Rent Vs Buy: True Economic Cost Analysis
Posted on: November 7, 2013 by Martin Curiel, CFA in Wealth Management
When working with MYeCFO clients, we find that in many cases the financial analysis of buy vs. rent is miscalculated – some costs are ignored and some savings are overestimated. The standard approach is to focus on comparing cash flows, but our team prefers a concept we term True Economic Cost, which is affected by taxes, interest, and opportunity costs. Below is a sample comparison between the standard approach and how we would approach the issue.
Standard Approach: Simple Cash Flow Analysis
We often hear renters say, “We are throwing away our money on rent.” This perspective implies that most of the payments made by homeowners are used to build equity (no economic cost), and therefore renters lose a lot of money by not owning a home. However, in actuality there is a cost to owning a home that is similar to the cost of renting a home. To decide which is a better choice, it is most efficient to focus on the true economic cost of owning and compare that to the cost of renting. The decline in home prices from 2006 to 2010 did a lot to convince people that there are advantages to renting.
The ratio of home price to annual rental rate varies across the country from about 10 to 25 (this is similar to a price/earnings or P/E ratio). The ratios are usually higher in the coastal regions and lower in the middle of the country.
For this sample analysis, we’ll assume a ratio of 20, with a property value of $360,000 and a rental rate of $1,500/month ($18,000/year). We will also assume the following:
1% annual property tax
35% combined marginal tax rate, and that all of the interest and property tax is deductible
3.50% mortgage rate with 20% down, and $400/month for insurance/maintenance/Homeowner’s Association (HOA) fees
The standard approach would be to use monthly cash flows, which are as follows:
$1,293 mortgage payment ($288,000 mortgage, 30-year fixed at 3.50%)
+$300 property taxes
+$400 insurance/maintenance/HOA fees
= $1993 total cost before tax savings
– $399 monthly tax savings from interest/property taxes in the first month
= $1,594 total cost after tax savings
Under these assumptions, the cash flows suggest that it is a little more expensive to buy than to rent. Taking into account closing costs and the commission cost when selling the house, as well as the risk of a price decline, many would choose to rent rather than buy. Also, the tax savings typically come in the next year, so many would focus on the $1993 monthly total, which appears much more expensive than renting at $1,500/month.
Our Approach: True Economic Cost
There are a few significant items that are not included in the above calculation:
a) The mortgage payment includes both principal and interest. The values change over time, but in the first month, $453 of the mortgage payment is for principal. That is not a true economic cost because it is a form of savings – reducing debt.
b) There is an opportunity cost from not investing the down payment and the mortgage principal payments elsewhere. Assuming that these payments could earn a 3.50% pretax return, there is a $210/month pre-tax opportunity cost. The post-tax opportunity cost is $137/month.
c) Both home prices and rental rates tend to increase with inflation over time.
So, with these factors in mind, one can now discuss the true economic cost.
For mortgage interest, the calculation is:
(home price – down payment) * (rate/12) * (1 – tax rate).
For opportunity cost, it is:
(down payment) * (rate/12) * (1 – tax rate).
Combining those, the total is:
(home price) * (rate/12) * (1 – tax rate)
= ($360,000) * (3.50%/12) * (1 – 35%) = $683
The calculation would then be as follows:
$683 after-tax interest and/or opportunity cost
+$195 after-tax property taxes ($300 – $105)
+$400 insurance/maintenance/HOA fees
$1,278 true economic monthly cost
When we look at it this way, it is much cheaper to buy than to rent at $1,500/month. Also, the interest/opportunity cost is likely to stay fairly constant, while rents tend to increase every year. The property taxes increase with the home value, but the increased home value is much more valuable than the increase in taxes. So, whenever the rental cost is similar to the true economic cost and the buyer intends to live in the property for several years, we recommend buying. For those who move frequently, the closing costs and sales commissions make renting more efficient.
The closing costs are around 1% when buying and less than that when selling, but the seller usually pays a 5% commission when selling. So, for a buyer who intends to stay in the home for seven years, the home price needs to increase by about 1%/year to offset those costs. If the home price is flat, that adds about $300/month to the true economic monthly cost, but owning may still be cheaper if rents increase enough. If the home price declines significantly or the homeowner sells quickly, then renting is clearly better.
By using the same pre-tax rate for the mortgage and the opportunity cost, it does not matter if the down payment is 20% or 50% or 100% – the pre-tax mortgage cost decreases as the opportunity cost increases, and the total cost stays constant. Also, as the mortgage is paid down, the interest savings on the mortgage equal the opportunity cost of the principal payments, so that cost does not change over time either.
Not surprisingly, the general conclusion is that if you plan to stay in the same place for several years, you are usually better off buying. If you plan to move within 2-4 years, you are usually better off renting.
To summarize, the MYeCFO perspective and insight on this topic:
- Focusing on cash flows instead of true economic costs
- Ignoring the value of paying down the mortgage each month
- Excluding the opportunity cost of not investing the down and mortgage principal payments
- Determining the buyer’s actual marginal tax rate and ability to use tax deductions
- Calculating the true economic cost
- Focusing on the long term, taking inflation into account
We wish you Happy Holidays from the MYeCFO Team
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