Should you rent or buy your home?

Whether to rent or buy your home is one of the eternal personal finance questions. My two cents on this topic may be counter-intuitive to more conventional wisdom you may have heard.

Good Reasons To Own Your Home

If you can afford to do so, there are compelling non-financial reasons to buy your home instead of renting one. For example, you may want to:

  • be rooted in a specific neighborhood and school for your kids
  • live close to existing friends and family
  • renovate the kitchen or plant a garden

These are all sensible reasons to own, but that doesn’t mean it makes good financial sense.

Many of us hear stories of family, friends, and neighbors who made a “killing” in real estate. Some of the tales may even be true. Because people are more likely to share their successes than their failures, you don’t get a balanced view of residential real estate returns by relying on these narratives. Casinos and lotteries have winners every day, but that doesn’t mean roulette and scratch tickets are good investments.

If you were to examine historical numbers, you would see that residential real estate has been a mediocre financial investment. Over long periods of time, residential real estate values tend to just keep up with inflation. Its real rate of return (i.e., net of inflation) is a bit more than zero. That’s hard to believe if you’ve lived in San Francisco or Boston for the past 10 years or are in the midst of our post-pandemic real estate frenzy, but it’s more understandable if you look at many localities over long periods and include the expenses incurred along the way.

We are also easily fooled by compound growth. Consider a house that tripled in value over 25 years. At first glance, that seems worth boasting about at your next cocktail party, but if you were to run the numbers, you should probably stay quiet.

The annualized return would be ~4.5% — not terrible, but less than half what you could have expected from the stock market. Said another way, over that 25 year period, $100 invested in the stock market would have grown to $1,000 compared to your home’s value tripling to $300. (Stock market returns have historically averaged 10% per year.)

And, that ignores all the money you spent on your home over those years — property taxes, the new roof, plumbing emergencies, ongoing maintenance, transaction fees, etc. Those expenses would eliminate much of that 4.5% nominal return and you’d be back to earning a net return roughly equal to the inflation rate — or not much more than if you had put the money in a savings account.

Why isn’t residential real estate a good financial investment?

1. It’s a money pit.

While some tasks may be well-suited for DIY projects, many require expertise, equipment, or scale economies that you probably lack.

2. Houses depreciate.

Over time, construction methods improve, there’s wear and tear, building codes change, design tastes evolve, and you’re stuck with last year’s model in need of a makeover.

3. Transactions costs are substantial.

Besides the broker commission, there are other significant expenses such as mortgage points, appraisals, and legal fees. For example, in Massachusetts, the seller pays a county tax of 0.5% of the sale price and the buyer typically purchases title insurance that may be a similar magnitude.

4. Your net worth is too concentrated in a single asset — your home.

Renting allows you to diversify your asset base more broadly.

5. Your mobility is reduced.

You probably bought the house planning to stay there for many years. Things can change and it’s not always easy to sell a house quickly. If the unexpected happens, this “option value” can be worth a lot.

6. Land use becomes more efficient over time.

While it’s true that there’s no new land being created, land does get re-zoned and reclaimed for residential use, thus increasing the supply of buildable lots.

A common belief is you get to live in the house “for free” as you pay your mortgage. This “free rent” myth ignores your maintenance, taxes, and other expenses you do pay, as well as the money you’ve tied up in the down payment.

Buy a house for the non-financial reasons but don’t do it because you think it’s a great investment. A better financial foundation is to rent and invest the excess funds that are not being poured into the money pit.

Also:  The NY Times has a useful calculator where you can enter your own numbers to answer the rent versus buy question.

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