Young people face a lot of pressure from their parents and peers to own a home. Canadians in general have a high rate of home ownership at 69 percent, and in many cases homeowners have seen tremendous growth in real estate prices for the past few decades. For these reasons many people believe home ownership is the ticket to wealth and renting is a waste of money.
But is renting throwing away money? Or, just ‘paying someone else’s mortgage’? We need to show a fair comparison of the rent vs. buy scenario to know for sure.
Is Renting Throwing Away Money?
Most people tackle the rent vs. buy problem incorrectly by framing it as the cost of monthly rent versus the cost of a monthly mortgage payment. The argument goes something like, “if your monthly rent costs as much as a mortgage payment on the same or similar property, then it’s a no-brainer to buy the home and build equity rather than flushing your rent money down the drain.”
Others argue that a better comparison looks at the true cost of home ownership, which not only includes the mortgage payment but also things like property taxes, insurance, and maintenance.
However, as PWL Capital’s Ben Felix pointed out in the latest Rational Reminder podcast, neither argument paints a truly fair comparison of rent vs. buy. What you need to look at, he explains, is the total unrecoverable costs in each scenario.
For example, a monthly rent payment is a total unrecoverable cost – an expense that does nothing to improve the renter’s net worth. A mortgage payment, on the other hand, only has partial unrecoverable costs – the interest paid on the mortgage. The other portion reduces your mortgage amount and therefore increases your net worth.
A winning point for home ownership, right? Not so fast.
We need to add up all of those additional costs that a home owner bears (property taxes, insurance, maintenance), plus any upfront money spent on a down payment, land transfer tax, title insurance, home inspection, etc. to close on the home.
There’s also an opportunity cost on the down payment and other closing costs. That money could have been invested instead of put towards buying a home.
Rent vs. Buy: Let’s Do The Math
Let’s look at an example of a renter in Toronto who’s paying $2,000 a month to rent a 575 square foot condo. The same condo is listed for $449,000.
To purchase the condo our renter would need to put down 5 percent, or $23,450, plus add another $17,062 to the mortgage due to CMHC insurance (required on all mortgages with down payments of less than 20 percent), for a total mortgage amount of $443,612.
Our upfront costs are not done, however, as we need to add in land transfer taxes of $10,910, lawyers fees of $1,000, title insurance of $449, plus a home inspection for $500.
Total upfront costs = $36,309. The opportunity cost of this amount in 25 years at 6 percent a year = $155,834.
Now let’s look at the unrecoverable monthly costs. The mortgage is amortized over 25 years and has an interest rate of 3.50 percent. The monthly mortgage payment is $2,215. Of that payment, $1,200 goes towards interest and $1,015 goes towards paying down the mortgage principal.
Then we have property taxes coming in at $375 per month, and we’ll also add the difference between home insurance and tenant insurance, which is $40 per month. We also need to add expected maintenance costs, which we’ll estimate at 1 percent of the property value per year, or $375 per month.
Total unrecoverable monthly costs (interest, plus property tax, plus insurance, plus maintenance) = $1,990
The unrecoverable costs for the renter and homeowner are nearly identical. The total monthly payment for the homeowner, including property taxes, insurance, and maintenance, is $3,005. Just $1,015 of that is building equity in the home. So, back to the rent vs. buy argument.
Rent and Invest the Difference
We have to assume our renter has an extra $1,015 available in their cash flow each month to invest. What are the expected returns for a 60/40 balanced investment portfolio over 25 years – maybe 6 percent?
$1,015 per month invested for 25 years at 6 percent per year = $686,627. Add the opportunity cost of the down payment and other upfront expenses and you’d have a portfolio worth more than $842,000.
Historically, many people would be surprised to learn that the return on real estate has been closer to inflation. Certainly with the run-up in home prices over the last two decades one should not expect significant gains from this asset class moving forward.
So the expected future value of the $449,000 condo in 25 years at 2 percent growth per year is $736,600.
Is renting really a waste of money? Hardly. This is just one example showing how to frame the rent vs. buy comparison, but you can make a strong case for renting and investing the difference of the true cost of home ownership. Plus, we didn’t even get into the opportunity cost of the homeowner forgoing RRSP and TFSA contributions due to the higher cost of home ownership.
Who comes out ahead in this case? Clearly it’s our renter, who invested steadily for 25 years and ends up with a portfolio of $842,000. That’s compared to our homeowner who has a mortgage-free home in 25 years worth $736,600.
The next time you hear an argument that renting is throwing away money, stop and consider things like unrecoverable costs and the true cost of home ownership before drawing your own conclusion.