Most people tackle the rent vs. buy problem incorrectly by framing it as the cost of monthly rent versus the cost of a monthly mortgage payment. The argument goes something like, “if your monthly rent costs as much as a mortgage payment on the same or similar property, then it’s a no-brainer to buy the home and build equity rather than flushing your rent money down the drain.”
Others argue that a better comparison looks at the true cost of home ownership, which not only includes the mortgage payment but also things like property taxes, insurance, and maintenance.
However, as PWL Capital’s Ben Felix pointed out in the latest Rational Reminder podcast, neither argument paints a truly fair comparison of rent vs. buy. What you need to look at, he explains, is the total unrecoverable costsin each scenario.
For example, a monthly rent payment is a total unrecoverable cost: an expense that does nothing to improve the renter’s net worth. A mortgage payment, on the other hand, only has partial unrecoverable costs: the interest paid on the mortgage. The other portion reduces your mortgage amount and therefore increases your net worth.
A winning point for home ownership, right? Not so fast.
We need to add up all of those additional costs that a home owner bears (property taxes, insurance, maintenance), plus any upfront money spent on a down payment, land transfer tax, title insurance, home inspection, etc. to close on the home.
There’s also an opportunity cost on the down payment and other closing costs. That money could have been invested instead of put towards buying a home.
Rent vs. Buy: Let’s Do The Math
Let’s look at an example of a renter in Toronto who’s paying $2,000 a month to rent a 575-square foot condo. The same condo is listed for $449,000.
To purchase the condo our renter would need to put down 5 per cent, or $23,450, plus add another $17,062 to the mortgage due to CMHC insurance (required on all mortgages with down payments of less than 20 percent), for a total mortgage amount of $443,612.
Our upfront costs are not done, however, as we need to add in land transfer taxes of $10,910, lawyers fees of $1,000, title insurance of $449, plus a home inspection for $500.
Total upfront costs = $36,309. The opportunity cost of this amount in 25 years at 6 per cent a year = $155,834.
Now let’s look at the unrecoverable monthly costs. The mortgage is amortized over 25 years and has an interest rate of 3.50 per cent. The monthly mortgage payment is $2,215. Of that payment, $1,200 goes towards interest and $1,015 goes towards paying down the mortgage principal.
Then we have property taxes coming in at $375 per month, and we’ll also add the difference between home insurance and tenant insurance, which is $40 per month. We also need to add expected maintenance costs, which we’ll estimate at 1 per cent of the property value per year, or $375 per month.
Total unrecoverable monthly costs (interest, plus property tax, plus insurance, plus maintenance) = $1,990
The unrecoverable costs for the renter and homeowner are nearly identical. The total monthly payment for the homeowner, including property taxes, insurance, and maintenance, is $3,005. Just $1,015 of that is building equity in the home. So, back to the rent vs. buy argument.
Rent and Invest the Difference
We have to assume our renter has an extra $1,015 available in their cash flow each month to invest. What are the expected returns for a 60/40 balanced investment portfolio over 25 years: maybe 6 per cent?
$1,015 per month invested for 25 years at 6 per cent per year = $686,627. Add the opportunity cost of the down payment and other upfront expenses and you’d have a portfolio worth more than $842,000.
Historically, many people would be surprised to learn that the return on real estate has been closer to inflation. Certainly with the run-up in home prices over the last two decades one should not expect significant gains from this asset class moving forward.
So the expected future value of the $449,000 condo in 25 years at 2 per cent growth per year is $736,600.
Final thoughts
Is renting really a waste of money? Hardly. This is just one example showing how to frame the rent vs. buy comparison, but you can make a strong case for renting and investing the difference of the true cost of home ownership. Plus, we didn’t even get into the opportunity cost of the homeowner forgoing RRSP and TFSA contributions due to the higher cost of home ownership.
Who comes out ahead in this case? Clearly it’s our renter, who invested steadily for 25 years and ends up with a portfolio of $842,000. That’s compared to our homeowner who has a mortgage-free home in 25 years worth $736,600.
The next time you hear an argument that renting is throwing away money, stop and consider things like unrecoverable costs and the true cost of home ownership before drawing your own conclusion.
In addition to running the Boomer & Echo website, Robb Engen is a fee-only financial planner. This article originally ran on his site on Nov. 22, 2018 and is republished here with his permission.
