A Canadian's random thoughts on personal finance

Apr 12, 2008

Save money by renting your home

If you're renting, you're throwing your money away, right? Well, if you're paying mortgage interest to the bank, that's throwing money away too. Which costs less over the long term?

I pay $1200 per month in rent, including my parking space. That rent includes a number of items that would come out of my own pocket if I owned a home, such as property tax, repairs, maintenance, and some utilities. All told, I get about $500 in value every month included in my rent. That leaves $700 that is truly "thrown away" just like mortgage interest.

How large a mortgage would cost $700 per month in interest? Today's variable-rate mortgages are going for about 4.6% per year. At that rate, a mortgage of $182k would have interest charges of $700 per month. That means if I could stop renting and move into a house with a mortgage of $182k or less, I would save money every month.

Houses in my area don't sell for $182k. They sell for more like $482k, meaning I would need a $300k downpayment. With that large a downpayment, I'd need to look carefully at the opportunity cost of moving $300k worth of assets into a single piece of real estate. $300k in the stock market would earn about half the Canadian median household income every year, so that's a pretty high opportunity cost.

What if I get a larger mortgage instead? If I get a $300k mortgage instead of $182k, that would cost an extra $452 per month. I'd have to justify that extra cost either using the appreciation in the value of the property I buy, or else using non-financial arguments (e.g. I just really want to own a house). Since I don't particularly want to own a house, that leaves me with the appreciation argument.

So the question I ask myself is: do I want to borrow several times my gross salary to bet my entire net worth on a single real-estate investment? Given the current climate of the real estate market, I'm pretty happy with my current diversified portfolio, thank you very much.


Traciatim said...

Though, in ten years when your mortgage is still the same payment as it is today, and your rent has increased by 3% per year and is now 1615 a month are you still going to be doing the same comparison?

How about in 20 years when your mortgage is still the same and your rent is 2165?

25 years when you have no mortgage and want to retire a nice relaxing life on OAS and CPP . . . but your rent is 2500 so you have to move to a shanty and eat a complete diet of lettuce to survive?

How about in 40 years when you've had 15 years of no mortgage payment but your rent is now 3800 bucks?

Sure, in areas where prices went crazy they may come back to normal levels, they may stagnate for a while while incomes and rents catch up . . . what if rents just need to catch up instead and the home values are the norm now just because more people want to live there?

I would make the argument that the savings could be invested to make up for the difference in the home vs renting, but have you seen the savings rate in Canada . . . how about the RRSP participation rates? They are pathetic. Sure some people are dedicated enough to do that and will probably make out ahead. The vast majority will simply buy a car for $452 a month and call it a day.

Patrick said...

Hi Traciatim. It's true that buying a house protects your housing cost against inflation, but your comparisons are not fair.

My analysis factored out the assets that the renter and home owner would be accumulating during this time. Every month, while the home owner earns equity, the renter is investing the money he saves. After 25 years, when the home owner has paid off his principal, the renter would have invested about the same amount, and could then buy a house outright.

Also, don't forget that having a mortgage exposes you to interest rate risk. You can't get 25-year fixed rate mortgages anymore, so you have to hope that today's historically low interest rates persist for 25 years, or else you could easily end up with even higher payments than the renter. In my example, if you're unlucky enough to see 8% mortgage rates, then there will never be a single month over the life of the 25 year mortgage where the home owner has any advantage over the renter.

Gates VP said...

Tim:25 years when you have no mortgage and want to retire a nice relaxing life on OAS and CPP . . . but your rent is 2500 so you have to move to a shanty and eat a complete diet of lettuce to survive?

If you're going to make the assumption that rental costs are going to increase, it's also safe to make the assumption that salary is going to increase over the same period. Housing historically averages inflation, but your investments should be beating inflation (not much of an investment if they don't).

Either way, you have to include both sides in the model or the model is flawed. If you're going to predict out 25 years, the least you can do is write down inflation and use some form of constant such as "percentage of average annual salary".

Point is, you're not creating a very convincing model Tim. In fact it sounds like you're fear-mongering by throwing around clearly meaningless numbers.
At the end of the day, you either have a paid-for house that only needs maintenance or you have a bunch of investment dollars and a rental place that requires higher maintenance (with investments to help offset the cost).

So if we project out 25 years, the big question here is:
Investment Income minus Rent > Home Maintenance?

Traciatim said...

If you are factoring in and simply using inflation as a salary measurement and the rent simply follows inflation as well the house will win even more since each year the house gets cheaper relative to salary as the cost of the home is locked in to the purchase year dollars. If the renter and home owner start at the same percentage of salary, then inflation only helps the home owner.

The point that I'm trying to make though is well overshadowed by the fact that if the rent/price ratios in your city of choice are skewed to make rents cheaper than owning then it makes sens to rent until such time as the homes become more in line with rental prices. Only in places where real estate values have skyrocketed (and now are coming back in line again) is renting a better choice financially.

