Rent vs. Buy

Somewhere along the way people lost their common sense when it came to real estate. Houses that used to sell for $250k started looking attractive at $1m because everything else was selling for $1.1m. But while the prices of comparable houses in a submarket gives you some indication of the market value of a house, it doesn’t necessarily mean you should buy that house. The cheapest overpriced house is still an overpriced house.

One thing I like to look at is a simple comparison of rents and mortgage payments. Calculate the mortgage payment for a property you are looking at, then compare it to the rent of a comparable place. This can sometimes be difficult when trying to evaluate a large single family detached house, since there may not be too many comparable rentals in the area, but for a smaller house or a condo, you shouldn’t have a problem.

In my neighborhood, I’ve seen plenty of condos that are being offered as rentals for $2000-3000 a month. Assuming an interest rate of 5.25%, this payment would translate to a mortgage of $362,000-$543,000. Assuming a 20% down payment, this results in a house price of $453,000-$679,0000. Comparable condos actually sell for $550,000-750,000.

Looking a little wider, 2 bedroom single family detached houses are renting for $3000-4000 a month, translating to a house price of $750,000-$900,000. The asking price of these houses are still $1m and up.

This simple calculation doesn’t even take into account the additional recurring costs of homeownership: property taxes, insurance, and maintenance. Nor does it take into account the time or transaction costs involved when you happen to find a great new job and have to extend your commute or sell your house. Nor does it put a price on the risk of falling housing prices.

But never mind all that. Just keep it simple and look at the rent vs. mortgage payment as a starting point. Purchasing a house is a big emotional as well as financial investment, and emotions run pretty high when you’re talking about owning a piece of property with your name on it, providing a shelter for your family, and possibly regretting the biggest financial mistake of your life. By starting simple, you might be able to run a sanity check: Is the pride of homeownership worth a $100,000 premium on that small 2-bedroom condo? If you saved the $1000 difference every month in an ING Direct account at 1%, what could you do with the $61,500 you would save over 5 years?

11 thoughts on “Rent vs. Buy”

  1. Well, there's something to be said for ownership that kind of tips the scale one way making dollar for dollar a bad comparison. It's true though, if your mortgage payment is significantly more than the cost of renting a comparable property in the same neighborhood, you should reconsider purchasing a house.The general public ate up the low interest rate mimic, and purchased a lot of homes with a very high base cost. Building a house only costs like 50-100k. I think this argument can be extremely biased so it's hard to say what's more logically responsible: renting or purchasing.

  2. Those transaction costs can be quite substantial over the short term and when you take into account the market depreciation a property is likely to experience these days any old rules of thumb about "at least five years" go out the window. I looked at a place here and would have had to purchase at something like 75% of the asking price to feel comfortable.

  3. I agree with the analysis above. The only thing I would add, though, is that an analysis based on rent yields alone will fail to capture the tax advantages of buying a house, which can be substantial — especially if you pay AMT (the mortgage interest deduction is one of the few available to AMT-ers) or if your state+federal marginal tax rate is at 40 percent or more (by the way, escaping California's unreal income and sales taxes is one of the very nice side benefits that Adarsh has gotten by moving to a red state). I'm not saying I like this incentive structure — in fact, there is a strong case to be made that it's an unnecessary drain on the treasury — but there it is.

  4. Indeed, an $800,000 mortgage with a 30-year fixed rate of 6.5% will involve interest payments of $50,000 in the first year. Reducing one's taxable income by that amount can be quite a bonus — unless, of course, rent yields are really out of whack in a given region, or you're looking at the strong likelihood of near-term depreciation.

  5. The interest deduction is definitely something to consider, but it has to be considered along with the opportunity cost of not having the cash you used for the downpayment ($200,000 for that $800,000 mortgage in your example), as well as what your monthly cash flow looks like (you can alleviate this by adjusting your withholdings on your W-4).I'm interested, however, in coming up with a rule of thumb that would be useful.So let's see if we can make one up:For a 30 year fixed mortgage, 79% of your first payment is interest. You can deduct this interest from your taxable income, so you need to figure out what your combined federal and state income tax rate is in order to figure out what the actual tax savings are. So if your combined tax rate is 25%, that means you can count on getting 20% of your mortgage payment back. You can pay 25% more for a mortgage payment and net out at zero. If your tax rate is 35%, you can get 28% of your mortgage payment back. You can pay 38% more for a mortgage payment and net out at zero.Does that sound right?