Should You Buy or Rent a House?

A common question I’ve been asked a lot over the last decade is “Should you buy or rent a house?” Recently, I’ve been asked this question 5 times.

This topic is so deep that it would require the research equivalent of a doctoral dissertation to answer this question properly. Since I have a fiduciary duty to spend most of my time on investment research, I’m unable to write an in-depth write-up on the topic, but I’ll give you some important factors to think about. I’ll also share what I have personally done in the past and plan to do in the near future. I believe this will still be helpful and I hope you will think so as well.

Before we begin, I just want to point out that owning a home has multiple emotional, social, psychological, and even physical benefits. For this blog post, I will be focusing more on the financial aspect, but may slightly touch on other dimensions in passing. Aside from time constraints, the reason for concentrating more on the financial dimension is that the non-financial benefits of owning a home is different for everyone.

Key Questions

1. What are your current monthly/yearly expenses? If you buy a house, how much would your expenses increase by?

• For buying a house, make sure you factor in property taxes, home insurance, maintenance and remodeling costs, higher utilities and garbage collection expenses, home furnishing, and potential service expenses, such as landscaping and house cleaning. If you move into a house with HOA fees or a swimming pool, you’ll want to include those costs, as well.

2. Your overall financial picture: How much do you have in assets? How much debt do you have? Do you have enough money to buy a house without a mortgage? How comfortable are you taking on a mortgage? What are current mortgage rates? How much of a down payment are you considering?

3. For the house you are thinking of buying, if you were to hypothetically rent the property out instead of living in it, how much could you reasonably rent it out for and how much would your net profit be after subtracting all costs (property taxes, property management fees, home insurance, HOA, utilities and services not paid by tenant, repairs and maintenance costs, vacancy costs, etc.)? In other words, what would your capitalization rate be?

• An example formula would be: (Annual Rent-Annual Costs)/Purchase Price x 100. Let’s say you can rent the house for $48,000/year and your annual expenses would be $20,000. If your purchase price is $1,000,000, your capitalization rate would be ($48,000-$20,000) / $1,000,000 x 100 = 2.8%.

• Why is the cap rate a useful number to know? In a buying vs. renting decision it allows you to quickly estimate the rate of return that your house truly provides even if you are the “renter”. So in the above example, if you estimate a 4% appreciation rate, your total return on the property would be 6.8%. 

4. If instead of buying a house, what rates of return could you get if you invest in other asset classes? How does this compare with the answer you got in 3b? If the answer in #3b is higher than the answer in #4, then buying is likely going to be the better decision, and vice versa.

5. If you were forced to choose between achieving financial independence sooner or buying a house now and achieving financial independence later, what would you prioritize?

6. How would you weigh the positive emotional, social, psychological and physical aspects of owning a home compared to its financial aspects?

My Background

I am a numbers guy. For many decades, my compass has always pointed to one thing: maximizing my after-tax net worth. For me, that meant spending like a caveman, working like a madman, and investing like a contrarian. You can read more about how my spending habits have evolved over time in this blog post.

For a long time, everything else (emotional, social, psychological, and physical) was de-prioritized. I wanted to build up a huge nest egg in order to become financially independent as early as possible. If that meant buying a Subway Footlong sandwich for $5 or a Wendy’s burger/chicken nuggets/fries from the dollar menu in the early 2000s as my whole meal for a typical day for many years, so be it.

Of course, that kind of eating will have negative consequences later on, so I eventually realized that spending some money to take care of my health is important. Despite being less frugal than before, I continue to have the maximization of my after-tax net worth as one of my top priorities.

From 2006 to early 2008, my friends and family kept trying to convince me to buy a house. They dragged me to various open houses and even conferences where some guy was trying to persuade my friends and family to invest. I told them investing with these so-called “experts” was a bad idea and thankfully I didn’t listen to any of them. My friends and family thought I was an idiot. Then came the financial crisis, while all their capital was locked into real estate that was declining in value, I had a lot of liquid cash which I poured into 3 financial stocks after they were beaten down. After going “all-in” (25% of my net worth for each) on Wells Fargo, US Bancorp and American Express at very low prices, these more than doubled to about quadrupled for me (when including dividends) after around 5 years.

Even though I have grown my after-tax net worth significantly from 2008 to 2014, I continued to get pressured by friends and family on using the money I made into buying a house. Like before, I didn’t listen to any of them. In 2014, I decided to start WealthArch. Had I listened to friends and family, it would have been impossible for me to start the company, because there was no way that the business could support my living expenses with the vastly reduced investment income. Had I spent the money on a house, I would continue to slave for a large corporation today. It was only because I was able to use my investments as a source of income that allowed me the financial freedom to live my dreams.

