It can be financially more efficient to live on rent

Okay readers, let's settle this debate once and for all, right now: which is financially a better option, renting or owning? This debate seems to be an ever lasting discussion. It is hard to really quantify, since all situations are a little different. However, if you know all the parameters, you can quite well approximate how buying vs renting compares.

For the comparison to start to make sense, we should make some assumptions, for example:

  • That you are comparing the buying vs renting of the exact same dwelling
  • In the alternative that requires less monthly payments, you invest the difference

If we agree to try to compare apples to apples, we should be able to get to the bottom of this. Let's begin.

Why is buying a home often recommended

The power of buying a home to increase your wealth boils down to the fact that homes are expensive, they can appreciate in value at a rate higher than inflation (in areas people want to live) and you leverage buying them at reasonable interests. If you look at recent years after the 2008 subprime crisis, it's been a great time to own a home: low interest rates, low inflation and very good appreciation. But things can change.

Differing dynamics of renting and owning

When you are renting, things are pretty simple: you pay a monthly fee and some other expenses like water, electricity and home insurance. But most of these other expenses are not different to when you own your place - you still need to pay them.

If you happen to be able to save something after rent, you can invest that and get a return.

When you own a place, you have a multitude of possible costs you need to cover, which you wouldn't necessarily when renting. Consider for example, if a household appliance breaks down, will your landlord purchase you a new one? If the bathroom needs to be modernized, who pays for that? Or the roof? Does your housing company have mandatory maintenance fees? Who pays for sewage?

You get the point.

When you own your home and a mortgage, you're also paying for yourself. This requires you to have a little bit more available cash flow than renting, but you're usually accumulating wealth more than what the difference is. For example, let's imagine the market rent for your home was 1,800 €/mo, and if you owned the home, your monthly payments would total about 2,400 €/mo. The difference is 600€ but it could very well be that you're paying down your mortgage 900€/mo. So, with the same available income, you're saving 300€ more by owning your place. Are you with me?

You often need a little more income to own a home (in my example 600€ more), but you end up accumulating more wealth than the difference (in my example 900€).

Costs of owning

To have a comparable cost analysis, you need to account for all the costs related to owning that a renter doesn't need to pay. If both need to pay for electricity and water (i.e. they're not included in rent), then those costs don't change the analysis. However, if an owner needs to take an insurance while the renter doesn't, or, if the insurance is of different cost, it needs to be accounted for. Some common owning costs that the renter doesn't need to care for:

  • Property tax
  • Maintenance fee
  • Waste and swage
  • Renovations and upkeep
  • Renewing household applications

Some of these are easier and mandated by law, while others are more difficult to estimate. How often does a fridge break and needs to be renewed? Maybe every 10 years? Would that apply to all appliances?

How about renovations? How much should you reserve for them? They don't happen every month or even every year, but they contribute a lot to the cost of owning. Some sources say you should reserve about 0.1% of your home's market value every month to renovations. That's actually quite a lot when you think of it.

You accumulate more wealth when owning, but only in the beginning

Most of us mortals take on a mortgage when buying a home - whether it's the first one, or if you're upsizing. When you do, you use leverage, which is key to owning a home being so lucrative. Without leverage, there's really no point, financially, to own your home. Dumb idea. Unless it gives you peace of mind, then, whatever floats your boat.

But as you pay off your mortgage, you tie up wealth in your home - wealth that could be tied in more profitable assets such as stocks. It is therefore, that there becomes a time when it actually would be better to sell the home, live on rent and invest the freed wealth.

This of course depends on a multitude of things, such as:

  • Is your home appreciating? If not, chances are you shouldn't be buying at all.
  • How much is inflation? If inflation is more than appreciation, again, you're losing wealth. Might not be a good idea to buy.
  • How high are interest rates? If your mortgage is super expensive, again, renting could be cheaper.
  • How good returns do you expect from the stock market? If you're a solid investor, that again shifts the scale towards renting. But likely not immediately.

Let's get practical: an example

For this example, here are my assumptions:

  • Home value: 400,000 €
  • Down payment: 40,000 €, leading to a mortgage of 360,000 €
  • Monthly rent: 1,800 €
  • Loan interest rate: 1.5%
  • Loan duration: 30 years
  • Additional owning costs (maintenance, appliances, tax, sewage, renovation etc.): 850 €
  • Home annual appreciation rate: 2.2%
  • Inflation: 2.0%
  • Stock market returns (real, after inflation): 7%

Based on this, we know that the monthly loan annuity is 1,250 €. Of that, 800 € is paying back the loan and the rest, 450 € is interest. We also know that we must have the 40,000 € in savings, which we can put into stocks when renting. We know that in order to afford buying the place, we have to have about 2,100 € per month for living. That means, that if we are renting, we can put 300 €/mo extra into savings.

