There is an old adage that you it is better to buy a home and build equity while renting is a waste of money. But this goes against everything that a market economy stands for. So lets look at why renting is actually not a waste of money.
We’ll first start by discussing in theory why renting should not be a waste of money. Then move onto some actual numbers.
Theoretically Why it Should Not Be
We are going to look at this from the supply side. You could look at it from the demand side but it will be tough to project the demand curve as people’s personal finances are a determining factor in their overall decision to rent vs. buy. More specifically, a change in price on housing, where it might be ideal for a person to buy, may not result in them actually buying due to personal finances (not being approved for financing). So on a supply side from the renting side, if buying vs. renting truly was advantageous, it would be expected that people would buy properties and rent them out as the numbers dictate this would be an advantageous investment strategy. But given what we know about supply and demand, this would increase the supply of rental units available, decreasing the price to rent, making it less advantageous to buy and then rent. So theoretically, the market should be in an equilibrium meaning the renting vs. buying should work out to the same end financial result.
Theory Behind Why it Works Out to the Same
Intuitively, buying seems more logical than renting. When you buy, after you pay off your mortgage you are left with an asset that is worth a large sum of money, while when you rent you are paying someone else’s mortgage. So why not buy and pay off your own. While first of all when you buy a home you are required to make a down payment. An alternative would be to invest this down payment for the life time of your mortgage. Assuming you get a decent return on the investment, the end result will be substantially more than what you originally invested. Secondly, when you rent you do not incur the extra expenses of ownership. One of which is costs to maintain the house. I argue that if you take the present value of the invested down payment and compare that to the present value of the house less all of the additional costs associated with ownership, you will arrive at the same number, making an individual indifferent in renting vs. buying.
Here is a quick example. Here are the assumptions:
- Cost to rent and the mortgage payments are the exact same
- 20% down payment required
- 5% ROI when invested in the market
- $400,000 home – value increases at inflation (3%/year)
- Person sells their home after mortgage has completed
- 25 year mortgage
At the end of 25 years the value if the house will be approximately $837,500. The value of the down payment will be approximately $773,500. That’s a difference of $64,000 which the homeowner will certainly pay more than that over the 25 years (just on commission of the sale of the house amounts to more than that) making renting more advantageous in this scenario.
Now granted, 9.5% is an aggressive rate of ROI (although not unobtainable) and changing this will change the analysis. But the above numbers show that clearly renting is a completely viable alternative.
Last point. I know that this article greatly dismisses the current view of home ownership over renting. However, for most individuals, home ownership is better. This does not have anything to do with the financial concepts, it comes down to owning a home forces people to save and build wealth (generally people’s homes are their largest source of equity come retirement). Most people do not have the financial discipline to save their money and acquire the same equity that a house provides.