What's better financially, renting or buying?

There has been a lot of debate on this topic in the financial freedom world with some confusion about how to actually determine whether renting a property or buying a property is a better financial decision. The truth is that it depends mostly on the country that you live in and the terms that are associated with your mortgage agreement, i.e interest rate, deposit requirement etc.

In order to actually understand which is better, you need to do a calculation. You need to find out which method ends with you increasing your net worth year on year. This sounds easy but can be deceptively complicated and the reality is that in some situations renting is better and in others, buying with a mortgage is a no brainer.

Opportunity cost of buying

The biggest loss when it comes to buying is actually the opportunity cost from the money that you use to buy the property, usually for a deposit, also known as a "downpayment" on the property. This downpayment depends a lot on your independent situation and in the country in which you live. It can range anywhere from 0% to 20% of the value of the property you are buying.

If we say that we want to buy a property worth $500,000 and the requirement is that we must put down a 10% downpayment, that means we'll need to pay off $50,000 on the property immediately in order to meet the mortgage criteria successfully to buy the property. You are not losing $50,000. The money goes into your property. What this means is that you'll have a mortgage of $450,000 (on a property worth $500,000) and owe that much to the bank, plus interest. This means that if you sell the property immediately after you buy it, you would get back your $50,000 in a perfect world, however due to early mortgage cancellation fees and such this is not how it would be practically. However, these fees are negligible enough to ignore for the purpose of this explanation (for the most part).

The real cost here is the opportunity cost of no longer having access to the $50,000 to invest somewhere else that may bring in more money, such as an ETF which is practically guaranteed to grow 8% per year in value. If you invested the $50,000 into a standard ETF such as the S&P 500, you would get a compounding interest of around 8% per year adjusted for inflation. Over the course of 10 years you could expect this $50,000 to become worth $107,946.25, which you can see by using a compound interest calculator. This is an increase in net worth of $57,946.25 over 10 years.

Could you say that the $50,000 you deposited into your property would've netted the same appreciation in 10 years? That's one of the most important aspects of this entire breakdown.

Renting is completely dead money, buying isn't

When you rent a property, all of the money that you are paying per month is lost. This is contrary to a mortgage, where a portion of your payment is actually going into your net worth, as it is paying off the mortgage that you owe to the bank. On top of this, the monthly rent of an equivalent property is generally far higher than that of a mortgage repayment on the same property. When you combine both of these aspects, what you'll find is that on a month by month basis, your monthly costs will generally be significantly lower than renting.

There are some things to take into consideration however. There are additional taxes that you'll have to pay as the owner of a property and in some places these taxes can be significant. These taxes, just like on a rental property, are "dead money". On top of that, when you own a property you become responsible for any problems with the property, such as plumbing that malfunctions, broken roof tiles and various other things that can go wrong, further increasing your monthly cost burden. These types of costs are unpredictable and can yet again add more onto your bill. When renting, this is not something you have to worry about as it is the landlord's responsibility to take care of most of these issues.

Nobody will ever loan you so much money at such a low interest rate

Where things get really complex is when you intend to actually utilise your mortgage to buy a property that is in an area where the property value increases significantly over time. These can be in places like London, Amsterdam, Los Angeles, San Fransisco or numerous other densely populated cities and tourists attractions that aren't going anywhere anytime soon. You stand to gain an enormous increase in value in your property in these areas over time.

This is where the opportunity cost of the downpayment required on a mortgage starts to fade, as the property you are getting with the mortgage can increase in value significantly. While you may not be able to invest $50,000 into the stock market, you'll be able to invest $500,000 into the property market with just $50,000 plus an interest rate (between 1 and 4% in most places). Let's say that your property increases an average of 6% per year for 10 years and your interest rate was 3% with a property tax of 1%. That means you net a 2% profit year on year. Not as good as an investment in the S&P 500.

