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Renting Versus Owning Your Home

In my last post, “How Much is Your Home Really Costing You,” I suggested that, for some people, owning a home may cost so much that they should consider selling it to either buy a less costly home or rent a home. I got a question about what factors should be considered when evaluating whether renting a home is cheaper than owning.

In my last post I tried to illustrate how expensive owning a home really is and how it can impact your retirement savings rate and/or available income during retirement. However, you may decide that you can afford to keep your family home in retirement. But if you are not that attached to your home and would consider selling it, you may find that you prefer renting your next home during retirement; if for no other reason than to avoid the many hassles involved in being a homeowner. So how does one determine if renting a home is cheaper than owning it?

Let’s return to the example from my last post. The home is available either for rent or for sale (this is now a common situation in many parts of the country). The property will cost $400,000 to purchase and will require $13,000 per year to own and operate the property. Let’s assume that the property is offered for rent at $1,800 per month or $21,600 per year. So you have a choice of either purchasing the property for $400,000 (I am assuming you sold another similar valued property and would not need any financing for this purchase) or renting this property for $21,600 per year. As a renter you would still have to pay for all utility costs for living in this property. The total heating, power, and water costs are $3,900 per year. So the total cost to rent this property is $25,500 per year.

Applying the inverse of the 4% Rule to the $25,500 figure would indicate that as a renter this property would make a claim to $637,500 of your net worth. This is less than the $725,000 amount I calculated in my previous post that purchasing this $400,000 property would make on your net worth. This would seem to indicate that renting this property is cheaper than owning the property. But this is not the end of the analysis. As for every major financial decision in life you must always consider the impact on taxes.

Everyone knows that when you own your home there is a big tax deduction on the financing costs of the mortgage you obtained when you purchased your home. But did you know that there is also a huge tax advantage in owning your home even without a mortgage? And this tax advantage is even better because it costs you nothing out of pocket and governments, unless they stop taxing income, cannot change the tax laws and take this tax advantage away.

The big disadvantage to renting any property versus owning it is that the entire cost of renting must be paid in after-tax dollars. When you own your home with no mortgage payments, you do not need taxable income to pay your housing costs as with renting. Your mortgage free home is, in effect, providing tax-free housing versus renting. This tax situation may sound confusing so I will explain what I mean by continuing with my example.

We will make another assumption about your retirement tax bracket. Let’s assume you are in the 15% federal tax bracket and a 5% state tax bracket for a total of a 20% tax bracket. This means that in order to have the after tax $21,600 funds available to rent this house, you must dedicate $27,000 in pre-tax income ($21,600/0.80 = $27,000). Also, in order to have the $3,900 in after-tax dollars available for utility costs, you must have $4,875 income available ($3,900/0.80 = $4,875). The total annual pre-tax income required to rent this house is $31,875 ($27,000 + $4,875 = $31,875).

Applying the inverse of the 4% rule to $31,875 annual costs means $796,875 of your net worth assets must be dedicated to your housing expense if you rent. To be consistent only $4,000 of your ownership operating costs (the property taxes) are tax deductible leaving $9,000 of your ownership operating costs that are paid in after-tax dollars. $9,000 after-tax dollars is equal to $11,250 in pre-tax dollars ($9,000/0.80 = $11,250). The true comparison of owning versus renting in this example is summarized in the table.

So the apples-to-apples comparison of owning versus renting this property shows that either choice makes a similar claim to your net worth ($781K to $797K).

There is one last thing to consider in this analysis. 100% of your annual costs, if you are a renter, will likely increase each year with inflation. However, if you own this property, approximately 50% of your costs (the $400,000 equity claim) would be fixed for the entire time you own the property. This fixed equity claim is equivalent to having a rental fee that does not change regardless of how long you live in the property. This is the main reason why the longer you live in a property the better the ownership option becomes even if the property does not increase in value.

Finally, there is one other thing to consider when you rent long term. In this example, since you sold your old home, the $400,000 of liquid assets from this sale must be managed in order to generate income for your rental housing expense. This represents a large amount of capital that will be subjected to some investment risk in order for it to last 30 years. If you make a big investment blunder, the $400,000 asset that is supposed to generate the income to cover your housing expense could be severely reduced.

If I were considering the rent or buy decision in the example above, and I knew for certain I would be living in this house for more than 5 years then I would probably purchase the home. On the other hand if this home could be rented for $1,500 per month or less, I would probably opt for renting depending on the state of the housing market in the area at the time.

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