The financial argument for renting is that it has lower upfront costs and the money not spent on mortgage repayments can be invested into income generating assets. The current argument for purchasing a house is that at today’s interest rates home loan repayments are cheaper than rent. It also fixes your accommodation costs in perpetuity. But which school of thought gets you to financial independence faster?
To answer this question, I’ve modelled 3 scenarios using the following common assumptions below:
| Take home income | $90,000 |
| Cost of living ex mortgage repayments | $50,000 |
| Portfolio growth rate | 7% |
| There are no fees, taxes or inflation | |
| 0% interest on home deposit savings |
Scenario 1: The household pays the minimum principle + interest amount ($19,752.15) towards their mortgage and invests the remainder of their excess cash ($20,247.85) at a 7% return. Financial independence is reached once their portfolio exceeds 25 times their annual expenses (25 x $50,000 = $1.25M) plus their outstanding mortgage value. The idea here is that once this point is reached, they sell a portion of the portfolio and pay off their mortgage whilst living off their portfolio distributions as per the 4% rule. The assumptions specific to this scenario are as follows:
| House Value | $488,000 (Note 1) |
| Purchase costs | $30,000 |
| Total house purchase cost | $518,000 |
| Mortgage (80% total purchase cost) | $414,400 |
| Mortgage term | 30 years |
| Interest rate | 2.54% (ING 2021) (Note 2) |
| Repayment frequency | Monthly |
| Mortgage repayments per month | $1,646.01 (ING 2021) |
| Annual total cost of living inc. mortgage repayments | $69,752.15 |
Scenario 2: The household pays off their mortgage first before they start investing. To do this, they will use 100% of their excess cash ($40,000) to pay off their mortgage. Financial independence is reached when once their mortgage is paid off and their portfolio exceeds 25 times their annual expenses (25 x $50,000 = $1.25M).
| House value | $488,000 (Note1) |
| Purchase costs | $30,000 |
| Total house purchase cost | $518,000 |
| Mortgage (80% total purchase cost) | $414,400 |
| Mortgage term | 30 years |
| Interest rate | 2.54% (ING 2021) (Note 2) |
| Repayment frequency | Monthly |
| Mortgage repayments per month | $40,000/12 = $3333.33 |
Scenario 3: The household rents a home at the Perth median rental price of $420 per week (REIWA 2021). I’ve assumed that the homeowners spend $5,000 per annum on the upkeep of their properties; this cost does not need to be paid for by the renters so their cost of living is $50,000 – $5,000 = $45,000 excluding rent payments. Their total cost of living, once rent is included is $45,000 + $420 x 52 = $66,840. Financial independence is reached when once their portfolio exceeds 25 times their annual total expenses (25 x $66,840 = $1.671M).
| Cost of living ex rent | $50,000 – $5,000 = $45,000 |
| Rent per week | $420 (Note 3) |
| Rent per year | $420 + 52 = $21,840 |
| Cost of living inc. rent | $45,000 + $21,840 = $66,840 |
Results
Investment portfolio values
Similar to my post on paying off your mortgage before you invest the rise in portfolio values show the benefit of investing earlier. The home buyer that makes the minimum repayments is able to start investing after 3 years; and the renter household is able to start investing immediately. This gives both of them a significant head start over the home buyer that makes the maximum repayments. The simulation shows that the $40,000 per annum invested by the home buyer that makes the maximum repayments (scenario 2) is not enough to overcome the additional time in the market that is seen in scenarios 1 and 3 even though they only invest $20,248 and $23,160 respectively.
Time to financial independence
The following graphs show the portfolio values under the 3 scenarios (solid lines) along with the portfolio values required for financial independence (dashed lines) for the 25th to the 35th years. (Note 4)
| Required portfolio | Years to reach financial independence | |
| Home buyer – minimum repayments (scenario 1) | $1,330,336 | 29 |
| Home buyer – maximum repayments (scenario 2) | $1,250,000 | 32 |
| Renter (scenario 3) | $1,671,000 | 27 |
The simulation shows the household that rents reaches financial independence in 27 years compared with the household that makes the minimum repayments which reaches in 29 years. The home buyer making the maximum repayments takes the longest period of time at 32 years.
