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Your home: to buy or to rent
When I just started working, I was amazed at how so many of my colleagues could bend their knees under the weight of a boulder of a bond just to own a home. The few of us who rented definitely had more spare cash to enjoy every month. Until someone pointed out (what should have been obvious) to me what happens to your rent at the start of every year and continues to do so for the rest of your life, while your home loan instalment stays fairly stable for 20 years and then disappears.
Our Renting or Buying a Home calculator illustrates this point. Yes, we’re not comparing apples with apples here, as rent is an expense with no reward other than a roof over your head for a month, while your bond repayment is an expense linked to the reward of owning a property somewhere in the future. But the calculator can show you instantly:
- how your rent will increase over the years
- the instalment on a bond amount that’s appropriate to your level of income
- the up-front costs associated with a property purchase
(If you don’t want to purchase such an expensive property as the amount for which the calculator shows your income may qualify, our The real price of property calculator allows you to enter your own amounts for the price of the property and the amount of the bond that needs to be registered.)
Many disciplined investors don’t buy the ‘as safe as houses’ investment adage, though. They prefer to rent for the rest of their lives (or until they have saved up a large enough deposit) and invest the amount by which a bond instalment exceeds the rent that they are paying.
If you download the Renting or Buying a Home calculator, you’ll see it will take approximately 12 years before inflation causes rent of R4 000 per month to catch up with a bond instalment on that same property worth, say, R940 000 (Cape Town prices). That’s assuming that the bond applicant earned R30 000 p.m. to qualify for a 100% home loan at the bond rate of 10%, and that rent increases by 7% per year.
In the scenario above, the tenant investor will therefore have excess money to invest over 12 years. By ‘excess’ we mean the difference between what her bond repayments would have been and the rent she actually paid. If she invested all the money that she saved by not buying a property, including the up-front costs related to the property transfer and bond registration, and that investment yielded 11% per year after tax, she can expect her investment amount to be worth more than R1.1 million after 12 years.
But there are other expenses which the calculator does not show. Tenants normally do not have to pay maintenance and rates and taxes, which could be substantial. Let’s assume these additional ‘homeowner costs’ start at R20 000 per year and increase by inflation of 6% per year. Because our disciplined tenant investor did not have these expenses, she could have invested these amounts in the same place where she earned 11% per year after tax, and these accumulated amounts would have been worth approximately R600 000 after 12 years. That leaves her with a total investment lump sum of about R1.7 million after 12 years of renting and diligently investing all the money that she saved by not having to pay bond instalments, the up-front fees of a property purchase, rates and taxes or maintenance.
It may look as if tenants have a point – until you look at what a home owner’s property may be worth after 12 years. If we assume that the capital value of property grows at 7% per year, the R940 000 property should be worth just over R2.1 million after 12 years.
This is a very specific scenario, and by changing a few assumptions or by choosing a very specific investment term, we could make either the tenant or the homeowner look like the cleverer of the two. The important points to remember are:
- Think long-term when you make a financial decision.
- Understand all the risks and future expenses associated with your decision.
- Don’t underestimate the power of either inflation or compounded investment returns.
- Be careful of sweeping statement. Do the calculations.
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Tags: buy or rent, property, property costs, tenant vs homeowner
Hi,
This is a very important point you make here… One hears the following with monotonous regularity:
“Don’t rent – you are just throwing your money in the water. Why make *someone else* rich?”
The average homeowner (who is forced to take out a bond) *still* makes someone else rich – in this case the bank, by paying interest. The potential advantage of leveraging provided by the bond only helps the homeowner when speculating on a second property in a bull market (which makes the owner decidedly non-average). Another advantage of the tenant is that her excess money may be invested in equity or similar asset classes, which will most likely outperform the property investment of the home-owner in the long run.
I agree that it is very easy to make either the tenant or the homeowner come out on top, as it is sensitive to the exact financial scenario you consider. Let’s consider a slight modification of your scenario, which is a fairer comparison in my opinion. After 12 years, the R940 000 property is worth just over R2.1 million. If the homeowner decides to sell it, it will leave him and the tenant in exactly the same financial position (i.e. with nothing but cash in the hand). The only problem is that the homeowner still has about R600 000 left to pay off on his bond, leaving him with a profit of R1.5 million. The tenant, on the other hand, has R1.7 million to show for her investment strategy. This has implications if you are considering to buy a smaller “temporary” home before moving into a larger home 12 years down the line.
