If you are trying to decide whether to rent or to purchase a residence, there are a number of factors to consider.
First, let’s consider the advantages of renting.
1. It is easier to move.
This is especially important if you are not sure how long you are likely to be in the area where you will be living. If you rent, you may have to pay a penalty if you terminate your lease early, but that is usually easier to do than selling a house, especially during a period when the housing market in the area is depressed.
2. Maintenance and repairs are generally not the renter’s responsibility.
Not only does this mean you won’t have to pay for such expenditures, but also you won’t need to spend much of your time dealing with these matters. If you travel a lot or work long hours, not needing to spend your precious time in this regard may be an especially important consideration.
3. Generally, not as much money is needed to move in.
Although some types of mortgages may require only a small down payment, many mortgages require a down payment of 10% to 20% of the price of the residence. In comparison, most residential rental properties require a deposit equal to one month’s rent, in addition to the first month’s rent.
Home ownership may also have several advantages.
1. Purchasing a residence may be a good investment.
Not only does your equity in the house increase as you repay the mortgage, but also your house may appreciate in value. However, there is reason not to depend too heavily on the appreciation, as indicated by the following excerpts from an article in The Wall Street Journal (12-9-94):
Buying a home is a good idea if you want a house, but it’s shaky as an investment strategy. . . .
Home prices generally increase only at the rate of inflation over the long term. . .
A house should never be looked upon as an investment.
Excerpts from another Wall Street Journal article (8-28-02) provide the following additional perspective:
Think of your home as akin to a stock, one that both generates capital gains and also delivers a dividend. But in the case of a house, the biggest part of your gain will likely come from the dividend.
If you live in your own home, your dividend takes the form of what economists call ‘imputed rent,’ the fact that you get to live in the house rent-free.
Meanwhile, the capital gain from a house is relatively modest. [During a 27-year study period], home prices . . . appreciated at 5.8% a year. That is 1.2 percentage points a year faster than inflation [during that same period].
Now, consider what homeowners have to spend to garner that 1.2%. There are regular home-maintenance expenses, including costly jobs like painting the house, putting in a new furnace and replacing the roof. These costs might come to 1% to 2% of your home’s value each year. Subtract maintenance expenses from your home’s 1.2% price appreciation, and your house is likely lagging behind inflation.
It is important to note that the last Wall Street Journal article that we cited failed to take into consideration the following additional expenses, which further reduce the potential gain from ownership of a residence: (1) selling expenses, including the realtor’s fee, if a realtor is involved in the sale, plus possibly some of the closing costs incurred when selling a residence (e.g., an attorney’s fee, if the seller uses an attorney); (2) the net costs of mortgage interest and property taxes incurred during the period of ownership, after adjusting for any income tax savings from claiming these expenses on your income tax returns; and (3) the costs of insurance on the residence during the period of ownership.
With regard to thinking of a house as an investment, a Parade Magazine article (5-6-07) concludes,
If you’re looking for the best return, you’re often better off investing on Wall Street than Main Street. A study by the Fidelity Research Institute found that real estate produced returns above inflation of just 1.35% a year vs. 5.95% for stocks [during the study period of more than 43 years].
The article in Parade Magazine did not disclose how the real estate returns were calculated by the Fidelity Research Institute, so we don’t know if any adjustments need to be made to the 1.35% average return in excess of inflation. However, the study helps to confirm that the adjusted net annual appreciation in the value of a typical house probably does not substantially exceed, and may even be less than, the overall average annual rate of inflation in our nation’s economy.
2. Home ownership may provide income tax savings that lower the “real cost” of ownership.
As a general rule, interest payments on a mortgage and property taxes on the residence are fully deductible from taxable income, if a person itemizes their deductions on their income tax return. However, the savings on income taxes are probably less than most home owners think.
For example, if a person’s combined federal and state marginal income tax rate on each additional dollar of income is about 33%, only one dollar in income taxes will be saved for each three dollars paid for mortgage interest and property taxes on the residence. And, if a person’s combined federal and state marginal income tax rate on each additional dollar of income is about 20%, the savings will be only one dollar in income taxes for each five dollars paid for mortgage interest and property taxes on the residence.
Most families in the United States have a combined marginal income tax rate that is not much higher than 20%, or it may even be considerably less, so they are cutting their income taxes proportionately little by itemizing their mortgage interest and property taxes.
Furthermore, many families that itemize their deductions benefit even less. This is because they would receive a “standard deduction” if they chose not to itemize their deductions, so itemized deductions reduce taxable income only to the extent that they exceed the standard deduction. The following illustration should help to clarify this point.
Assume that a family qualifies for a standard deduction of $12,000 on their federal income tax return, or they can take itemized deductions totaling $15,000, including $5,000 for mortgage interest and property taxes on their residence.
The family’s taxable income will be reduced by only $3,000 as a result of deducting the mortgage interest and the property taxes on their residence. This $3,000 is the difference between the standard deduction of $12,000 that they would get by taking the standard deduction and the $15,000 of their total itemized deductions. Therefore, $2,000 of the $5,000 spent for mortgage interest and property tax on their residence has no income tax benefit.
3. The average annual cost of ownership of a residence may be less expensive than the annual cost of renting a residence with essentially the same features.
If the mortgage on the house has a fixed interest rate, the mortgage payments won’t increase, whereas rent payments do increase. Furthermore, if interest rates on mortgages decline, it may be possible to refinance the existing mortgage, thereby reducing future mortgage payments.
However, as previously indicated, there are also other expenses (property taxes, insurance, maintenance, and repairs) that are incurred as a result of owning a residence, and these expenses can increase over a period of years. Thus, in many cases, after taking into consideration these other expenses, the average annual cost of owning a residence may be higher, not lower, than the average annual cost of renting a residence.
4. Home ownership may provide special satisfaction.
Although this benefit is not financial in nature, nevertheless it can be an important factor in making a decision as to whether to purchase or rent. Women in particular, but also many men, enjoy living in a residence that they can call their own and that they can adapt to their own preferences without having to get approval from a landlord.
After considering the previous information, it should be clear that it is difficult to reach a clear-cut conclusion as to whether renting a residence or purchasing a residence is preferable. Nevertheless, in an attempt to make an informed – and, hopefully, satisfactory – decision in this regard, each family would be wise to try to assess, in the light of its own particular situation, all of the factors we have discussed.