Rent or Buy are two different things. A renter is someone who enjoys stable fixed monthly costs, lots of cash flow to invest, travel , enjoy good meals, to help out family members and enjoy the state of mind of not being tied down. A homeowner is someone who just wants to own some bricks and plywood and know they simply have to squirrel away any excess funds to fix the plumbing, the roof, the fence, the furnace and forget about spending money on personal fulfillment. Your title “Is renting throwing away money” is also quite offensive,such as asking how long has it been since you beat your wife? For those who rent because they financially don’t have the capacity to own, then any comparison is not real. Many who own do so because of peer and family pressure and lack of knowing the real options and would not invest outside the place they sleep in regardless.
Also add in the costs of selling and buying additional homes – I have read that people move on average every 6-9 years. The renter can easily pick up and go as circumstances change, with little cost. The home owner…..
Renter wins again.
A very balanced assessment of rent vs buy, but can you do the calculation where rent also increases by inflation?
You forgot to tax the income on the investments (if you assume that both parties are sensible and have maxed out their tfsa/rrsp). Suddenly it’s the complete opposite.
Do not forget that you pay tax when you liquidate the investment while there is no tax when you sell your principal home.
Tax on the investment income – no tax on the increase in your house value. Each house payment gradually increases the amount going towards the principle. in the last 10 years or so, almost the full payment is going towards the principle. There is also always the chance of a severe downturn in the market, such as 2008-09 which can wreak havoc on your investments. Happened to me and forced a delay in my retirement plans. There is also the security of not having to worry about being asked to move or having a landlord who doesn’t keep the property up or excessive rents due to an extremely tight rental market such as now. Last but not least is relatively stable monthly payments that remain roughly the same each month. Doesn’t work with rent prices. I almost forgot the sense of freedom you have when you own your own home. You can pretty well do what you want.
Good analysis but you missed the final step – the after tax value of the scenarios. Primary residence can be sold tax free, but not so for investments. So if the the renter’s investment gains are all capital gains, they will have to pay tax on $842,000 – (36309+1015*12*25) or $501,191, at say 50% of the 50% taxable or $125,298. The renters after tax value is thus 842,000-125,298 or $716,702, slightly less than owning. Given the assumptions here the rental case is probably worse with annual tax bills along the way for income from investments.
Nice summary.
Mortgage payments in inflation adjusted terms, will generally decrease over time all else being equal. Rent will generally increase with inflation or may exceed inflation. Moving every few years will Favor the renter, staying in one location will tip the scales toward the buyer.
The return of the investment portfolio will depend on taxation and marginal bracket of the renter, as well as how often they might trade to achieve that 6% return. (After fees). Going forward 6% in a balanced fund may not be realistic.
It is not slam dunk either way, and both scenarios are likely pretty similar in most cases unless you’ll be moving frequently (better to rent) or certain staying in the home for 15-20+ years (likely better to buy). A diversified approach is a good idea, ideally the buyer is in a market where he or she can enjoy owning a home while still having cash flow to invest. (And Not borrowing everything the bank is willing to lend)
You left out the monthly condo maintenance fee which could be $400- $500. This cost alone over the 25 years would cover any cap gains tax by the renter
Good article and even better comments….to add to the need to assess each INDIVIDUAL
case….another factor is LOCATION. A decision in Toronto may give a different answer than in Sudbury! Remember the old real estate rule…LOCATION×3).
Anybody can make up numbers to make renting look good. Much depends on when and where you bought and if you how much did you put down. My apartment rent in 1982 was $440/month and today 2018 it is $1,500/month and was then and is today still a dump! I would not live in that place today and an apartment rent equivalent to my condo today be $3,500/month. I paid $100k for my condo and now worth $1,000,000. I can sell my condo and pay no taxes. Take out an annuity in old age if need be.
Typical case of misinformation. As pointed out by other readers, tax on the the whopping 6% gain on index funds(-2% this year). Also, maintenance is that high only for a condo not for detached houses. Property tax $375/month wtf? Its $250/month for a 6 bed bungalow in etobicoke. Maybe true for a pricey neighbourhood like rosedale, moore park or high park but inaccurate numbers favoring renting.
Typical naysaying real estate bear.