Buying or renting your place of residence – what should you do? There are probably hundreds of thousands of articles contrasting the two paths scattered across the web. These articles will give you anything from in-depth analysis to general guidelines. Buuuuut regardless of the amount of content out there, I like sharing my own point of view on debates regardless of originality – plus it’s a HUGE decision in life! So let’s get on with it!
In my Big Three – Housing, I talked about some considerations for buying a home. Buying a home is undoubtedly a considerable purchase. For most, it will be the largest purchase you will make in your entire life. So you probably want to nail it…right? Being in the mindset of buying a home myself in the near future, here are a few of my own views:
What kind of FI blog post would this be if we didn’t consider the financial aspects of a decision?
Ok, so obviously you need to think about the finances. When considering buying versus renting, consider the following:
The single greatest disadvantage to renting is that you are putting a pretty decently sized chunk of change into someone else’s pocket. Rent is 100% an expense, but there are pros. Here are some advantages renting can afford you:
Consistency: Rent is extremely predictable since it is the same month-to-month. Even year-to-year it should be pretty much the same. Here in Ontario, renters are protected by the “Residential Tenancies Act” that outlines the maximum rent increase year-over-year that a landlord may charge. As an example, the maximum increase from 2018 to 2019 is 1.8%; this is determined in accordance with the change in Ontario Consumer Price Index (i.e. expectations of economic growth for the province). Renters are given the gift of steady cost and even predictability as you can budget for the following year.
This consistency also affords you the opportunity to invest everything else in an S&P 500 tracking index fund (or other asset) at a low 0.05% expense fee that I personally expect to provide a real return of 5% per annum on average over the long-term (8% historically). Renting does not carry the same expenses as owning, such as property taxes, hot water, water & sewer services, etc. and unpredictable large expenses (such as a new roof, furnace, etc.) that you need to budget for.
Non-Ownership: Renting means if sh*t breaks, you’re not responsible (within reason…don’t go taking a sledge hammer to your dry wall please).
- Dysfunctional furnace or AC? Landlord.
- Refrigerator on the fritz or leaky faucet? Landlord.
The benefit is not really needing to focus on your place of living as it is not an asset in your portfolio. You don’t need to maintain or improve your rented residence – that is not your job, nor does it serve a purpose in improving your net worth. This allows you to:
- Free up time to work on side hustles to boost income;
- Work on that garden so you have fresh organic fruits / veggies while shaving off cost from your grocery bill and being more self-sustainable;
- Hobbies / passions to boost happiness; or
- Your main job if you love it and/or see the possibility of boosting your income here.
The point is you have more time, which is then up to you to use efficiently. But it’s there for the taking!
Location Perks: Typically if you’re renting, you will have the extreme luxury of renting an apartment or condo that is pretty central (if living in a city). You can’t necessarily do this with a house (as you won’t be able to score a plot of land…count the number of times you’ve seen a house plopped in between two office buildings. Although, who would want that anyway!). Living in an area like this can provide some perks such as being walking / biking distance to work, the grocery store, and more. But living right downtown can get tiresome for some rather quickly. Nonetheless, this is a financial perk if you can score a decent pad at a reasonable rate due to limited transportation costs.
(This is on the premise that you want something other than a condo. If you want to purchase a condo, you certainly can live centrally! You will pay condo fees, but from my experience, you can be net positive on cost as your marginal expenses for utilities, property tax, etc will be lower…bear in mind that you are subject to the condominium board’s decisions regarding building facilities, security concerns and maintenance. You may be called upon for lump sum payments or boosted condo fees! No such thing as a free lunch, right?)
Convenience and Risk Avoidance: A nice benefit to renting is being able to pick-up and go. Moving to another place usually only requires 30 to 60 days notice. No need to try and cancel a mortgage and pay cancellation fees or sell off a massive asset at the mercy of the market. You also benefit from not carrying interest rate risk or asset liquidity risk.
“Sorry, huh? What are those?”
Interest Rate Risk: For an owner, this really means the risk the interest rate on your mortgage goes up. Don’t lose sight of the fact that a mortgage is a loan. You are borrowing money from an institution who needs to make money on lending you said money (shareholders of that company would not be happy with them not earning a return). So they charge interest. How?
