When we’re asked if rent money is dead money, our answer is no. With some caveats (of course).
Last week the team talked about reframing housing as consumption, not as an investment. Whether you rent or buy, you’ll have a roof over your head. Understanding the intangible benefits of owning (what economists call ‘utility’), is essential. You should consider the pros and cons to determine if that utility is worth the extra costs of buying. This is a very personal judgement that needs to take into account all the true costs of buying. ⚖️
Renting equals buying
Renting and owning a house have historically cost about the same according to The Reserve Bank of Australia (RBA). So despite all the reports about property booms and never-ending price growth, buyers and renters have ended up even over the last 60 years or so.
What about the future? Without a crystal ball, the best we can do is look to what the economists are saying: we are now in an environment of low interest rates, low economic growth and therefore low future returns on assets (i.e. housing). Which means it may actually be better to rent.
The recent housing construction cycle will result in a glut of new housing becoming available over the next few years, especially apartments. This should keep rent levels in check and slow house price growth, further tilting the scales towards renting.
While the banks and lenders with their simple online calculators and lengthy fine print might encourage you to buy, remember they make most of their money from mortgage lending, so always take their advice with a grain of salt.
The true cost of buying
You might think that all you need to do is compare rental payments against mortgage payments on an equivalent property. However, there are three important factors that should be considered when deciding whether to buy or rent:
- Ownership costs
- Interest repayments
- Opportunity costs
Never-ending ownership costs
Owning a house costs money—a lot more than you might expect. When you buy, there are major transaction costs. You pay tax (in Australia, stamp duty can be over 5% of the total property price). Stamp duty is a sunk cost, meaning you’ll never get it back. There’s also the cost of conveyancers (lawyers) for the paperwork, property inspections prior to making an offer, and if your deposit is less than 20%, you may be on the hook for mortgage insurance.
After purchase, there are all the maintenance costs: council rates, repairs, home insurance etc. These are not one-offs. They persist throughout the life of ownership. In order for any house to retain its value, you need to pay for its upkeep. While you may start with small repairs, a larger renovation can be expected in the medium term. These costs can be immense, and are often underestimated because most of us are inexperienced at building and renovating—so can’t predict what they’ll entail.
Interest is dead money
In the early stages of buying a house, you’re more likely to be paying significant interest. Interest payments on your mortgage go straight into the bank’s pocket, never to be seen again. They don’t go toward paying off the actual loan.
One way to look at it is that when you rent, you’re paying rent to a landlord to use their property. When you pay interest, you’re paying rent to a bank to use their money. Another factor is that interest rates are very low and are likely to go up at some point, so that dead money may increase.
The forgotten cost
This brings us to opportunity cost, which is often omitted or misunderstood. It refers to the loss of other alternatives when you choose one option.
It’s crucial to consider what you’re forgoing by purchasing housing. What if, instead of putting all your savings into the mortgage, you invested the money elsewhere (like in a term deposit, or buying some shares)? You could earn a higher interest rate and spread it across a few different investments to diversify.
Diversification is considered one of the most important components of long-term investing. It maximises your return while minimising your risk as you invest in areas that react differently to the same event.
The opposite of diversification is concentration. Having all your money concentrated in one big asset if the market falls or crashes (as it did in the US during the global financial crisis) could mean you lose all the money you’ve put into your home.
The above are all financial implications of buying. There are other non-financial factors you might value, like not having to talk to real estate agents when you want something fixed, being able to hammer that nail into the wall, or just knowing you won’t be kicked out anytime soon. On the other hand, you could value the flexibility to move around that renting gives you.
The results also assume you’re a disciplined saver. Some economists think young people aren’t capable of saving because the lure of smashed avocado throws the budget out the window. Having a huge debt like a mortgage is sometimes called a ‘forced saving’, without which you might not have the motivation to save.
Rent or buy?
The costs of ownership are high and easy to underestimate. Given most economists are predicting a slowdown in the housing market that will keep rental growth and house price growth low, deciding whether to buy relies more heavily on your utility (intangible, non-financial benefits) of ownership. Renting will give you the flexibility to move around. It will also enable you to take an alternative path by putting your money in different areas and diversifying.
The upshot? Unless it is personally critical for you to buy, renting for the next few years could end up saving you money, time and stress!
Laura Ryan is a quantitative researcher (maths gun) at a global fund manager with 17 years of investment experience. She has a PhD in statistics and is just generally awesome. Thanks Laura!
Note! This is for informational purposes only and is not intended as advice.