Americans Love Home Ownership
But Should They?
All – Thanks so much for your feedback! I have made some modifications to this post based on comments and feedback you have left me. Since the original post I have updated the following:
- Changed the format of the charts so hopefully they are easier to understand
- Added information about the 4% rule and why we use 25x factor when planning for retirement
- Made a few other grammatical updates
- Never hesitate to leave comments for the benefit of the group!
One of the 2021 goals that I mentioned in my last post is that we are targeting to pay off our house by the end of this year. We have been increasing our principal payments more and more over the last few years trying to accelerate progress. My wife and I have been in alignment during this entire process and we want the mortgage gone. But was this the right decision? In fact, should we even tie up our capital in a house, or should we rent forever?
When we first started, we lived everyday by the Baby Steps. As we looked into advancing our investment strategies, it has become evident that this is not the universally accepted path. In fact, there are many people who say never pay off your mortgage, stay leveraged and keep your capital working for you. There is another segment of the FI community that say you should rent forever. This is the reason I am writing today. Topics that are this controversial are some of the most interesting to me so let’s try and dig in.
As part of my research for this, I posted this question in the Let’s Talk Fire Group:
Does anyone have a strong feeling about renting vs buying for your personal residence? If so, what are your reasons?
To which one of the founding members quickly pointed out:
Wow Chris, you have chosen a very hot topic. Folks will say, don’t talk about religion, sex or politics but frankly any of those will get less heated than talking to a bunch of Americans about home ownership…
So emotions aside, there are two main topics that I would like to cover:
- What is the cost of paying off your house early?
- Is buying truly better than renting?
The directions that this conversation can go seem limitless; so, let’s try and narrow down the scope so that we can find a path to a solid answer.
After some brain storming, the list was consolidated down into the following topics:
Out of Scope:
- Renting allows for moving around. If you do not like an area or want to make a change of scenery, it is much easier to move while renting. We will not take this into consideration during the review due to the fact that you cannot put a price on this freedom. Also, it is more important to some people than others.
- Repairs and Expenses – While renting, repairs and expenses are covered by the land lord, not the renter. For this reason, the evaluation will take into account some level of costs for the homeowner so that the true difference in value can be compared.
- Equity for Renters – Renters do not have equity tied up in their housing (non-liquid asset). For this model, the money that would have been tied up in a down payment on a house will instead be invested. This can then grow in the market over time.
- Equity for Buyers – There is a portion of your mortgage payment that goes to the principle and is stored as equity value in your house. For this process, we will essentially ignore this value from an investment standpoint. This is because it cannot be accessed without actually selling the house. The exception would be if you rented your house out and generated passive income off of it. While that is a real value, we will not be considering it. The one portion that we will discuss, however, is the fact that once the mortgage is gone, cost of living can be significantly reduced.
- Identical Properties – For the sake of this model, the properties have to be identical so that we are comparing apples to apples.
- Closing Costs – Closing costs are an expense that will occur when buying a house. Even if they are negotiated to be paid by the seller, that is money that could have been potentially negotiated off the price of the house. For this reason, we will need to account for them in the model.
- Rental Ratios – We will consider various rental ratios in the model. We are defining rental ratio as RR = (Monthly Rent)/(Home Value). A rule of thumb for real-estate investors is 1%, so we will ground ourselves around that value. Make sure you understand this because we will be referencing it a lot in the post.
- Mortgage Conditions – For the sake of this model, we will only be considering fixed rate mortgages. We will run the model for various time frames and payoff rates. Interest rates will not be varied at this time. This model will use one fixed interest rate for all cases.
- 4% rule (25x rule) – There are plenty of blogs that have already gone into depth on this concept. Check this one out by MMM if you want to know more. As a quick highlight, the 4% rule is an estimate of the amount of money you can safely withdraw from your nest egg so that your money lasts your entire life time. The 25x rule is the opposite. By multiplying your annual cost of living by 25, you can calculate how large your nest egg should be to meet the 4% rule.
This topic could blow up into a discussion of infinite scenario’s so we have to distill it down. I have tried to do this in a step-by-step sequence in order to consolidate.
- We are going to exclude income ranges. In order to make this an apple-to-apple comparison, we will only consider money that could be spent on housing costs and then assign the most expensive option as the base case.
- For valuing rental to purchase price scenarios, we will utilize the 1% rule. This is a rule of thumb that states if a property can rent for 1% of its value per month, then it could be a good investment. Because this is a pretty well-known target, it is not unreasonable to assume that it will be in line with the market. None the less, we will consider a range of 0.5% – 1.5% in order to capture a range of expected rental rates.
