Advanced Considerations in Buy vs Rent

So much has been written about the age-old question of whether to buy or rent your primary home. The very basics often take center stage: rent vs mortgage, property taxes, lifestyle differences, etc. We will not pile on to the existing literature.

This article will help you evaluate the more advanced financial implications of buy vs rent. These considerations can often change purchase or rental costs by 50% or more and tilt the decision, especially for high-income earners, but they require deeper financial knowledge and are not typically suitable for the average Internet reader. If you are already acquainted with the basics and are ready to nerd out about the “advanced level”, let’s get started.

Buy vs Rent 101

Before diving deep into the nuances, let’s ensure we’re all aligned on the foundational elements of the rent vs. buy debate. Feel free to skim or skip if this is too basic for you. Most buy-vs-rent arguments fall into 2 categories:

  1. Monthly Housing Costs: At the most basic level, you should compare the monthly housing cost of buy vs rent for comparable homes in the area. If you buy, your costs will be (a) mortgage payment; (b) repairs and maintenance; and (c) property taxes and insurance. If you rent, you generally pay a single monthly rent and the landlord takes care of other costs.
  2. Stability vs Flexibility: Buying and selling houses is expensive. If you buy a house and sell it shortly afterwards due to unforeseen moves, the transaction cost can be 5+% of the purchase price and will significantly reduce your total return; renting is the better option to preserve flexibility. However, if you plan to stay in the same area for 5+ years, the added stability and peace of mind can be reassuring: you will no longer move at the landlord’s request, and you may improve/modify your home exactly to the way you want it.

Financially, Monthly Housing Cost is usually what people focus on for their personal buy vs rent calculations. Using a hypothetical example of a house at $500,000 that would rent for $2500 per month. Assume the purchaser puts a 20% downpayment and can obtain a mortgage at 8% interest.

Rent Buy
Monthly Rent $2,500 Mortgage $2,935
Insurance $150
Maintenance $200
Property Tax $420
Monthly Renter Cost $2,500 Monthly Owner Cost $3,705
Annual Renter Cost $30,000 Annual Owner Cost $44,460
“Buy vs Rent 101” arguments would favor renting.

Now let’s dive into the advanced nuances.

Investment Returns

The most overlooked consideration in the monthly housing cost is the investment return of buy vs rent:

  1. If you rent, you do not have to put in any downpayment and may invest this downpayment in a broad market index fund, such as the S&P 500. While it’s hard to predict the market, over the long term, the investments have had solid returns in the past. This return effectively reduces your cost to rent.
  2. If you buy, you are also investing in real estate. The price of the house is likely to appreciate. It’s also hard to predict the exact appreciation over the short-term, but historically housing has underperformed S&P but outperformed inflation in the US. While you only put in a 20% downpayment, you are getting percentage appreciation for the entire house value.

Finally, part of the mortgage payment is a principal payment that reduces how much you owe the bank. This isn’t a real “consumption cost” of housing, but merely a “forced savings account” to ensure you pay down the mortgage over 30 years. This amount helps build equity and you may tap into it in the future via refinance or equity line of credit. If you ever sell the house, the amount goes back to you as well. When comparing financial returns, it’s important to correctly classify principal-paydown not as a housing expense.

Annual Renter Cost $30,00 Annual Owner Cost $44,460
Stock Return (8%) on Downpayment -$8,000 Home Appreciation (4%) -$20,000
Principal Paydown -$3,220
Real Rental Cost $22,000 Real Owner Cost $21,240
When you adjust for the implied investment returns, rent vs buy are now basically equivalent in net costs for our example. Of course, this is highly dependent on investment returns that can never be guaranteed, but we should still use a reasonable estimate and not ignore them.

Tax Considerations

The second often overlooked consideration is taxes. You may have heard of mortgage interest deductions as a “tax break for homeowners”, but we must get into the specifics to understand exactly how large of an impact they make on rent vs buy.

In general, mortgage interests are deductible against regular income if the couple takes itemized deductions in their tax filings, subject to the $750,000 loan limit. Many of our clients are in high tax brackets (50+% in California, or at least 35+% federally). Assuming a 40% combined bracket, the couple in our hypothetical example pays $32,000 of mortgage interest a year, and can save $12,800 a year in federal taxes alone. Rent, however, is always paid using post-tax money.

In addition, the investment return from stocks is generally taxable; while the first $250,000 to $500,000 appreciation on a primary home is generally not taxable1. This can mean a difference of tens of thousands of dollars.

Annual Renter Cost $30,00 Annual Owner Cost $44,460
Stock Return (8%) on Downpayment -$8,000 Home Appreciation (4%) Non-taxable -$20,000
Principal Paydown -$3,220
Tax on Stock Return $3,200 Mortgage Interest Deduction Value -$12,800
Post-Tax Rental Cost $25,200 Post-Tax Owner Cost $8,440

Owning now beats renting by a wide margin.

When do advanced considerations apply?

In theory, the advanced considerations apply to every buy vs rent calculation; in practice, their impact varies greatly:

  • High-income earners will notice the most impact from mortgage interest deductions due to their high tax bracket. They are also most likely to not worry about the additional principal paydown each month and treat it correctly as a “forced savings account”. Low-income earners, retirees, foreigners, generally see less value from tax breaks.
  • People in low-tax states will benefit less from owning because their mortgage interest may not be higher than their annual standard deduction2 amount, so a large chunk of their interest deduction would not be beneficial to them: For example, Nevada owners would benefit the least; Texas would benefit a bit more (due to high local and property taxes); California owners would max out the tax benefit (due to high income taxes).

Buy/Rent as Metric to Predict Housing Price

The median cost to buy vs rent can sometimes be used as a barometer of broader housing market health. (Presumably, if the cost to buy is significantly higher than the cost to sell across the US, housing prices are too high; vice versa). You may have seen similar charts like this one:
Buying vs Renting in America, Q3 2023

On the surface, this would indicate the cost to own has outpaced the cost to rent and would predict a price decline. However, these data are almost always using the “Buy vs Rent 101” view. Case Shiller, BLS, and Zillow data generally only consider “sticker prices” for buying and renting and there are no clean data sources for post-tax, post-investment-adjusted prices.

Our hypothetical example above is very close to a median single-family home in America today (as of October 2023). You can now understand why a higher sticker price for owning may still be a lower actual cost for owning. Areas where there are largest gaps between “cost to buy” vs “cost to rent” are usually areas with the highest concentration of high-income earners in high-tax states (e.g. San Francisco Bay Area, New York City), and these owners benefit most from the advanced considerations we mentioned above.

This is not a prediction to say housing prices will not drop (many areas have declined in value and many have increased in the past year; the future is uncertain), but we hope that this nuanced view gives you a much better understanding of when to buy vs to rent for your circumstances and understand market data with more clarity.