One last piece of background is that I am not psychologically comfortable with any type of debt. While I’m open to having a mortgage, I’d strongly prefer not to have one.

My Situation Today

My oldest daughter, Sophie, is currently in 8^th grade and she will move onto high school next year. As of this writing, we have narrowed down her high school options to three. Two of these options are private schools, and if Sophie chooses one of them, we don’t technically have to move, but we will do so because my wife wants a bigger place. I personally wouldn’t want to move in these two scenarios, but I want my wife to be happy, so I will do it even though this will decrease the trajectory of my future after-tax net worth. The third option is La Canada Public High School, so if Sophie were to choose to go there, then we will have to move to La Canada (a city near Pasadena) to assure she gets a spot in the school.

Here is a quick breakdown of some of my financial information (due to privacy reasons, I’m not going to disclose the full picture in this post):

• Current Rent: $1,900 per month. This includes trash and water. There have been many repairs and maintenance issues of which I paid nothing. I also pay $325 for storage, but this only started 6 months ago because of the new property management’s policy.
• La Canada median home price: $2,312,500 according to Redfin in December 2023.
• La Canada rental options similar to the median house: most likely between $4,100 to $6,900 per month. No utilities covered but maintenance and repairs should be.
• Pasadena median home price: $1,152,000 according to Redfin in December 2023.
• Pasadena rental options similar to the median house: based on the listings as of this writing, most likely between $3,000 to $4,750 per month. No utilities covered but maintenance and repairs should be.
• Last year, I spent no money on home insurance and property taxes. I didn’t hire any gardeners, but I did spend $1,200 for cleaning services. I spent $807.67 for both Electricity and Gas. (I have tracked every single expense I made since 1997).
• On average, since 2001, I estimate that my personal investments have returned more than 10% on an annualized basis.

What Happens if I Buy a House?

If I do decide buy a house, it will only be in Pasadena, because buying a house in La Canada will be a big drain to my liquid assets.

For Pasadena, assuming I buy the median home, I’d have to shell out $1,152,000 excluding any other transaction related fees, so let us just round this up to a nice round number for discussion purposes, $1.2M.

When buying a house, I have to pay for property taxes (around $15k per year), home insurance ($1,400 per year), maintenance and remodeling costs (unknown for me, but the average California homeowner spends $17k per year according to a blog post from Compass on July 14, 2018), higher utilities expenses (probably $2,400 more annually than the $800 I spend today), furnishing expenses (probably $20k initially), and service expenses (probably $2,400 more annually than the $1,200 I spend today).

What Happens if I Rent a House?

Instead of discussing both La Canada and Pasadena, I’m just going to talk about renting in Pasadena, so we can compare that to buying a house in Pasadena as discussed in the previous section.

Let’s use a nice round number of $4,000 a month for rent as the base case assumption. Similar to buying a house, I will have higher utilities expenses (probably $2,400 more annually than the $800 I spend today), furnishing expenses (probably $20k initially), and service expenses (probably $2,400 annually more than the $1,200 I spend today).

Buying vs. Renting Comparison

To make the comparison easier, I have created a table below showing annual numbers for buying or renting a house with the assumption that I will use $1,200,000 for either buying a house or investing in the stock market.

You might ask, why only a 4% appreciation in the real estate value? Thanks to over a decade of fiscal and monetary stimulus, as well as COVID, Southern California home prices have surged in the last decade to extremely expensive levels compared to history (based on home prices to household income). It is only rational that its future appreciation rate will likely be lower than what it has been in the past, because continued further stimulus is likely unsustainable in the long run and the chances of another pandemic occurring in the near future is probably very low. But of course, what happens in the future could easily be different than what I predict.

If home price appreciation decelerates, should I lower the investment income assumption that I can generate from stocks? No, because I’m confident that my investment philosophy and skills will still allow me to generate a 10% return on average in the future. In fact, we would benefit more if a large stock market correction were to happen. You can read more about our investment philosophy here. Similar to my home appreciation forecast, this too may not happen because nothing is guaranteed when you invest in stocks.

In the future, if home price appreciation is higher than I expected and my investment income is lower than I expected, buying a house could have been the better choice.

As a reminder, I am unable to spend vast amounts of time to make the numbers above really accurate, comprehensive, and show detailed sources. The numbers above are just ballpark estimates, and that’s good enough for me, since no one can really predict how home prices and investment returns will be in the future.