- Rent increases over time, I get it, but I did not account for that in the current model. This plays in favor of the rental scenarios by making them more favorable in the model. Not to give it away too soon, but after review I did not see the need to further scrutinize the rental scenario.
- We will assume 20% down on the mortgages to avoid PMI. To make the comparison consistent, we will assume that the renters have the same amount of money starting out but they invest it into the market instead.
Alright, so there is a lot to digest and try to consolidate into our model.
Subpoint 1: (Effect of Paying Off the Mortgage Early)
In all mortgage scenarios, what is the best way to pay off a house? Pretty easy answer. If you make more in the market than you spend on your interest, you are better off putting the extra money in the market. No surprise there. Now, this only considers the financial standpoint and not the peace of mind/security of not having a mortgage payment. With this understanding, what is the effect of paying off a house in various intervals on a fixed rate mortgage?
Note: Market returns are not guaranteed but we are going to assume an 8% annual return for the duration of this post.
In the following table you can see the other assumptions that we made. Essentially all parameters were held constant, except the duration of the loan which changes the required monthly payments. In order to create a base line for home expense and investing, we called out $2911 as the total available amount for all scenarios. This may seem arbitrary, but this is the mortgage payment for a 5 year loan for a $200k house on a 3.5% fixed interest rate. All other cases will use $2911 as their available bucket. Anything remaining after mortgage has been paid will go into investments. Once their mortgages are paid off completely, the full $2911/month will go into investments.
Once again, the time value of money wins the battle. This is not a big surprise but wanted to start with this in order to ground ourselves. Despite having the increased amount of money available after paying off the 5-year mortgage, the base case cannot catch up to its peers.
This is a total net worth comparison. One thing it does not account for is the fact that once your home is paid off, your cost of living is reduced. This means that in retirement, if you do not have to pay for housing, then your retirement nest egg can be reduced accordingly.
THIS IS A HUGE DEAL.
I did not do a good job emphasizing this in the original posting. If you do not have your mortgage paid off going into retirement, then your nest egg needs to include 25x you mortgage payment extra in order to sustain your lifestyle. None of the scenarios above create enough of a spread to account for that. For this reason, you are better off paying your house off before retiring so that your required nest egg can be reduced. Not to mention the peace of mind…
And the Winner is…
To keep our scope narrow, we are going to make a pretty big cut here. The more money you can get into the market the better; however, we do not want to carry the mortgage into early retirement. For this reason, we are going to assume that this person was able to hit Financial Independence & Retire Early (FIRE) in 10 years. This means they will maximize investing up to the point that they can still pay their house off at 10 years.
Note: I know you super math nerds are out there yelling “what if you pay minimum payments and put the rest in an brokerage account to save at a higher rate of return but also use it to pay off the house eventually”. Congrats, you got me, but I am going to ignore that for now…
Subpoint 2: (Rent vs 10 Yr Mortgage+ Home Repairs)
So, we have a baseline for the mortgage scenario. 10 years fixed rate mortgage. As stated above, we need to take into account varying amounts of annual homeowner expenses and various rental ratios:
Home Owner Expenses:
The red lines represent the total dollars invested by renters in the various rental situations.
Notice that all of the renters start at $50k in the positive. This is because the home buyers had to put their 20% down payment plus the closing costs into the house while the renters put that same money into the market. You can also see the effect of the range of rental ratios on ability to save money.
The home buyers are the white and blue solid lines. The chart calls the expenses out as repairs but they could also be other expenses too (HOA’s, Taxes, Repairs, etc). The point is that we are considering $0, $5k, and $10k in extra annual expenses that the renters do not have to worry about.
Subpoint 3: (Effect on FI Number)
So Subpoint 2 showed that there is a lot of overlap. Depending on the set of circumstances, total net worth can swing in favor of renting or home ownership. How do we take into account the fact that the homeowners no longer have the expense of their mortgage but the renters still have to pay rent?
I had a hard time trying to figure out how to show a visual until I realized this: The people who are renting have to have 25x their annual rent accounted for in their investments in order for their nest egg to compensate for the added expense (this is based on the 4% rule discussed above). So, taking the same scenario above, I subtracted out the portion of their net worth that would go towards paying rent. This gives a like to like comparison:
Now this shows that the majority of scenarios are in favor of home buying. Only the extremely low end of RR holds up against home buying. Now if we took it a step farther and accounted for the fact that rental rates increase over time, there would be very little chance of renting ever coming out on top.
I have to be honest here, these results do not shock me and I would be surprised if they shocked you. Let’s think about the big picture, if it was really better to rent forever instead of buying, then why is the rental market so big? No one would invest in rental real-estate if it was not a profitable business. Rents are increased to pass the costs from the owner to the renter so that a profit can be made.
