Consumer Finances and releases the data. The most recent is from 2016, and shows the median net worth of home owners was $231,400 while median net worth of renters was $5200. Obviously home owners won by a landslide (over 44x as much).
Wait, so I SHOULD buy??
Not so fast. While some people would read that statistic and determine that owning makes you richer, there’s more to it. Owning a house is a forced savings plan. Since the bank demands you pay your mortgage each month, you do. Some of that payments goes to interest (the banks portion) while the rest gets applied to your principle (your portion). When you own, there is an outside force demanding you save some of your money each month (in the chunk of the house you pay off).
This doesn’t actually mean that owning a house mathematically wins though. North Americans are terrible at saving money (I define saving as putting it in the bank to grow, not “saving” as in shopping sales). What if we weren’t though? What if there were two very similar houses available, and you could choose to rent rather than buy but you were smart with the surplus money? What does that look like in terms of how rich you are 25 years later?
If you actually make the monthly financial output equal (since regardless of whether you rent or buy you’re getting a very similar house), which wins? Time for a fun case scenario!
Renting versus buying a house: which wins?
Since it’s most accurate to compare houses in an area where I know all costs, lets look at my boyfriends house and an incredibly similar house for rent less than a block away (listed on rentfaster right now).
Both houses are in the same neighborhood in Edmonton. They have 2 bedrooms, 1 bathroom, and similar square footage (the rental is actually 110 square feet bigger). Both have a garage, fenced in backyard, and a fire pit.
Costs to own the house:
L bought his house for $360,000 a little over a year ago. We recently had a realtor reassess it (we were trying to determine which of our houses we should live in) and the price has not changed much.
If you want to buy his house and do not want to pay CMHC fees, you would need to have 20% or $72,000 saved as a down payment. Let’s assume you have that money available (if you don’t then the numbers favour renting even more).
We’ll be nice and ignore closing or inspection costs to keep the math simple.
Since you bought the house for $360,000 and put $72,000 down, you have a mortgage for $288,000. You want to pay it off in 25 years, and the bank offers you a 3.19% interest rate (we’ll assume it never goes up). Your monthly payment will be $1391.18 for 25 years (mortgage calculator).
Using his real bills, you will have additional monthly costs associated with carrying the house as well. He pays ~$325 a month property tax, $225 utilities (Edmonton winters are cold!), $105 for home insurance, and $300 for home repairs*. His total monthly costs come to $2346.18.
*[estimating 1% of your house value yearly for repairs such as a new furnace, roof, etc is a fairly common approach. In his case 1% of $360,000 is $3600 a year or $300 a month. In an older home this may not be enough]
What about renting a similar house?
The house a block from his is currently renting for $1250 a month. Utilities are not included, so let’s say $225 a month keeping it even with owning. You will also need to spend $30 a month on renters insurance. The total monthly cost comes to $1505.
Clearly renting is cheaper, so why are home owners net worth’s usually so much bigger? I believe the main reason is because people typically spend/save what they’re forced to. Since your monthly mortgage payment is required, you pay it and end up with forced savings as you pay the house off. But what if we kept the monthly financial output the same for both the renter and owner? After all, you get to live in a similar house either way! Which method wins then?
Let’s assume the person deciding between the two houses decided to rent after all. Since they had the $72,000 available for the down payment but no longer need it, they tuck it in an index fund investment. Since they’d been considering buying originally, they can obviously afford the $2346.18 monthly that home ownership would have cost. Every month, they invest the $841.18 surplus that they’re saving by renting ($2346.18 to own – $1505 to rent). Now the amount of money they’re putting out each month is equal to the owner, and they get the same house.
Assuming their investment money grows at a conservative 7% per year on average, how much does the renter have after 25 years? (Ie the same amount of time for the owner to pay off the mortgage)
$1,049,452.32!! [investment calculator used]
Yep, that poor renter who society deems as “throwing their money away” is worth over a million bucks!!
What about the person who bought? Well, they have only just finished paying the house off.
You may argue houses appreciate over time, so I’m not being fair. You’re right. Renting still wins though.
Let’s assume the $360,000 house went up in value by 3% per year. 25 years from now, that house would be worth $753,760.05. Not too shabby!
However, the renter could buy it outright and still have almost $300,000 leftover! ($1,049,454.32- $753,760.05).
Renting can make you rich!
Obviously these comparisons depend on housing and rental prices in the area you want to live. However renting should not be overlooked as something people only choose to do when “they don’t have enough money to buy”. It’s incredibly possible to rent and get rich, and it’s worth doing a comparison in your own area before deciding.
I understand that there are many emotional reasons why people want to own their home. You can renovate however you want, never worry about your landlord kicking you out, and there’s a sense of pride associated with owning your land/home. I personally want to own a home for these reasons, so I understand it.
However, you shouldn’t use emotions to justify financial decisions by ignoring the facts. There are lots of valid emotional reasons to buy your home, but that doesn’t change the math. Purchase a home because you consciously value being a home owner, not because you think it’s the only path to financial stability. A lot of the time, renting (if you invest the surplus) wins.
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