Opportunity cost is what a person sacrifices when they choose one option over the other.
Is it better to rent or own your primary residence?
First, we need to look at unrecoverable cost.
For rent, that’s easy. It is the rent price plus rental insurance. In this example, let us use $2000/mo or $24,000/yr.
Many people make the mistake of saying they can make a mortgage payment of $2000/mo and it’s the same as paying rent. Not true. There are many other costs of home ownership such as maintenance, insurance, property taxes and “opportunity cost” of the down payment.
The general estimate of maintenance cost is 1% (per year) of the value of home. This can fluctuate. I replaced my air conditioning unit and roof in the first 5 years of owning my current home.
The insurance cost can vary, but let’s say it’s .5%.
Property taxes in Myrtle Beach, South Carolina are relatively low, but in North Carolina and South Carolina the average is .5% (per year).
Mortgage interest is an unrecoverable cost that comes with borrowing money. Let’s use 4% (per year).
There is an “opportunity cost” in making a down payment. Most home purchases require a 20% down payment, which means you are making a down payment on real estate as opposed to investing that same sum elsewhere, such as a balanced portfolio of stocks and bonds.
The historical average of price appreciation net of inflation for real estate is around 1% and for a balanced portfolio of stocks and bonds is around 4% (The Rate of Return on Everything, 1870-2015, April 2019). So, the opportunity cost of your down payment is 3% per year.
Total the home ownership cost:
- Maintenance cost: 1%
- Insurance cost: .5%
- Property taxes: .5%
- Mortgage interest: 4%
Total: 6%
Now let’s compare home ownership cost to rental cost.
We begin by dividing $24,000 (annual rental cost) by 6% — this comes to $400,000. This math suggests you buying a home for $400,000 or less is equal to or better than renting, but if the home costs more than $400,000, it would be better to rent.
How do interest rates affect the rent vs. own decision?
If interest rates go up, the cost of home ownership also goes up which, in turn, makes renting more sensible than owning, but this holds true only if rents do not go up at the same rate.
Other factors to consider include,
- Mortgage payments can be a “forced savings,” whereas a renter may not be disciplined enough to invest the savings from renting over owning.
- Taxes are not considered.
- Renting can be subjected to rent increases on lease renewal.
- The transaction costs of purchasing a home can be disproportionately expensive if the holding period is short.
Throughout my 25+ years in the financial industry, I have heard people say (more times than I can count) “my home appreciation has done so well.” They tend to see it this way because they look at the value over years, instead of days.
Imagine if they looked at their stock and bond investments the same way…(sigh)
Stocks and bonds have a similar comparison. If interest rates are higher, this can make bonds more favorable (higher income). If interest rates are lower, a company can borrow money at less cost, therefore the company should have a higher valuation.
On the lighter side, Elliott and Iren are in Bulgaria visiting her family. I am headed over there this week. Stay tuned for European observations in the upcoming Finger Financial Fives.
If you have any questions, email me at je****@Ri*********.com or click here for a phone appointment.
Listen to the Retire Happy podcast Episode 4, Thinking of Social Security as an Asset.
Hope all is well with you and your family,
Jeremy
Finger Financial Five – 5 points in 5 minutes or less – is to provide you with a weekly shot of useful financial information. My intention is to share principles, so that you will have more clarity and peace, that help you make better financial decisions.
Investment advice offered through Stratos Wealth Advisors, LLC, a registered investment advisor; DBA Riverbend Wealth Management.
This content is developed from sources believed to be providing accurate information and provided by Riverbend Wealth Management. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stratos Wealth Partners and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