Except, instead of earning 8% per year on your $50,000 in the stock market, you're actually earning 3% per year on $500,000 in the property, which is a significantly higher investment. Over 10 years your property would be worth $609,497.21. This is an increase in net worth of $109,497.21 over 10 years, compared to your prior increase in net worth over 10 years via the renting and stock market strategy ($57,946.25).

In this particular example, you've made double the money buying the property that you would have gotten from renting and using the upfront buying costs to invest in the stock market. This example however is assuming quite a large return on your property at 6% per year. This isn't unheard of or unusual of course, many major cities and tourist destinations have had their properties increase in value like this, if not more in some cases. This is why it comes down to where your property will be located and what kind of returns it'll give over time.

A mortgage is a very powerful investment tool, if utilised properly

If I said to you, I'll loan you $500,000 at a 3% interest rate and all you have to do is give me $50,000, what would you say? I hope you'd say yes, because you could just take that $500,000 and invest it in the stock market and earn 8% per year in returns, easily paying off the interest I charged you while earning a net profit of 5% per year for yourself. It's a no brainer. This is essentially what a mortgage can be for you. There is almost no other situation in which someone will lend you so much money for such a relatively low interest rate.

When you are young, with a good career and some money saved up, you should utilise this to buy a property as close to or in a major city as possible. The most you'll be able to afford is probably a tiny studio. However, if you choose wisely, that studio will grow in value far more than your money would've done in the stock market in the same period. You can then sell the studio and use the money to invest in the stock market and move out to a cheaper area and get a bigger home when you actually need it. You don't need a big home when you're young, you need to be taking steps to financial freedom. If your job is in a big city, you'll also probably be getting paid more and you'll save money on transporting yourself to your job if you are getting a property that is near your office.

Every individual situation is different

No two situations are similar, thus everyone will need to actually calculate their own situation themselves to figure out what the best strategy is. I've outlined the most important things to remember above when making your calculation but there are even more factors that you need to take into account. For example, if you buy a property but it's further away from your job and/or groceries or other necessities, how much extra money will you have to spend on transport? Think; gas, car tax, car depreciation over time, etc. What about unforeseen costs? Think; property damage, breaking pipes, malfunctioning electrics, breaking appliances.

The truth is, it's almost impossible to actually account for every single factor. There is however, what I believe to be a rule of thumb that can make it quite simple.

Large city, tourist attraction, wealthy area, expensive already?

Then it's almost always worth buying any property you can afford while utilising a mortgage in an area like this because the chances are, over time the increase in value on the property will outweigh the opportunity cost. It is in fact, probably the best investment you can make as a young person with a steady source of income. As mentioned before, nobody will ever give you this much money for such a low interest rate in any other situation.

Small city, not a popular destination, middle class suburb, not a lot of price volatility?

In this case, the answer is not so clear. It really depends on the individual situation, such as the interest rates being offered on the mortgage, the downpayment percentage of the value of the property required and the property taxes. I will say that in most situations, buying is still probably advantageous, just perhaps less so and more debatably so. You can invest that downpayment from the poorest areas in your country in the stock market and get 8% return regardless, will your property in these poor areas be stuck at a mere 2% growth year on year while you're paying 2% on the interest rate and 0.5% on the property tax? That's what you should be trying to find out.

Summary

In summary, buying is almost always more advantageous, however, there are some situations in which the opportunity cost associated with obtaining a mortgage is not worth it.

Keep in mind that every example here, we are talking about spending as little money as possible on your mortgage by putting down as little money as possible. You should always be leveraging the low interest rates and high loan capital of a mortgage, rather than paying off as much as you can afford on your mortgage. Without mortgages, this question becomes a no-brainer, you should never buy a property outright with cash unless you want stable income from an investment property. That cash will always be better invested on the stock market.

You want to get as much money as possible, at as low an interest rate as possible to invest in as valuable a property as possible, while spending as little money as possible to get it, so that your opportunity cost is as limited as possible.