We own our own home; we aggressively paid down the mortgage so that we could be free of non-deductible debt and put our efforts towards building an investment portfolio as quickly as possible. While most Australians seem quite happy to chip away at their mortgages by making the minimum repayments over 20 or 30 years I’ve always approached the home loan from a different perspective. I view the home mortgage as a debt that was stopping us from accumulating wealth and becoming financially independent.
Growing up I was taught by my parents that buying was a far superior option to renting. They constantly drilled into me sayings like “rent money is dead money” and “why pay someone else’s mortgage”. So my natural course of action was to buy a house. However over the years I like to think that I’ve smartened up and can see the merits to both sides of the debate so I’m going to offer my thoughts on some of the considerations that should be made prior to making the decision to buy or rent. After all, it’s a pretty hefty financial decision.
Let’s kick start things with some monetary considerations.
Insurance and council rates
When you own your own house you will responsible for all of the additional costs that would not normally be paid if you were renting. You are responsible for council rates as well as home and contents insurance which for us was a little over $2700 in 2016.
Principle and interest payments
The average size of mortgages in Western Australia was $384,700 in November 20181. Using an interest rate of 4.2% p.a. interest payments alone amount to $16 157 per year. A quick search on realestate.com.au reveals that you could rent newly constructed 3 bedroom 2 bath room house around 20 km from the city for $420 per week ($21,840 p.a.), here’s a nice pic of the front of the house.
Or if apartment living is more your thing; a 1 bedroom apartment in the city for $350 per week ($17,680 p.a.)
For the record I have no affiliation with either of the properties or property owners, I simply did a search on realestate.com.au and the above two properties popped up.
Maintenance and home improvements
I’ve bundled these two in the same category since when you are the owner of your property you will inevitably have to do maintenance on your home and often you’ll find an excuse to do some home improvements as well. For example we’ve spent over $5 000 per year 2015 and 2016 on home improvements redoing floors, putting in security doors and additional lighting. The mentality when renting is different in that because the property doesn’t belong to the renter they won’t be inclined, or in some cases even allowed, to make modifications to the property.
Stamp duty
This tax is a killer! If you buy a home you’ll have to pay stamp duty if the home you purchase is over $430,000. For example in WA a property valued at $550,000 will mean the buyer will pay stamp duty of $20,140 upfront2, this tax represents 3.66% of the purchase value.
A brief cost analysis
I’m going to highlight a couple of roughly equivalent buy vs rent scenario for a couple of houses in a similar area. Now just remember I’m doing this for the readers of this blog which are pretty savvy people so I’m going to run with a larger deposit and estimate that you’ll be probably aiming to finish the mortgage in less than 10 years
You’ll notice that I haven’t included items such as electricity, water and food bills since in this model we assume that they would be same in each case. Here we can see that is a little more expensive when we consider an interest only loan. However at $173,640 the upfront costs of buying are considerable to say the least.
You’ll own an asset at the end of your mortgage
Home ownership means precisely that, ownership and property is an asset class that can grow in value. Running through the numbers the home owner in the above scenario will pay over $26,533 in additional interest payments over the 9 year 8 month payback period – assuming that the above conditions hold. If we assume that the property grows at a rate of 5% per annum the value of this house will grow to $881,437 over the repayment period, which means the owner makes a profit… YAY!
Now you’re probably asking where I got that 5% growth rate from and the answer is…
….I made it up because…
…why? Because it doesn’t matter!
Let me explain, with the primary residence it is only a quasi-asset because if the home owner wanted to extract is $881437 – $591,173 = $290,264 profit they would have to sell their home and be homeless or go down the rental path. Now they could sell the house and move to a property of lesser value however it is a fairly safe to assume that this property did not have a growth rate that far exceeded that of other properties in the same market. This means that the owner would need to sacrifice something of value such as land size or location in order to extract the monetary value of this growth. There are other ways to extract his value but I’ll discuss it in another post.
The opportunity cost of buying vs renting
A core principle in economics is opportunity cost. Essentially this means: What else could be done with the money and what benefit would this give? When it comes to financial independence the opportunity cost of owning a house is investing the money not consumed in the ownership costs.
The above table shows that if the excess money produced by renting was invested in a standard index tracking type fund with the returns modelled at 7% p.a. the value of the investment portfolio would be $939,202 after 10 years. Let me remind you that this is not a quasi-investment like family home, but a real investment that will produce yearly distributions as well as being much more diversified against risk than having all wealth stored in the family home.
At this point we can make a fairly strong argument that renting is economically better than buying. However if everything was up to economics we would use 100% of our waking hours to work, never take holidays and live pretty miserable lives. Because personal finance is more about psychology than pure economics and numbers here are some of the non-monetary considerations for the rent vs buy debate.
House for you enjoy the way you like i.e. a home
Maybe you’d like to customize your property so that you teach your kids to how to make wood fired pizza on Sundays; perhaps you don’t like the kitchen in your rental; or maybe you’d like to put in a dog door so your best four legged friend can go in and out at his/her discretion. If you truly want to live life in the home that suits your needs then home ownership beats a renting hands down. Everything in a rental property will generally be installed/fitted out so that the owner can either raise rents; decrease maintenance costs or increase competition to find a good tenant which means it’ll won’t be customized for the renter.
Stability
A land lord can evict their tenants once their lease is finished. Meaning that renting may not suit your needs if you value stability. If you have children for example you might consider the value of keeping them in the same place for an extending period of time so that there is minimum disruption to their education and friendship groups.
Tax Concessions on profits
There is currently no capital gains tax charged on the profits of one’s primary residence if it is sold at a higher price than what it was purchased for. If you’ve found a property that you can add value to by renovating, subdividing or simply buying and holding and you are willing to live in it for a period of time then buying a house works very well under the current taxation system.
Forced Savings
This probably isn’t relevant to most readers of this blog since you’re probably fairly disciplined people that are pretty good at sticking to plans however it is worth a mention. For the majority of the Australians that rent the additional income that they are saving by renting as opposed to buying will probably go towards some sort of frivolous consumption as opposed to building an investment portfolio. Thus having a mortgage would force these people to at least own some sort of an ‘asset’ after their mortgage has finished as opposed to going 20 or 30 years with nothing to show for it.
So rent or buy?
Since everyone’s personal circumstances are different I don’t sit firmly in either the buy or rent camp. If I had my time again I would have likely made exactly the same decision to buy, that being said, I would have liked someone to discuss with me at least some of the considerations that I’ve highlighted in this article so that my decision would have been more informed. I thoroughly enjoy where we are at the moment and have no intention of moving for at least another 10 years. We enjoy the space we have for ourselves and our dog. I also enjoy doing the odd modification here and there. The stability as allowed us to focus our energy towards investing and building our investment portfolio to allow us to achieve financial independence.
So overall buying suits people that:
- Intend on living in one place for a long period of time
- Value stability
- Value the freedom of being able to modify the property so that it suits their lifestyle
- Need to have a method of forced saving
- Are comfortable with the fact that in the current market Perth market it an economically inferior decision
Conversely renting suits people that:
- Do not intend on living in one place for a long period of time
- Live lifestyles where they do not necessarily enjoy the benefits of home ownership i.e. travel for many months of the year
- Are disciplined enough to invest the excess cash that they will save by renting
So there you have it, despite the prevalence of sayings such as “rent money is dead money” renting in the current market actually makes more sense from a financial standpoint. So for anyone currently deciding which route to take I won’t try to convince you that one scenario is better than the other but simply ask that you do your numbers and also consider the non-monetary reasons behind each decision.
Engineer your freedom