I think the main reason there is such a polarized view on this topic is that people are not comparing on an equal basis. The group that raves about renting forever are most likely in small/cheap units that they can rent for a fraction of the price that the average person pays for a home. This pushes them way up on the curve in ability to save. On the other hand, if those same people built a tiny house with cash for $15k, they would be much better off than renting… there is always a way to live cheaper. As for the argument that renting is better than buying, if you compare apples-to-apples, based on our case study I would answer “not really”.
One thing I did not explore was the effect of various interest rates on the mortgages. Higher interest rates will shift less money to investments and then make home buying less favorable. With that said, mortgage interest rates are at all-time lows right now and are very favorable for buying.
Finally, paying off the house early needs to be balanced against the opportunity cost of not being in the market. I get it… but there is still benefit to getting rid of it before FI due to the reduced cost of living.
As stated above, if you do not have your mortgage paid off going into retirement, then your nest egg needs to include 25x you mortgage payment extra in order to sustain your lifestyle. You are better off paying your house off before retiring so that your required nest egg can be reduced. Not to mention the peace of mind…
Thanks for reading,
Until next time – continue to Choose Beta,
January 28, 2021 @ 10:50 am
Hey Chris! You’ve got a detailed analysis on buying vs renting here.
Good job accounting for a lot of the variables that are often overlooked!
Overall, I think that there’s no blanket statement that can really be formed to say renting or buying is “better”. And I think you came to a similar summary—it’s really going to depend on an individual’s situation.
If we could imagine an ideal hypothetical where there’s a direct apples-to-apples comparison between renting and buying (imagine two units in the same location with identical construction), it’d be safe to assume that the better financial choice would be to purchase the home…but only if we could make a couple assumptions:
1) The owner stays in the house long enough to recapture the value of the transactional costs (agent fees, transaction costs, etc)—which I think the average is 7 years
2) Mortgage rates are less than the rental market’s profit for the region/unit
That second point is important since loan rates are so low (we’re looking at a refinance around 3% right now). For folks to invest capital in a rental unit, they expect to earn some sort of a profit and it’ll need to account for their own debt costs (or opportunity cost if they paid in full). If we could assume a relatively efficient housing/rental market, there should be some profit in there for the rental unit owner which accounts for risk, effort to manage the property, etc.
Really it’s this difference between mortgage rates and rental profit percent that slant the financial decision toward owning.
But, and it’s a big but—this is an ideal comparison. In reality, individuals will put more value on certain aspects of the owning or renting experience:
1) More flexibility in living location—ideal for renting—since they’re less concerned about my first point, recapturing the transactional costs of owning
2) More control over your surrounds—ideal for owning—people like to customize their house; the layout, design, style, etc. where landlords often limit such refurbishment
3) Desire to live in a specific place—could be either!—I think this point is often undervalued. Some specific locations ONLY have rental units or ONLY have places to own. If you’re deadset in living in a specific neighborhood, building, complex, or area, there might be only one choice.
Of course there’s lots of other subtle, personal reasons and desires that skew the relatively simple financial math that underlies this. You mentioned things like the mental weight some people have about debt, or similarly, people who are worried about their landlord potentially kicking them out on a whim.
It’s all very personal with each individual situation being a bit different. I think that’s why this is always a hot topic.
I’m excited to see your analysis of something you alluded to in your post (and something I did as well on our post which you commented on)—how having no mortgage and owning your place means a lower cost of living on paper. By having a lower necessary set of monthly expenses, you’ll not have to realize quite so much income to pay for your life. That becomes very important when you have direct control over your income during retirement since many folks live off of capital gains.
If you don’t have to realize quite so many gains to afford life, you might qualify for lower tax brackets/deductions, subsidies, or different programs. That’s where owning with zero debt can really pay off over renting, though it’s a pretty specific situation. Looking forward to your analysis of it!
January 29, 2021 @ 12:11 am
You brought up a huge point. Everything in this post assumes that the people never move and the home buyers only pay closing costs on the initial purchase. Every move makes home buying less attractive due to the added expense. Your second point is also correct. I mentioned in the summary that mortgage interest rate increases would make the situation less favorable but decided not dig into it at this time.
I really don’t think you can put a price on the flexibility that renting provides and I have to admit I am a little biased on that front. We have 4 young kids and grandparents close by so we have no intention in moving in the next few years. For someone that is not tied to a specific job, and no kids in school, the tradeoff for the flexibility to move has to be a huge.
I am definitely going to expand on the concept of low cost of living in one of the February posts so hopefully it goes well.
Thanks for reading and taking the time to comment!