Considering RRSP participation rates, the savings rates, and the amount of people who receive the max CPP/OAS and the number of people who receive the GIS it is obvious that the vast majority of people don't save for retirement anywhere near the amount they should. The comparison was done for people who spend their income rather than save, and will rely on CPP/OAS mostly in retirement. People who own there home outright at this point will have a far more comfortable retirement.

Patrick, the only way there will be savings by renting is if the prices of homes are skewed by something or you downsize. You could use the same argument for buying a smaller house.

Here is a small comparison, lets say Bob here makes 60K a year and spends 30% of his income on housing in year 1 making his rent $1500 (Heated) or his mortgage/tax/heat $1500. Both Rent, Housing and his Salary match inflation at 3% in some magical coincidence.

Year 1 . . . Salary $60000
Rent: 18000 (Heated, property tax included) = 30% of income

Own: 18000 (1150 Mortgage, 150 Property Tax, 200 Heat, 12 months)

Year 10 . . . Salary $80600
Rent: $2015 * 12 = $24180 = 30% of income

Own: $19440 (1150 Mortgage, 201 Property Tax, 269 Heat, 12 Months) = 24.1% of income.

Year 20 . . . Salary $108300
Rent: 2708 * 12 = 32496 = 30% of income.

Own: $21384 (1150 Mortgage, 270 Tax, 362 Heat) = 19.7% of income

Year 30 . . . Salary $145500
Rent: $3639 = $43668, or 30%.

Own: $10176 (362 Tax, 486 Heat) or 7% of income.

What happens to Bob Renter when his CPP and OAS hit and his income is cut drastically? He's on the news whining about how hard retirement is . . . while Bob Owner is in his garden planting his flowers.

I really didn't mean to rant that much, but the only time renting makes sense to me is when home prices vs equivalent (not reduced size) properties get all out of whack, or personal situations make renting a better choice. Under most normal circumstances owning is a far better choice financially for a vast majority of people.

Traciatim said...

In Fact, I found a great paper that has a fantastic quote:

"This paper examines whether by not owning, renters miss an important opportunity for accumulating wealth. The results are quite striking, for renters to accumulate the same amount of wealth as owners, they must be extremely diligent savers, invest in a high yield instrument, do so with minimal fees, and have the good fortune to live in one of the cities where the right combination of low rents and/or low house price growth allows them to invest more in a relatively higher return asset. Thus, even if they careful savers, investing with high yields and low fees, renters in Toronto and Calgary cannot on average accumulate the same wealth as can homebuyers in these cities who merely have to make their mortgage payments."

It's not a perfect paper... but agrees with my statement. For the vast majority of people, buying is the sensible choice.


Patrick said...

Hi Traciatim,

You are right that the $1200 I pay in rent gets me a home that is not equivalent to the typical $480k house in my neighborhood, so I'm not comparing apples and apples there. What I am comparing are the options available to me given that I want to live in this area. There are some condos some distance away that are comparable to my townhouse, and they go for about $250k, which is only a little more than my $182k break-even point for cash flow. But it's still more, and it still requires commitment, maintenance, and exposure to the real estate market that I don't have where I live now.

Regarding your Bob Renter example: I agree that if you can get a deal where your total mortgage equals your rent, then the mortgage is obviously better financially because part of that mortgage payment goes into your home equity. If I were presented with those choices, I'd think very seriously about buying a home.

Regarding the paper you cited, I have a hard time believing any conclusion it would reach because it is riddled with flaws. For example:

- It gauges the profitability of home ownership by looking at home values in 2006, at the very peak of the housing bubble.
- It focuses on urban areas, particularly Calgary and Vancouver, where the housing bubble is most inflated.
- It doesn't account for the age of the investors. Perhaps renters are typically younger and homeowners are typically older, meaning the homeowners have had longer to build their wealth.
- It focuses on investors with incomes under $46k/year, which is atypical, since it is significantly below the median Canadian household income.
- It assumes people won't move over the course of the study period, while my freedom to move is precisely one of the reasons I prefer renting.
- It assumes renters will pay 0.75% MER on index funds and ETFs, whereas MERs under 0.30% are readily achievable.

These are just a few of the reasons I wouldn't pay any attention to the results of this study. My analysis, I think, has much fewer built-in assumptions.

Traciatim said...

I agree the paper isn't perfect, but the quote was priceless for describing what I was trying to point out above.

It looks like we're pretty much arguing the same points though, and are in agreement. For example you state in your city a condo is out of reach, a home that's a good place to live you would have to sacrifice location and they are still far too expensive. In my city the average home goes for about 2.4 times the median family income right in the city (it's fairly small, just over 100K people) and rents are pretty comparable and therefor buying makes the most financial sense if funds are available.

As an example I found the first home in the paper for rent and find "3 bdrm duplex. Fridge, stove, dishwasher, Wash/dryer hook-up, heat, lights incl, $1200 up, $1050 down." . . . yet my 3 bedroom 1150 sq foot bungalow I purchased last year for a smidgen over 100K, walking distance to a grocery store, elementary and middle school, movie theater, library, church, on a bus route . . . It doesn't make much sense to rent as long as the current plan is to stay in the same city for a while.