With these assumptions, we can observe how our real net wealth (net of inflation) develops over time in both scenarios. Indeed, in the beginning, we save 500 € more by owning and as we can see from the chart below, the blue net worth line climbs more quickly. But the red catches up, by around year 17 and about 500k net wealth. Why is that?

The reason is simple: net wealth by renting catches up, because the 300 €/mo is put into higher interest assets, which allows compounding to take effect. The 800 € we put towards paying off mortgage every month doesn't compound almost at all, since inflation eats the appreciation almost completely.

But this isn't quite all. You see, when you're renting, everything grows pretty nicely with inflation, both salary and costs. When you're owning, it's a little more complicated. If loan rate doesn't change, your loan annuity stays nominally the same. Your other living expenses will growth with inflation, but so will your salary. In the beginning we assumed that the available income (for this calculation) was equal to loan annuity and other living expenses. When available income increases with inflation and the "other living expenses part", but not loan annuity, it will leave something extra to invest over the years. This needs to be accounted for too.

But the interesting bit is not really the year at which renting scenario net wealth takes over. What's more interesting is looking at the rate of net wealth increase, plotted across different net wealths. Meaning, at 100k euros, how much more will the wealth be 1 year from that point owning your home versus renting. And 150k, 200k and so on. I'll tell you in a minute why this is interesting, but first, here's what it looks like.

So this net wealth growth starts higher for owning, but at around 180k net worth, growth rate of renting takes over. That's a lot less than the 500k, where the previous chart crosses. So what does this tell us?

That point, 180k, is the net wealth amount when it makes financial sense to sell your home and start renting. Why? Because you first take advantage of buying a home, accumulating wealth by paying off your mortgage, and once you hit that sweet spot, you start to take advantage of compounding - which doesn't really work for you otherwise. In this calculation, that point has a loan-to-value of 42%, but depending on the inputs, it can vary a lot.

So what would happen if we did just that? If we'd own the home until 190k and switched over to renting? This red line would happen:

See that red line take off! Okay maybe it's not that drastic, but it is significant. At 25 years the difference is 300,000 € in real value, net of inflation. And the difference comes from releasing all of the wealth tied in your home to compound after year seven.

You have another option

Selling your home and living in a rental apartment might not sound so appealing to you. Firstly, are suitable homes even available to rent? And secondly, it might be less than ideal if you cannot make modifications and renovations like you want. So what other options do you have?

The whole benefit of owning comes through leverage. The higher your loan-to-value (LTV) is, the faster you are able to accumulate wealth. This only works though when your home at least maintains value net of inflation.

As you start to have paid off most of your loan, your LTV shrinks and your wealth is tied in a non-appreciating, non-compounding asset. Are there other ways to free that than selling the whole thing? Yes.

Some countries allow you to refinance your mortgage. That's certainly an option I'd use, if it was available to me. In other countries, if you move or renovate, you can usually take on more debt, increasing your LTV.

Owning has a viable alternative

As I've now shown, buying your place is often the right choice when you're considering it. However, the wealthier you get, it starts to make financial sense to increase your LTV, or to move to rent.

That everyone should own where they live is not an absolute fact - far from it. The society is moving more and more towards not owning expensive things such as cars, tools and even homes. It is more efficient to centralize ownership of houses, as they can be maintained better, compared to the skills of an average Joe.

Owning has its place though. If you want to make customizations, you're likely only allowed to do those to a place you own. If you're planning to be the neighborhood menace, throwing parties every night, it's likely harder to be evicted from your own home. But again, the reasons are not always financial.

Renting lets you have more flexibility, move around, up and down more easily, carry on less risk (what if there's a fire? water leakage?) and ties no wealth. Often the most expensive things you own end up owning you, and a home can be like that.

How do you fare?

So what about you? Which "side" are you own currently? Are you owning, or renting?

If you'd like to try out the calculator I made for this post, you can find it here. You'll need to make a copy of it for yourself first before you can make changes. Let me know what you think!

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