Let’s face it, life can be expensive. While there are many things you can probably live without (for instance, this pillow), shelter is not one of them. And that’s why when the day comes that you’re ready to leave your current home for another, you’ll have to make an important decision: buy or rent?
For the purposes of this analysis, we should note that we approached the decision on a completely quantitative basis. If it’s been your dream to own your own home, we assign no value to achieving that dream nor to the security of knowing your landlord can’t raise the rent on you for the sixth consecutive year. Prefer the flexibility that comes with renting? Again this is in no way taken into consideration, nor is the avoided stress of potential home price declines. Rather, this analysis is purely about the money and specifically, how much you’ll end up with after a specified period of time given an equal amount of starting capital under each of the two scenarios.
As background, let’s take a look at two important concepts when it comes to making your decision.
- Buying your home requires a good amount of capital: If you choose to buy, you’re going to need some capital. You’ll have to make a down payment, it’s likely to be sizeable (20% if you want to avoid private mortgage insurance), and you’ll also need money for closing costs. This initial capital is an important concept, because when it comes to comparing buying to renting, we’ll have to take into consideration the fact that you could have put this capital to work in other ways had you chosen to rent.
- You’ll face monthly costs regardless of your choice: If you buy your home, you’ll have all the associated expenses that come with it: mortgage payment, property taxes, insurance, maintenance, HOA fees, etc. Yes, you probably get a tax deduction on your mortgage interest and property taxes, but that isn’t going to completely offset your other monthly costs. Of course, with renting, you’ll have to pay, well, rent. It’s the difference between these two monthly amounts (your total rent vs. all your monthly costs that come with owning) that will drive our analysis.
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Buy vs. Rent – Final
So with those concepts in mind, let’s see how the buy vs. rent calculator works by thinking through the analysis chronologically:
- Day 1:
- We calculate your starting capital by adding the size of your down payment to your buyer’s closing costs. This amount is used as the starting value of your portfolio if you had chosen to rent (and thus would have been able to invest). We’ll call this amount your “rental portfolio”.
- As each month passes:
- You will incur expenses in both options. As such, we focus on the net difference between the buying vs. renting. For example, if your monthly rent is cheaper than your monthly cost of ownership, then that “savings” is presumed to be added to your “rental portfolio”. If your monthly rent is more expensive than your monthly cost of ownership, then that amount is deducted from your rental portfolio.
- If you buy, you can build equity. A portion of your mortgage payment will go towards paying down the principal balance of your loan. In other words, when the time comes to sell, you’ll owe the bank less and get to keep more of the proceeds generated from selling your home. Plus, the value of your home may increase, also adding to your equity.
- If you rent, your “rental portfolio” can earn a return. The money you didn’t use to pay for the down payment and closing costs can in theory be invested in other ways that should generate a return.
- Ultimately, you will leave your home:
- If you bought, you’ll now have to sell your home and move out. Ideally, the value of your home has appreciated, but the selling price isn’t going to be what you end up with. Unfortunately, you’ll likely have to pay seller’s closing costs and a broker’s commission. You may have to spend money to make your house presentable for sale. You may incur capital gains taxes on profits you generated. And of course, you’ll have to pay off whatever remains on your mortgage. But after everything is paid off, the amount you’re left with is yours to keep and that’s the number we focus on: your net wealth at the end of the day after choosing to buy.
- If you rented, you’ll simply need to move out. Under this scenario, all we have to look at is the value of your “rental portfolio” to see your net wealth at the end of the day after choosing to rent.
- Reviewing the results:
- The ending net wealth under each option is compared and a buy/rent recommendation is offered.
Regardless of whether you chose to rent or buy, you’ll have lived in your home, made memories, and enjoyed shelter for the same amount of time before moving to your next home. Owning your home can give you pride and renting your home can bring a sense of freedom (or vice versa), this analysis simply helps you to determine whether buying or renting that home left you with more money.