Should you rent or buy your home?

owning versus renting 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 conventional wisdom you may have heard.

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 in a specific neighborhood and school for your kids
  • live near 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 real estate returns by relying on these narratives. Casinos and lotteries ensure they have winners every day, but that doesn’t mean you should play roulette.

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 near zero. That’s hard to believe if you are currently living in San Francisco or Boston, but the long-term numbers are clear.

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 about half what you could have expected from the stock market. Said another way, over that 25 year period, $1 invested in the stock market would have grown to $10 instead of $3 for your home.

And, that ignores all the money you spent on your home over those years — property taxes, the new roof, plumbing emergencies, transaction fees, etc. Those expenses would eliminate much of that 4.5% nominal return and you’d be back to earning a 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. Construction methods become more efficient, there is inevitable wear and tear, building codes and design tastes change, and you’re stuck with last year’s model in need of a new paint job.
  3. Transactions costs are substantial. Besides the broker commission, there are other significant expenses such as mortgage fees, appraisals, title insurance, and legal fees. For example, in Massachusetts, the seller pays a county tax of 0.5% of the sale price.
  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. While this “free rent” myth is not entirely false, it ignores your maintenance, taxes, and other expenses you do pay.

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.

Update:The NY Times has a useful calculator that helps answer the rent versus buy question.

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