Property: Should I Buy or Rent?

Should I buy or rent?

It’s one of the largest financial decisions you’ll make, but many of us approach it in the wrong way.

Traditionally, everyone has sought to buy a house. On some level, it makes sense, and we’ll explore why shortly. But the housing market is a very different proposition today compared with 50 years ago. For starters, over those 50 years, the house price to earnings ratio has doubled, making housing far less affordable.

To make a more informed decision, we need to go deeper into the relative merits of buying and renting, before adding some simple calculations to assess both options on a level playing field.

Before that, a few myths to get out of the way.

MYTH 1: RENTING IS MONEY DOWN THE DRAIN

Traditional advice would suggest that renting is money down the drain. Why? Supposedly, because you’re not getting anything in return.

But this is an absurd conclusion! What about a gym membership? Or meals out? Are they money down the drain too?

Of course not – you pay out to receive a service; when renting, that service is a property in which you can live, and which offers you flexibility. You might not own the asset if you rent, but you’re paying for the service of living in someone else’s property. There’s nothing wrong with that.

To make a proper comparison, the economics of renting needs to be compared with the economics of buying. We will address this later.

MYTH 2: HOUSE PRICES ALWAYS RISE 7%/YEAR

Just because we have seen dramatic house price growth in recent decades, it doesn’t mean we will see the same going forwards.

House prices should grow in line with economic growth plus inflation, adjusted for interest rates (lower rates lead to higher prices), population growth and housing capacity.

Over the past 50 years, economic growth has been strong, interest rates have trended downwards, there have been bouts of higher inflation (in the 1970s and now), the population has grown, and housing capacity has lagged. It’s unlikely we’ll see such a perfect backdrop for house prices moving forwards.

If you knew that house prices would again rise 7%/year over the next 50 years, it would probably make sense to buy rather. But it’s too simplistic to expect that what happened in the past will continue in the future.

MYTH 3: MONTHLY COST COMPARISONS MAKE SENSE

You may have fallen into the trap of comparing monthly mortgage costs with monthly rental costs and deciding whether to buy or rent based on which monthly cost is lower.

This ignores many other aspects, including maintenance costs, interest costs and the implicit cost of having money tied up in your property. A proper comparison requires (a little) more work.

THE BENEFITS OF BUYING

First off, owning your own place is cool. It offers you security that you have somewhere to live, and the incentive to pay down your mortgage to own your place outright.

While it can be a mental strain for some, having a mortgage forces you to pay it down. If you don’t, you’ll lose your home. It’s that simple.

For some people, this is useful. They may not have the discipline to save into their investment account each month because the benefits are far out in the future, but they sure will pay down their mortgage, because if they don’t, the bank will repossess their home. If you lack saving discipline, the ‘sword of Damocles’ over your head might work in your favour…

Owning property also offers a potentially appreciating asset. Sure – you won’t necessarily receive the 7%/year we have seen through history, but prices are likely to rise over the long-term, through the combination of economic growth and inflation.

It’s not just the financial gain – ownership also offers you the chance to redesign your property. And financial flexibility – you can downsize later in life to help fund your retirement pot. The danger of renting is that once you’ve stopped working, you’ll still have to pay rent each month. Will you have put aside enough of a pension to afford that? By buying and paying down your mortgage, your house is essentially free later in life.

THE BENEFITS OF RENTING

Renting gives you flexibility. With a few weeks’ notice, you can decide to move from one area (or country) to another, without incurring steep transaction costs along the way.

But renting is attractive for other reasons. Most people underestimate maintenance costs over their lifetime of owning a house. We’re not talking about extension work – it’s redecorating, gardening, bathrooms, kitchens, repairs – the works. On average, maintenance costs account for 1% of a property’s value each year.

Just as ownership has its psychological benefits, so does renting. Some people are sufficiently disciplined that they don’t need the threat of repossession to save enough each month. In fact, they may find a mortgage to be stifling, because it forces them to work for money in a job they dislike. Renting removes that pressure and allows you to upsize or downsize your property more easily, as circumstances change.

HOW TO ANALYSE THE NUMBERS

There are clearly benefits to both buying and renting. But to have a better comparison we need to examine some numbers. Let’s assume we’re looking at a £500,000 property, and whether it’s best to buy or rent.

Renting. Here the case is very simple. Your cost is your monthly rental cost, multiplied by 12 to give you an annual figure. In this case, let’s assume the rental is £2,000/month, or £24,000/year.

Buying. Let’s assume your £500,000 property is being funded with £100,000 of equity (i.e., deposit) and £400,000 of debt at a 5% interest rate. To compare buying with renting, we need to consider the following:

• Monthly INTEREST cost. This is not the total monthly mortgage cost. Part of your monthly mortgage payment goes to paying down the mortgage balance, and part goes to interest payments. Using Google’s mortgage calculator, we can see that the total monthly cost of that £400,000 of debt is £2,019/month. But the interest cost is the interest of 5%, multiplied by the debt of £400,000, divided by 12 to give a monthly figure. This gives an interest cost of £1,667/month, or £20,000/year. (COST: £20k/year)

• Capital Gain. This is the amount you gain through the increase in the property price. Let’s say that the price appreciates 3%/year. Your gain would therefore by 3% of £500,000, or £15,000 gain in the first year. (GAIN: £15k/year)

• Maintenance Cost. Here we assume the industry standard of 1% of the property’s value being used each year for repairs and renovations. (COST: £5k/year)

• Opportunity Cost. In this example, you have £100k as equity in the property. What if you had invested that in the stock market instead? Your return, after fees, would be around 6%/year on average. So there is a cost on your £100k of equity, at 6%/year. (COST: £6k/year)

• TOTAL NET COST = £20k interest - £15k appreciation gain + £5k maintenance + £6k opportunity cost = £16k cost.

So in our example, the total cost of buying is £16k/year, against the total cost of renting at £24k/year.

THERE IS NO UNIVERSAL TRUTH

Fundamentally, this buying / renting question can be answered in two ways – through the relative emotional benefits, and through the numerical benefits.

I would propose that you consider both aspects to make the right decision for you. Perhaps you’d rather have the security of your own home. Or perhaps you’d rather have the flexibility of renting.

All you need to know is the price you have to pay for these relative benefits. In our example, the cost of renting is £8k/year more than the cost of buying. So if you prefer to rent, ask yourself whether you’re willing to pay £8k/year for that privilege. If so, rent. If not, buy (once you can afford to).

This is the beauty of putting numbers to the problem – it helps provide clarity on the trade-off you’re making. And you can play around with these numbers to tailor the model to your own circumstances.

This piece is designed to give you the tools you need to make your choice. But it is exactly that – your choice. There is no right answer – it all depends on your circumstances. Now, at least, you can find your own answer more clearly.