Buy or rent: What's the best option?

Rent money might be dead money, but so is paying interest. So what's the better option? Photo / 123RF

"Are you still renting? Why don't you buy yourself a house already. Rent money is DEAD MONEY!"

If you rent, I'm sure you have come across one of these people at least once in your life. And it's most likely coming from a loved one who genuinely cares about you.

It's easy to understand how they come to this conclusion too. At the end of every month you have to fork over hundreds (sometimes thousands) of your hard earned dollars for nothing more than the privilege of having a roof over your head.

If you were to buy a house however, at least your payments are going towards something you can call your own. That's the common theory among most (especially parents) at least. If you have the deposit ready, is it always better to buy than to rent?

Why you should buy

Let me just make one thing clear before we delve into this debate. I'm going to be looking at this purely from a financial point of view. There are many intangibles that come from buying a home that you can't measure in dollars. Your home is your castle that you raise your family in. There is an emotional attachment when buying a home which varies greatly from person A to person B.

I personally only really see one major benefit from buying a house to live in.

Security

It's a pretty major benefit too. When you rent you are always at the mercy of the landlord. Rent could be raised at the end of your lease. Leaky pipes may never be fixed. You're not allowed to buy a cat because it's against the rules.

And what happens if the landlord decides to sell to homeowners who want to move in and kick you out? You have to find another place to live, and anyone who has ever moved or helped move someone can attest to how they would rather take a bullet than do that s**t again. OK it's not quite that bad but it sucks trust me (have been involved in 10-plus moves).

Forced Savings

Some people just can't save money.

If it's in their account and disposable, they just can't help themselves and must spend it. I don't have this problem personally but I understand that for many people it's an issue. So how can you save money when you spend every spare dollar you earn?

Unless you're on an interest only loan, you will be paying some principal in your repayments each month. It's the principal that actually pays off the home, the interest is just how the banks make their money.

The principal payment therefore are sort of like a forced savings mechanism. I say 'sort of like' because it's a bit more complicated than thinking about it purely as savings. Theoretically if you bought your house for $X amount of money and sold it 30 years later for the same price after paying it off, then yes you would be essentially receiving a lump sum of all your principal repayments you have made during those 30 years (not factoring in buying/selling costs and inflation).

But! What happens if you never sell? What happens if the house goes down in value? What happens if no ones wants to buy your home?

It's is extremely unlikely that you're are going to have your house go down in value over 30 years but it could happen (see Japan). And it's for this reason that savings via equity is not as straight forward as you think.

Regardless of these situations though, for people who struggle to save when they have disposable income, a forced savings plan might be a good thing for them. And the banks do a mighty fine job of making sure you 'save' every month. They are even kind enough to visit you if you miss too many 'saving' payments.

Why you shouldn't buy

Locked in

Since already establishing what I consider the single and biggest pro when buying to be security, if you find yourself in the dilemma of choosing between renting or buying you must ask yourself: 'Why do I need security'?

There is merit for people who need the stability that buying comes with. If you have pets, children, elderly parents who you take care of or something else that would be greatly disrupted if you ever had to move. Then I could 100 per cent see the importance of security.

But with security there also comes restrictions.

When you buy a home, suddenly you can't just pick up your things and leave. You could rent out your house but that's a pain in the arse. You could sell your house. That is also annoying and it costs money to do so.

Really, really expensive

Buying a home usually means taking out a mortgage. Having debt on something that does not produce any cash flow is a liability. Some people say your home is an asset, I disagree.

But lets push aside some negatives for the time being and imagine that you are someone who needs stability and believes that they are not going to want to live anywhere else for the next few years. Now you actually need to buy the house and pay it off over the next 30 years. Lets crunch the numbers.

How much does it actually cost to buy a house?

Most lenders will require a minimum deposit for a home loan of at least 20 per cent of the amount we are borrowing. So on a $600,000 house this works out to be $120,000 for the deposit. The loan amount is $480,000 and even though interest rates are still at record lows in New Zealand, they will eventually go up, so lets just go with 7 per cent fixed interest rate for the entire 30 years of the loan.

A few things instantly pop out at me.

Firstly you may notice that the total cost of servicing this loan amount for 30 years equals $1,149,643. Wowsers.

Secondly, you end up paying more in interest than you do for the actual loan amount. Just think about that for a second. Some say rent money is dead money, well the same can be said for interest too. YOU JUST SPENT $670K ON 'DEAD' MONEY!

