To rent or to own? It's an age-old question and one that will be asked more and more by Generation Y as many of us move out, develop career paths and grow our net worths. Up until that point, many would default to staying at home with parents or renting a place to take post secondary or gain independence while working their first full-time jobs. Buying a property worth hundreds of thousands of dollars is not yet in sight during this initial stage of adulthood.
But once you have had some time to save enough to consider buying a property, the question quickly becomes a tug-of-war of advantages and disadvantages, and whether it makes sense to buy. It is prudent to point out that at the time most people first start looking at properties to buy, most would not be able to afford it. It usually comes at a time when you have only barely saved enough for a small down payment of 5-10% of properties you are interested in, but with no buffer for all the related monthly costs of owning a home, fees for acquiring a home and ensuring you have an emergency fund for anything life throws at you. So the first answer to the question is - stay out of the home ownership game just a bit longer. Your emergency fund should increase prior to buying property, as your monthly expenses will be higher to cover a mortgage, and it shouldn't be used for part of a down payment.
So, you've waited a few more months and have a good emergency fund, your finances in order and pre-approval from your bank for a mortgage. But now we have to consider the total financial picture of whether it still makes good sense to buy instead of rent. The first indicator is a city-specific factor (and in some cases, neighborhood-specific) - Home Price-to-Rent Ratio. This is a ratio that divides the house price to the comparable cost of renting the same house per year. Since rents are typically quoted per month, you will multiply that value by 12 for the denominator:
Ratio = Home Price / (Monthly Rent x 12)
- < 15 - Better to buy a house (rent being charged is relatively high)
- 15 - 20 - Depends on your specific personal position and local real estate market
- > 20 - Better to rent (house prices are much higher than the rent they would get)
Quickly looking at this ratio can give you a good sense of what side you should lean towards. In cases where the ratio is clearly very low or very high, you can be confident in the decision you are making.
The next question to ask yourself is whether you can afford the monthly expenses of owning a home. Although you may be building equity while making the mortgage payments, if the monthly cost is too high, you will want to wait until you can afford it or look at cheaper properties.
I have created a spreadsheet to help look at the total financial picture to answer the question of owning, which breaks down monthly expenses, too:
The inputs that are starred (*) are values you have to fill in, as they apply to you. For the "Rent" side, this would be the monthly rent, renter's insurance and utilities/other monthly costs. The sum of this is the monthly cost of renting, which is shown below the components.
For the "Own" side, you will need to populate monthly home ownership expenses including home insurance, property tax, condo fees/utilities and other monthly costs (IE: maintenance or upgrades). In addition, you will need to enter the house price, down payment, mortgage rate and amortization period. These will be used to calculate the monthly mortgage payment automatically. It should be noted that although mortgage rates today can be had quite easily for the 3% to 5% range, this is lower than historical rates and it would be beneficial to assume a higher rate if you are looking at time frames longer than 5 years. An additional input you can modify are closing costs, which is set at 1.5% of the house price as default, and would go towards legal fees, land title transfers, registration and home inspection. You'll notice that if you enter a down payment of less than 20%, your mortgage amount will be more than the difference between house price and down payment. This is because the Canadian Mortgage and Housing Corporation (CMHC) tacks on mortgage insurance for high loan-to-value (LTV) mortgages to protect lenders against borrowers becoming insolvent. The percentage applies to the mortgage amount and ranges from 2.8% to 4.0%, depending on the size of the down payment in percentage terms.
The sum of the monthly expenses based on the inputs for "Own" comprises your total monthly cost of home ownership (broken down in the pie chart), which in some cases can be more than double the comparable rental situation. As such, you need to be sure of your financial position before buying property. For us Canadians, it should be noted that you cannot typically claim the interest portion of mortgage payments for tax credits, which is possible in the US. The only way to really do so in Canada is through a strategy called the Smith Manoeuvre, which allows you to claim the mortgage interest if you use a home equity line of credit (HELOC) to invest in taxable accounts and instruments. This requires a paper trail to show the taxable investment activities in case the CRA audits you, and you should speak with your mortgage provider if you are planning on doing this (legal) strategy.
When it comes to answering the question of renting or owning with defined numbers, what should we be calculating? The result that concerns us is the total equity after a certain timeframe. The timeframe you want to look at can be inputted in the drop-down menu (in 5-year increments) on the top right side of the sheet and would imply a minimum amount of time you'd be staying in an owned property or renting similar rental units.
For renting, what you would otherwise spend on a down payment and closing fees can be invested in appreciating assets like stocks (which is not as risky as it may seem). And, each month, you can put additional savings towards these investments because of lower monthly costs versus owning. The only assumption you need to make here is the average annual rate of return. Historically, North American stock markets have grown by 6% to 11% compounded annually, and the default assumption of 7.5% is an achievable one, but can be changed as you see fit. The investment equity will be the amount you have after the timeframe selected based on the rate of return, compounding interest and monthly contributions based on the differential between renting and owning.
The main assumption to be made for owning a home is the annual house price increase. This is how much you expect the value of the home to increase each year. This is a much more city/neighborhood-dependent number to guess, but, in Canada, falls between 3% and 7% for most major cities if history is to guide us. The default value in the spreadsheet is 5%, although strong growth in recent years for Canadian house prices in select markets combined with record household debt levels has many analysts sounding the alarm on a real estate bubble that is nearly unmatched globally (a topic for a future article). By the end of the timeframe selected, your total home equity will be your down payment, principal portion of mortgage payments paid in the timeframe and any increase in value in the home at the annual house price rate of increase.
Finally, you can compare the investment equity to home equity of the scenario you created to see which situation gets you a higher net worth. Of course, there are other considerations for owning and in cases where the numbers are relatively close (within 5 or 10%), you likely wouldn't be making a poor choice in either. So, experiment with different combinations to see how each factor can give you a different answer to this important question.