Most Canadians dream about buying and owning their first home. A significant rite of passage, buying a home is not only a big financial deal, it’s a big life deal.
Most people assume it’s better to buy a home than to rent, and to be honest, I have a bias toward home ownership, too. That being said, I have counselled people on the merits of renting. Recently, I met a young man named Sam, and thought I would share his story on renting versus owning.
RENT OR OWN
Every new homebuyer should first understand the differences between “renting and saving” and “buying and owning.”
For most people, renting is better on cash flow, not just because mortgage payments are often higher than rent but because of all the other costs associated with owning a home, such as condo fees, property tax and maintenance.
The idea of building equity can justify the increased strain on cash flow, but renters can build equity through renting and saving.
RENT AND SAVE
Sam is 26 years old and currently paying $600 per month in rent. He shares a three-bedroom condo with two roommates and has saved $25,000 to buy his own place. Sam has found a two-bedroom condo for $300,000 but is nervous about taking the leap.
Based on a five-per-cent interest rate, a $275,000 mortgage would require monthly payments of $1,600. Condo fees and property taxes would add $350 per month, bringing the total monthly cost to almost $2,000. That’s a big increase from $600-per-month rent.
BUY AND OWN
Let’s assume Sam buys the two-bedroom condo and we look ahead five years. In that time, Sam will have paid down his mortgage balance to $243,395, which means he has built up $31,605 of equity (assuming no growth on the property).
What will Sam’s situation look like five years from now if he continues to rent? In the rent-and-save scenario, if Sam can afford $2,000 per month to buy the home, theoretically he should be able to save $1,400 per month ($2,000 less $600 rent). If he were to save $1,400 per month for five years, he would have $84,000 in savings or an investment (also assuming no growth). This simplified mathematical analysis makes rent-and-save look like a better financial option after five years than buy-and-own.
CAN HE SAVE THE DIFFERENCE?
The biggest challenge in renting and saving is, of course, the saving part. Few of us have the discipline to save $1,400 per month for five years.
Buying and owning for some is a means to force savings, with mortgage payments seen as one of the most important payments you make.
Although Sam feels he is a pretty good saver, he does not think he can save $1,400 per month. He’s also concerned about becoming house-rich but cash-flow poor. He wants to enjoy life, and buying a house would drastically reduce extra cash flow.
One option is to get a roommate in the new condo to help pay expenses. Sam’s costs will drop to $1,400 per month. If he continues to rent and saves the difference of $800 his roommate is paying, he will have $48,000 after five years.
If we work backward to figure out how much he needs to save per month to have the same $31,605 equity in the home, he would have to put away about $525 per month.
INVESTING VERSUS REAL ESTATE PRICES
In this example, I have assumed no growth in property values or alternative investments. Sam asked me which would give him a better return, investing in real estate or mutual funds?
Real estate agents are likely to tell you that owning is a great investment because house prices are going to go up. Investment professionals will tell you that investments have performed better. The problem is no one knows which will do better in the future.
So although there are advantages to buying a house, it may not always make sense.
Jim Yih is a financial expert. Visit his award-winning blog, RetireHappyBlog.ca