It's hard to even think about. If we break up that interest over the 30 years it works out to be $429 a week or $1861 a month. You could rent a really nice place for that kind of money.

But because you have chosen to buy you have to pay the interest repayments PLUS the principal, which comes to $3193 per month.

That's a s**t load of money leaving your account each month. I don't know about you, but that would severely impact my lifestyle if I had to make those repayments each month for the next 30 years.

So far we have covered how much it's going to cost you to buy the house, but we haven't covered how much extra it's going to cost you to keep it running.

Here are just some extra items that come with the privilege of buying:
• Rates
• Home Insurance
• Water Fees
• Body Corp Fees
• If anything breaks in the house (plumbing, electrical wires, air con etc.) YOU have to pay to fix it

Why you should rent

Flexibility

Other than your lease period, renters are free to jump from one place to another.

Don't like the cost of rent? Move.

Don't like the location anymore? Move.

Landlord not fixing things around the property? Move

I know that moving is a pain in the arse but do you know what's more of a pain in the arse? Trying to sell your home AND moving.

It seems to be a growing trend among young people to spend their 20s travelling around the world, studying and trying new experiences. And that's awesome! I think that your youth, particularly between the ages of 23-29 is an extremely precious and unique time in your life when you're not tied down and most likely have finished your trade/degree and working full time.

You have full time money coming in, are young and can do what you want. Why would you want to tie yourself down by buying a house? You are in such a unique position to be able to drop everything and move/explore/discover the world.

Renting can provide you with the flexibility needed to live this kind of lifestyle.

Usually Cheaper

If you think rent is dead money, then you must certainly see interest repayments on a home loan to also be dead money. You can work out the percentage of interest repayments quite easily because they are set by the bank. But comparing that to rent repayments is a bit trickier at first but is easy once you realise how to compare the two.

To work out if you are better off renting and saving money than you are buying and forcing savings (through principal repayments), you must know the rental yield of the property. To calculate this you have to know two things:

How much the place you want to rent is worth?

How much does rent cost?

For example:

The place you want to rent is currently being advertised for $400 a week and you think it's worth about $600,000 because the place next door is nearly identical to it and is for sale for $600,000. Rental yield is calculated using the following formula:

Rental Yield = R/PP

Where R = Rent (Per Year)

And PP = Purchase Price

In our above example this would be

Rental Yield = $20,800/ $600,000

Rental Yield = 3.5 per cent

Can you find a bank with a lower interest rate than 3.5 per cent? Right now the answer is no.

To compare to our example above. If we rented at $400 for 30 years and factoring in inflation at 2.5 per cent we end up paying $913,176 in rent. This is being pessimistic too because I didn't factor in inflation for the rates, insurance, body corporate, etc, above so it would have actually been even more to keep the house running over 30 years.

Still, this means that renting over 30 years come out over $600,000 cheaper than to buy.

However, the person in the above example now owns the assets outright and at worst is sitting on about $1.23 million of equity ($600,000 over 30 years at 2.5 per cent inflation rate) where as the person who rents has no equity.

BUT! The person who rents has a far greater cash flow position than the person who buys. The renter should have just over $600,000 (total cost to buy over 30 years minus paying rent for 30 years) extra over 30 years if they managed their money and saved the difference. This works out to be an extra $20,000 per year the renter has up their sleeve.

Lets assume that the renter realises this advantageous position and instead of blowing the extra $20,000, they invest it yearly in a diversified portfolio. Suddenly something strange happens.

At $20K per year over 30 years with a rate of return of 9 per cent (historic average) can you believe that the renter can amass a net worth position of $2.7 million!!!

Final thoughts

I think too many people (especially younger people) get caught up in what is 'normal' and buy homes young when they don't even know what they want to do in life. If rent money is dead money than so is interest repayments, which are much higher than rental yields for the majority of people.

You do not make money when you buy a house to live in. You may get lucky and sell it at a profit later in life, but you never hear about all the people that sell at a loss, only the ones that triple their money in four years (unlikely). You shouldn't be thinking about making money when looking at a home to live in anyway. It's first and foremost your home to make your own and to raise a family in. If you want to make money, look at actually investing into income producing assets (stocks, bonds, rentals).

Don't get caught up in the stigma and shame on renting, break down the numbers and work out what actually costs more. If it's cheaper to buy then by all means go ahead and buy, if it's cheaper to rent, ignore the misinformed who try to make assumptions that you can't afford to buy or that you must be doing it wrong.

Try to break out of the Matrix and look at what is best for YOU not what others think is best for you.