Well, they charge you an interest rate based on your credit risk (how likely you are to default and not make a payment) and current interest rate markets. Here in Canada, mortgage rates are on the rise at a whopping…3.5%? Wow that’s cheap! Historically this is insanely low. I talked about this a bit in my post here.
If you loaded up on a big mortgage and locked into the popular 5-year fixed product, like many did, at a rate of 2.5% because you could stomach the monthly payment, what happens in 5 years when the you have to re-up at a 4.5% or 5.0% interest rate? You’re going to be hit with a 20% – 30% increase. You do not carry interest rate risk as a renter.
Asset Liquidity Risk: The risk that one must sell an asset at a depreciated value lower than fair market value. This lowers your return on investment.
So what happens when you want/need to sell the house? Well if you’re in a rush, you need to sell that asset in whatever market currently exists, even if that’s a buyer’s market! If you’re forced to sell in a buyer’s market, you will likely need to sell at a price below the true value to entice a buyer due to competition (many sellers and few buyers). You do not carry asset liquidity risk as a renter.
Owning a house is owning an asset that will return 2.9% per year historically. However consider the following expenses:
- Property tax can make up approximately 1.0%;
- You’re paying the interest on the mortgage, which could be 2.8% (assuming a 3.5% mortgage rate and 80% borrowed);
- Maintenance can be 1% or more (1% is an old rule of thumb, but I’ve seen some articles citing as much as 5%);
- Not to mention inflation erosion, say about 1.8%;
The above can add up to 6.6% or more of house value per year. This is huge – so unless you’re buying in a highly coveted area, you may be net negative until you can bring down the outstanding mortgage balance and maintenance cost.
The house appreciation will completely depend on where you buy…the 2.9% is just the historical New Housing Price Index (NHPI) for all of Canada. While the return isn’t as high as what you can make elsewhere and the cash cost of owning a house can be high, there are some financial advantages:
Asset Ownership: You will be the owner of your place of residence. Again, while the expenses can be high and the return not as favourable, you will be gaining some ground in your net worth. You also avoid paying rent to someone else, investing the principal portion of your mortgage payment. It is also a forced saving mechanism as defaulting on your mortgage isn’t really an option – the value of this is greater for some folks than others.
Possibility of Rental Income: This is really the most intriguing option and can really boost your return. Not only can you charge rent (boosting the revenue on your house asset) but you can claim tax deductions on numerous housing expenses such as utilities. While you have to play landlord, this can really make owning a house a much more profitable endeavour.
Possibility of the Smith Maneuver: This is a risky move that more advanced readers in Canada may be interested in. While in the USA, mortgage interest is tax deductible, here in the North they are not (at least directly).
The Smith Maneuver is where you leverage the existing principal of your home and invest said principal in another asset. To do this, you need a Home Equity Line of Credit (HELOC). Note that there are limitations on the amount of principal you can “borrow” (Last I checked it was 65% of the home value less outstanding mortgage) and the HELOC borrowing rate is variable. The typical strategy here is to invest the HELOC in blue chip Canadian dividend paying stocks and beat out the HELOC interest rate and then some. This, while leveraging more risk, allows one to pay down their house faster…you can read more about this here on Million Dollar Journey (One of my favourite Canadian FI blogs), or do a Google Search as many other blogs have the steps and associated risks laid out. I think a HELOC is looking less attractive as the Bank of Canada raises rates, which increases the borrowing rate on your HELOC, which means you need a higher rate of return from your blue chip stocks.
After ensuring you’ve got the financial boxes ticked, you will likely want to consider the quality of life aspects, for example:
- Knowing you’re buying in a place you can live in for a long time (as selling a home can really dig into your return on investment and in general be a pain in the ass);
- Lots of mature trees providing natural shade in the Summer and fresh air;
- Close proximity for biking or walking;
- Peaceful area, private, etc.
This section could honestly be as long or as short as you want it to be. This is the qualitative side of the purchase and really subjective.
While these aspects are extremely important, I would urge you to put the financial perspective first. Not because I’m a lifeless robot and don’t care about the memories you will eventually create in your beautifully crafted and positively distinct place you call home, but because this is a purchase.
At the end of the day, you’re buying a plot of land, the materials on that land, and paying for the labor that it took to get the materials in a shape of a house. If you go into this as an emotional buyer, you will overpay for your asset, and you will suffer from small long term gains. This kills your nest egg and can quickly crush early retirement goals.
Stay frugal my friends!