This result is due to the fact that the renter household has more free cash flow than the home buyer in scenario 1 ($23,160 vs $20,248) as well as an additional 2.6 years to build their investment portfolio. The additional time is the result of not needing to save $103,600 for a home deposit. It is also interesting to note that even though the renter household requires a a significantly larger portfolio to become financially independent ($1.671M vs $1.33M), they can achieve this faster by investing more money and starting earlier.
Key financial considerations when choosing renting
Rent price movements
The considerations for scenarios 1 and 2 are detailed in my previous post here so I’ll focus on the risks of adopting the renting lifestyle choice. The biggest risk with choosing renting is rental price movements. This simulation has fixed the price of rent however in the real world it can move in either direction. As a result, it would be financially prudent for a renter build a portfolio large enough to cope with increases in the rental price. For this scenario, if the rent were to increase from $420 per week to $500 the household’s total cost of living would be $71,000 which would require a $1.775M portfolio.
Higher overall cost of living
In the long run, renters will have a higher total cost of living than home buyers. This means that to become financially independent they require larger investment portfolios. In this example after 29 years the household in scenario 1 only needs enough money to satisfy 25 times their household expenses ($1.25M) + the outstanding balance on their mortgage ($80,336) = $1.33M whereas the renter will always require 25 times the total of their household expenses ($45,000) + rent ($21,840) which totals $1.671M.
Investing the excess cash flow
Choosing renting over buying often gives households increased free cash flow. To build wealth as a renter investing this cash at a suitable rate of return is crucial. The issue is that the temptation to spend this money is very high and many households do not use the excess cash in a financially prudent manner. This is observed in Australia with property owning households in the over 65 age categories having a median net worth of over 22 times that of renter households (Thompson 2020).
Upkeeping your landlord’s property
In this simulation I’ve estimated that renters will save $5,000 per annum in property upkeep costs. However, I have known some people to be really good tenants who treat the property like their own and take on some of the upkeep costs themselves. While this is a great thing to do, it will reduce the financial benefit of renting.
Concluding thoughts
In this simulation renting is shown to achieve financial independence faster than purchasing a home, paying the minimum amount on the home loan; and investing the remainder. This is because renting gives the the household more excess cashflow to invest and they can start investing earlier.
Because renting and paying the minimum amount on a home loan involve maintaining a higher overall cost of living, I would say that both strategies can be viewed as riskier than paying down a home loan as quickly as possible; if you choose either of these courses of action you need to be able to identify and be comfortable with these risks.
As with many financial planning type scenarios there are a large number of variables (income, cost of living, interest rates, rent prices and house prices) that can alter the results of the simulations. However, the most financially prudent thing anyone can do in any situation is to maximize the amount of excess cash flow that their household generates. For renters this means choosing a reasonably priced rental; and for home owners this means choosing a suitably priced home and managing debt levels.
Engineer your freedom
Notes:
- Perth median house price as of December 2020 (REIWA 2021)
- Home loan is for owner occupier, principal + interest LVR is 80% or less
- Perth median rent as of December quarter 2020 (Domain 2021)
- Rounded up to nearest whole year
References
Domain, 2021, Domain Rental Report, Domain, available from: <https://www.domain.com.au/research/rental-report/december-2020/#perth>
ING, 2021, Home loan interest rates, ING, available from <https://www.ing.com.au/rates-and-fees/home-loan-rates.html>
ING, 2021, Home loan repayments calculator, ING, available from <https://www.ing.com.au/home-loans/calculators/repayments.html>
REWA, 2021, Perth Market Snapshot week ending 14 February 2021, REWA, available from: <https://reiwa.com.au/the-wa-market/perth-metro/>
Thompson, G, 2020, Older Australians who own their home more than 20 times better off than those who rent, data shows, ABC News, available from: <https://www.abc.net.au/news/2020-02-10/older-australians-who-own-home-more-than-20-times-better-off/11815006>