I therefore speculate that the biggest return of homeownership is psychological
Fine insights, Ludwig. And you correctly point out that I did not take the outstanding bond amount of the homeowner into account. Thanks for that.
Your example got me thinking again.
At the 12-year mark, our tenant has a slight edge (about R200 000) on her overall portfolio, while her rent payments have caught up with the bond payments of the homeowner (which I calculated as about R9 100 for a 20-year bond). It looks like her days of prosperity are counted… Let’s look at what happens next!
The homeowner still has 8 years to go on his bond. For the next 8 years, it’s his turn to have excess money to invest in an attractive asset class. Let’s assume that he invests the difference between the tenant’s rent and his fixed bond payment each month, and also receives 11% tax-free per year on this investment. The tenant, on the other hand, spends all that rent just to have a roof over her head, and makes no new investment. This way, their financial situations remain comparable. Her R1.7 million lump sum keeps growing at 11% per year, however. At the same time, the homeowner’s property also keeps growing in value, albeit at a modest 7% per year.
After 20 years, the homeowner’s bond is finally paid off. The poor tenant’s rent is still rising with inflation, and this represents money she cannot invest. The homeowner continues to invest this rent amount each month in an investment returning 11% per year, while their past investments also continue growing at their respective rates.
If this is the whole picture, the homeowner’s portfolio (1 property + further investment @ 11%) will slowly catch up with the tenant’s growing lump. This can be surprisingly slow, thanks to the investment head start of the tenant. In our example, the homeowner only breaks even with the tenant after 20.5 years. After that, the difference grows exponentially, but at a slow rate. After 40 years, the homeowner will have R42 million compared to the tenant’s R37 million.
But this is not the whole picture… I’m taking on your statement: “Until someone pointed out (what should have been obvious) to me what happens to your rent at the start of every year and continues to do so for the rest of your life, while your home loan instalment stays fairly stable for 20 years and then disappears.”
Sure, your bond instalment disappears, but it is replaced by rates and taxes, and home maintenance costs. You don’t stay in your house for free. These costs grow at the inflation rate for the rest of your life. They may be much lower than the corresponding rent payment on the same house, but the comparison of buy versus rent turns out to be very sensitive.
For our example, I took the monthly rates and taxes to be 10% of the corresponding rent payment, while the maintenance is coupled to the property value (1% of the value yearly – not sure if this is realistic?). Both these costs grow at 7% annually. If you reduce the money that the homeowner can invest each month by this amount, it swings the argument back in favour of the tenant. In fact, the homeowner never catches up and has a portfolio value of R32 million after 40 years, compared to the tenant’s R37 million.
The moral of the story?
* It is very hard to make a clear-cut argument for either buying or renting. It is very sensitive to the exact parameter values you feed into your calculations. As these numbers are necessarily projected into the future, they may be wildly inaccurate too. I still maintain that the psychological advantages of homeownership (stability, freedom to express yourself, satisfaction of nesting urges, etc.) outweigh the hard numbers in the standard home-buying scenario.
* I think you were cleverer than your colleagues… Since property has no clear advantage, I consider it a mistake to buy property very early in your life if (when?) you can barely afford it (controversial statement of the day). This increases your financial risk for little gain, and robs you of the opportunity to kill your bond quickly and thereby reduce the money you waste on interest. The folly of youth is not that we are not buying property, it is that we are wasting all our spare cash on booze and entertainment instead of investing it in high-performance assets. This makes us tenants look bad in the long run.
* The head start provided by an early investment in quality assets is impressive.
Things not covered that may be interesting:
* Killing your bond quickly (or having no bond at all) may swing the numbers back in favour of the homeowner. I am hesitant to say this, though, as property as an asset class will most likely never outperform equity and similar classes. The earlier you can put your money into a high-performing asset class, the better.
* Of course, buying lots of property at the start of a speculative bubble such as was the case 10 years ago is a great idea. Then the advantage of leveraging really comes to the fore. But that’s a bit besides the main argument here, which is whether you should buy or rent your primary dwelling.
Regards,
Ludwig
I really enjoy the way you thought this through from all angles. And I agree with you on all points.
Also, pshychologically buying a primary dwelling is the only way many people can save or invest in an asset in a disciplined way and at least have something to show after 20 years. Without that compulsory bond repayment every month it would just be too easy to use your spare cash to splurge out and enjoy life. And perhaps that’s what your early twenties are for. Life is about more than building an invesment portfolio
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