Rent vs. Buy, Part 1

In my continuing research on real estate I’ve come across some sobering facts. I suppose my ignorance of these facts put me squarely in the camp of the uneducated consumers of my generation who have managed to rack up unprecedented personal debt loads (credit cards and other loan types). But I’m slowly learning. Using the following example, I’m going to try to illustrate the economics of renting versus buying: to keep it simple there’s no downpayment, the mortgage is for $500,000 at a fixed rate of 6.5% interest amortized over 25 years.

The monthly payments are about $3375. After the first year you’ve paid $3375 x 12 = $40,500. BUT…sorry to say that what you still owe the bank is not $459,500 ($500,000 – $40,500). Instead, you still owe $491,745 because over $32,000 of that 40k went to paying interest. So much for renters “paying someone else’s mortgage”, or rent being equivalent to “throwing money away”. For the first few years of owning a property most of what you are paying is going to someone else as well – the lender.

Okay, you say, but over time you will pay less interest and more principal and eventually you will own the home outright. Well, let’s look at another sobering fact.

That house that cost you $500,000? When your 25 years is up and you’ve paid off your mortgage, what you will actually have paid for your house is $3375 x 12 x 25 = $1,012,500

That’s right, at the end of 25 years you actually paid over one million dollars for a house that you thought was half that amount. Is it just me, or is this INSANE? And that amount is not including the maintenance costs, property taxes, strata fees, and what-have-you that go into owning a home. Let’s say that taxes and strata/maintenance fees add on about another $500/month which, over 25 years, would be another $30,000. That brings our total up to $1,042,500.

So, 25 years later, when you sell that house, you need to get at least $1,042,500 in order to just break even. Even if the house value doubles you will have LOST $42,500. But what if you sell the house for more than double? Certainly people in our parents’ generation saw good returns on their homes. Well, how much more would you have to sell it for to make it a “good investment”?

A typical savings account yields about 4% interest these days. What if you had put all that money into a savings account instead? $40,500 per year in a compound interest account earning 4% annually would yield, after 25 years: $1,740,971. Compare that to the $1,042,500 paid into the house. Your house would need to go up by about 290% to equal the return on the savings account. Okay, you say, but you need a roof over your head, right? So, let’s look at what would happen had we paid rent and put the difference in a regular savings account.

Half a million doesn’t get you much in this town. You could get a very modest house in a not-so-popular neighbourhood, and judging from the rental listings I’ve been looking at you could not get more than $2000/month for it, if that. If it was a “luxury” one-bedroom downtown condo you might rent it out for $2400/month max. That’s a generous guess, but lets go with that:

$2400 x 12 = $28,800. This is a savings of $11,700 each year over the cost of paying the mortgage. Let’s say you put this in a compound interest savings account at 4% annually. Each year you add another $11,700. At the end of 25 years you will have $502,947 sitting in your account.

So, over 25 years you will have paid your landlord $720,000 but you’ll have $502,947 in your pocket, giving you a net loss of about $217,053. If you’d bought, you’d have paid $1,042,500 and will have to sell that $500,000 house for over $825,447 to do better than if you had rented. In today’s market it’s easy to assume that such returns are commonplace, since people have actually done much better than that. But historically, such returns are rare.

Now, this example is obviously a simplification. Mortgage rates change and so do the payments and interest amounts. Rents also change accordingly, and right now we are seeing a very low ratio of rent/buy monthly payments, so the difference in what you pay for rent versus a mortgage could be smaller. Who knows what will happen as far out as 25 years. And inflation changes what a dollar is worth, so that a profit of $250,000 might not be worth as much then as it would be now.

I’m not saying that people are crazy to buy real estate. I still want to buy a home one day. And I’ve shown above that, in the long term, it could be difficult to make a profit if you are renting. Most people don’t have the willpower to put the extra money into savings, and if house prices fall (or rents increase) the losses could be more. In my next entry, I’m going to explore the factors that affect the rent versus buy debate in the short term, and why renting for a few years makes alot of sense in our market right now.

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