By: Ian Mucignat
We all need a place to live. Let’s assume our parents have kicked us out of the house, and living rent free is not an option. We are faced with the choice of renting a home or buying a place and making mortgage payments.
However, it’s not that simple because, for most people, buying a place requires a down payment investment and closing costs. It’s also going to require taking care of the property and doing our own maintenance.
At 40,000 Feet
Intuitively speaking, buying a place makes a great deal of sense. Instead of your rent payment going to someone else, a mortgage payment goes to you by paying down a loan. A portion of every mortgage payment pays for the interest cost but also amortizes the loan. Over time, 25-30 years later, you’ve paid off the mortgage loan and now own a giant asset. You can sell the asset or live there without the burden of paying a mortgage or rent payment.
When you rent, you pay the landlord a monthly rental amount. In most cases, the rent amount will go up each year by at least the cost of inflation. Aside from making rental payments, renters are usually responsible for the utilities they use. Pretty simple.
From the landlord’s perspective, the owner of the property will want the rent to cover their mortgage payment and ongoing costs. If they don’t, then they are losing money and basing their investment on the expected returns from the property increasing in value. Overall, you can expect the rental amount to be somewhat close to a mortgage payment.
Purchasing a Home
When purchasing a home, there are other considerations and transaction costs. The down payment is the obvious one. With mortgage insurance, a home can be bought with as little as 5% down, or you can put 20% down and avoid the insurance cost. For some lucky people, they receive gifts from parents, but for others, it means disciplined saving to build the down payment. The down payment isn’t so much a cost as it is an investment in an asset.
The next biggest cost is the land transfer cost. The cost is based on a graduated scale, so the higher the value of the property, the higher the calculated tax will be. If you’re a first-time buyer, you also get a rebate, which can help significantly.
Furthermore, one must qualify for a mortgage. Assuming you have a decent credit score and employment income, then you can qualify for something. Mortgage qualifying rules have changed in recent years to make it more difficult, so you’ll want to speak to an experienced mortgage broker that can help you assess your qualifications.
Obviously, there are utilities to pay, such as heating and electricity; however, you’re likely to have to pay this when renting too.
When you own home, you’ll need to worry about property taxes to the local municipality and the upkeep costs. Ball park, the property tax is about 0.45% of the value of the home. The upkeep costs are things like repairs and maintenance. Over time, things such as the roof and HVAC system need to be replaced or repaired.
It’s hard to know what repair costs will be in the long run because they can be lumpy. The roof and furnace might break in the same year, while others have very minimal expenses. Based on my experience, I’d peg a 1.0% cost each year. For example, a 900k home might require about 9k of repairs annually. A condo will be different and less because condo fees go towards a reserve fund for all shared items, such as the exterior and parking garage.
Furthermore, home owners are required to carry home fire insurance. The cost of this is relatively inexpensive, but it should be mentioned.
Pride of Ownership
This might be priceless in a sense. For many people, it’s the dream of owning your own home and doing what you want with it.
Cash Flow and Saving Money
In all likelihood, renting will produce a slightly better cash flow. In a rational economical model, one might take that excess cash flow and invest it into something, such as the stock market, which can produce a higher rate of return. If the rate of return is greater than the return with owning real estate, then you could be ahead. This saving can be imperative because renters need to ensure they have money to pay rent after they retire.
However, we are far from being rational people. It’s common that, when people earn more money, they spend more money. We get used to earning more money. I don’t know the psychological term for it, but it’s simply something we all do. It’s therefore unlikely that you’re going to be disciplined to take all the excess cash flow and invest it.
With a mortgage, however, we are forced to make payments towards the loan. For many people who are debt adverse, having a mortgage loan is terrific because it’s a goal to pay off quickly. These “forced savings” are put towards a debt that reduces interest costs at a guaranteed rate (the rate on the mortgage loan) and doesn’t carry risk the same way the stock market does. Remember 2008 when portfolios went down 40%?
Buying an asset (the home) with only 5-20% initial investment is leverage. When the asset goes up in value, it’s going up on the whole home. For example, let’s say you put $100k down on a $500k house. If the property goes up 20% in 1 year to $600k, then you’ve earned $100k on a $100k investment, which is a 100% return. Many people have benefited from this in recent years and seen their personal wealth increase.
Anyone that knows me knows I love spreadsheets and numbers. It’s a big reason I completed my CFA designation. So, I started to build a spreadsheet to compare the financial results of the two options. It amazed me how I can produce wildly different results based on small changes to the assumptions because of the compounding effects over time. For example, I can change the rate of inflation a little bit and have renting be more favourable or home ownership more favourable. The assumptions make big differences. Therefore, I think the question of whether it’s better to rent or buy should be a higher plane decision.
At the end of the day, I would ask higher level questions:
- Do I believe in the long-term real estate market?
- Do I prefer to have pride of ownership?
- Do I like the idea of forced savings?
- Am I disciplined enough to sock away money for rent costs at retirement?
- Do I have the upfront money needed to enter the real estate market?
Owning your own home has worked well for many people and families. Maybe it can work for you, too.
Keep calm and mortgage on.
About the Author:
Ian Mucignat, CFA, is an independent mortgage agent at TMG The Mortgage Group. He graduated from Wilfrid Laurier University with a Bachelor of Business Administration, minoring in Economics, and is a CFA Charterholder. Ian has worked in the mortgage industry since 2000 at lenders, banks, and brokerages. If you are purchasing, renewing, or refinancing your mortgage, don’t hesitate to contact Ian directly for a free consultation.