So, as you can see above, I predict that my after-tax net worth will increase more by renting rather than buying a home.

You might ask, “What if you (Earl) get a mortgage? Wouldn’t that help make the buying column look better?” Yes it would, because the mortgage interest would be tax deductible and I can invest the portion of the $1,200,000 I didn’t use to buy the house to invest in the stock market. In this scenario, that investable amount would initially be $940,000 (purchase price: $1,200,000 – down payment: $240,000). But don’t forget that you are also making both principal and interest payments over the 30-year mortgage, so the average investable amount over this time period is much lower.  I’ll explain this more shortly.

The table below compares buying a house with a mortgage vs. renting. Due to time constraints, I want to remind you that the table below isn’t going to be accurate, but again I’m just trying to get into the ballpark.

More Details

How did I come up with investment income, interest expense, and the tax savings on the interest?

Let’s start with mortgage interest, because that is the easiest. For simplicity, I just took the total amount of interest during the life of the mortgage above and divide that by 30 ($1,385,892 / 30 = $46,000).

For the tax savings, I just took about 1/3^rd of the total interest ($46,000/3 = $15.400). Why 1/3^rd? That’s my estimated marginal federal and state tax bracket.

Finally, the investment income is more complicated. As mentioned above, if I bought a $1,200,000 house with a 20% down payment, I’d initially have $960,000 left to invest in the stock market. The principal payments (only the principal part, not the interest part of a mortgage payment) divided by 30 years would come out to average $32,000 over the life of the mortgage. Since this amount is being paid back as principal, I would deduct $32,000 from the amount of investment income one could make if the full $960,000 was fully available for investment. Therefore, investment income would be approximately $64,000 (($960,000 X 10%)-$32,000).

If I wanted to be a little more accurate, I should also deduct the funds I’m paying towards interest less the tax savings as part of the money available to me to invest in the stock market, but I don’t want to make this blog post even more complex than it already is. Just know that the $41,200 net profit excluding furniture in the buying column is overstated. Again, for complete accuracy one should do a full year-by-year spreadsheet for 30 years that is more detailed, but due to time constraints, I have significantly simplified the calculations.

For me, I believe that when we compare buying a house with a mortgage vs. renting is a comparison that is not apples-to-apples. Introducing leverage (debt) amplifies the returns of an investment both on the upside and the downside. The 2008 real estate bubble and other housing bubbles are a good reminder that significant losses can occur in the equity of your real estate if leverage is introduced.

There are still two more things to take note of. The first is that under the renting scenario, a larger investable capital base ($1,200,000 principal) is going to be compounded over 30 years compared to the buying scenario with a mortgage (an overstated average investment capital base of $640,000, calculated from $64,000 of average investment income divided by 10%), so the actual investment income difference will be larger for the renting scenario as the years unfold over a full 30-year period.

The second is that both scenarios do not account for investment-related taxes. Obviously, the renting scenario will have higher taxes, because of the larger size of the stock portfolio, but when these two factors are introduced together into the decision process, the combined effect of these two items should still be in favor of the renting scenario. In other words, the case for renting is further strengthened. But again, doing a detailed demonstration of this would be beyond the time I’m able to spend on this blog post.

Conclusion

Everyone’s situation, location, beliefs, and psychology are different. Each real estate property will offer different financial prospects.

Because it is very important, let me emphasize that owning a home has several emotional, social, psychological and even physical benefits. For you, these benefits may more than outweigh any financial drawbacks.

For me, renting a home has almost the exact same benefits compared to buying. I have zero psychological need to own a home.

There are two additional factors that are specific to my situation:

1. It is possible that I could rent a home with a terrible and unresponsive landlord. If I owned the home, then I don’t have to deal with landlord issues. I’ve been a renter for decades and have experienced bad landlords but that’s not a big deal for me. If the landlord is really difficult to deal with, then I’ll just move. Yes, that’s a big hassle, but I try to ask good questions to determine the personality of the landlord before renting so I hope the chances of getting a bad one would be lower.
2. Sophie may not be a good fit for the high school we initially choose, so we may have to move after her freshman year if things do not work out as we expect. When Sophie goes to college, it is possible that we might move again. Of course, my younger daughter may need to go to different schools than Sophie does. Renting gives our family a lot of flexibility.

For all the reasons above, renting makes the most sense for my family and me, but your situation could easily be different. I hope that sharing key questions and my own background and situation have been helpful for you. If you need any further assistance regarding the topic or with managing your investments, please feel free to contact us.

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