Buying a house is a huge financial decision that will impact your life for over a decade. It is far too important to be left to folksy catch-phrases. If you’re debating whether to buy a house or continue renting, you should definitely spend some time looking into buy-vs-rent calculators, of which there are many:
But one of the key inputs you need to plug into this calculator, quite obviously, is the rent. What exactly should you fill into this field?
When filling this out, people are often advised to enter in “the cost of renting a similar home.” Ie, similar to the house you’re looking to buy. This makes intuitive sense, but is bad advice. It can fool you into making decisions that you think are in your financial best interests, but actually aren’t.
Instead, here’s what you should do when considering buying a house for personal use.
Here are some examples to illustrate why this distinction is vital.
Scenario 1: Overpriced rentals
- You’re considering buying a house for $500,000
- According to the real estate agent, houses of that size in that neighborhood would go for rent for $2000/month
- Hence, the buy-rent ratio is
500000 / (12*2000) ~= 20
- According to the calculators, this is a bad ratio, and you’re better off renting
This makes sense hypothetically. But the reality is that you can’t actually find a house in that neighborhood for $2000/month. Similar rentals in that neighborhood do not exist, and seldom come up. For example, because all the other houses in the neighborhood are 4 bedrooms, whereas that specific house has only 3 bedrooms, and you’re dead set on living in that neighborhood. Hence, the realistic alternative to buying that house is paying $3000/month in rent for a bigger house than you need.
When viewed from this more accurate framing, the calculus completely changes. The buy-rent ratio is now
500000 / (12*3000) ~= 14. According to the calculators, this is a great ratio, and you’re better off buying.
Here is a highly simplified example to illustrate why you’re better off buying in this scenario. Suppose you bought the house with all-cash – you would have $500,000 less in cash, but you no longer need to pay rent. Now suppose you didn’t buy the house and instead invested your $500,000 in bonds paying out at a 6% interest rate. This would produce $30,000 in investment returns every year.
- If you were truly paying $24,000 in rent each year, you would still come out ahead by $6,000
30000 - 24000 = +6000
- But if you were actually paying $36,000 in rent each year, you would be short $6,000 instead
30000 - 36000 = -6000
Hence why it’s so important to consider the amount of rent you would actually be paying. Not a hypothetical rent amount.
Note that in this simplified example, we are ignoring all sorts of complicating factors such as mortgage interest rates, taxes, bond appreciation rates, real estate appreciation rates etc etc. Hence why you should really use a buy-rent calculator to make these decisions.
Scenario 2: Cheaper rentals
- You’re considering buying a house for $1,000,000
- It’s a massive 6 bedroom house – you and your wife don’t have any children, and have no need for 6 bedrooms
- Regardless, the real estate agent tells you that this is a fantastic financial investment, because comparable houses fetch $8000/month in rent
- You plug the numbers in the calculators and find that the buy-rent ratio is
1000000 / (12*8000) ~= 10
- The calculators are all saying that buying this house is far better than renting. You’re on the verge of buying this house.
That’s when you suddenly realize something. If you didn’t buy this house, you certainly wouldn’t be paying $8000/month in rent. Why on earth would you and your wife rent a 6 bedroom house when you have no need for it.
Instead, you would be renting a smaller house for $3000/month. You plug this number into the calculator instead, and find that the buy-rent ratio is now
1000000 / (12*3000) ~= 28. The calculators are all saying that you’re better off renting rather than buying this house.
Sure enough, the latter is the correct framing to use. Let’s return to the earlier highly simplified example, purely for illustrative purposes. Suppose you bought the house with all-cash – you would have $1,000,000 less in cash, but you no longer need to pay rent. Now suppose you didn’t buy the house and instead invested your $1,000,000 in bonds paying out at a 6% interest rate. This would produce $60,000 in investment returns every year.
- If you were truly paying $96,000 in rent each year, renting will set you back by $36,000 each year
60000 - 96000 = -36000
- But if you were actually paying $36,000 in rent each year, you would come out $24,000 ahead by renting instead of buying
60000 - 36000 = +24000
Once again, this is a highly simplified example for purely illustrative purposes. You should use an actual buy-rent calculator to make these decisions.
Scenario 3: Buying as a rental property
Note that there is one very important exception to the above guideline. That is when you’re buying a property for the purposes of renting it out. In such a scenario, you should indeed consider the rent that you would get by renting out that property. Not the rent that you yourself are paying for your own housing. The reason for this is subtle.
In the 2nd scenario, the real estate agent was actually right in saying that the 2nd property is a great buy. If you buy it for $1,000,000 and rent it out to someone else for $96,000 every year, that is a fantastic investment – far better than 6% bonds which would generate only $60,000 in interest every year.
Where things go awry is when you decide to live in it, instead of living in a cheaper home that adequately suits your needs. By living in the house, you’re foregoing $96,000 in rental income, in order to save $36,000 on your own rent. From a purely financial perspective, this ruins the entire purchase. And makes as much sense as renting a $8000/month house when you’d be perfectly happy with a far smaller one.
Hence the earlier advice that when calculating buy-rent ratios, you should consider the rent that you would otherwise be paying – not the rent on the house you’re looking to buy. This advice makes perfect sense in the context of buying a house for the purposes of living in it. But if you’re looking to buy a house in order to rent it out to others, then you should certainly be focusing on the rent that you would be able to get on that specific property.