The 'Rent vs. Buy' Lie

August 10, 2006

After a multi-year plateau, rents are finally rising again. Rising rents can make buying a smart move, but with inflated home prices, renting and investing in mutual funds could be a better move.

Renters are watching closely, and asking themselves if now is a good time to buy a home. Rents are currently going up faster than home prices, reversing a multi-year trend of homes price increases far outpacing rents.

Unfortunately, many so-called “rent vs. buy” calculators on the Internet can lead you down the wrong path. For one thing, they should be called “rent & invest vs. buy”.

For the last few years, home prices have climbed, but falling interest rates (and creative mortgage products) have made homes almost as affordable (in terms of monthly payments) as they were before the big run-up. Recent increases in interest rates — notably shorter-term rates that are used to set many adjustable rate mortgages — have made the current home price levels unaffordable for many new buyers. This increases demand to rent, which, coupled with decreases in the supply of rental units from condo conversions, can raise rents. But do rising rents make buying a smart decision now?

Buying instead of renting is almost always a good idea in the long run (over 10 years) because you are essentially renting the property to yourself for phantom income, and are generally putting away more (toward a mortgage) than you would if you rented (forced savings). Surprisingly though, the actual return of the underlying investment, adjusting for maintenance, is pitifully low and on par with inflation (recent memory of wild home price gains aside).

With renting, costs are predictable. The main thing to worry about is rent increases. While a hot rental market with limited units and an inflow of workers can cause double-digit percentage increases when the lease is up, in reality, the inflation rate (or slightly above the inflation rate) is a good starting point for your guess on future increases. Three to five percent per year is a good estimate.

With buying, monthly payments on the mortgage are the main cost — but these can be fixed and made more predictable than future rent changes. Less predictable are maintenance and taxes. It is not out of line to use the same estimates for future growth here as with rents, namely three to five percent.

If the rent was the same as your mortgage, tax, and maintenance cost, owning is a smarter move, as not only will your rent go up and ultimately be more than your fixed mortgage, but you'll also own an asset in 30 years as opposed to owning nothing. However, buying the same home you rent is almost always more expensive. How much more is where the nuances of renting vs. buying come into play.

Most rent vs. buy calculators do a fine job of letting you plug in variables for the above items (including important considerations like tax rates). The trouble starts with two key figures: how much your home appreciates in value, and how much you can earn on money if you didn't put it toward buying (and maintaining) a home.

Many calculators, notably the one run by the Government National Mortgage Association (Ginnie Mae), miss on these points. Ginnie Mae is the government entity that insures mortgages against default; it was created to increase home ownership in America. What better way than to make home buying always seem like a brilliant idea? You can't enter a negative number for “Yearly Home Value Increase Rate” into Ginnie Mae's online calculator.

If the total cost of home ownership is $5,000 a month and you can rent the same place for $3,000 a month, buying is always going to make good financial sense if you assume (like many “rent or buy” calculators) that home prices do not decline (it’s just a matter of how much they go up!) AND that you would spend the extra $2,000 a month you are “saving” by not buying a home on non-investment consumer purchases (like eating out, vacations, and flat panel TVs).

While many renters who can afford the extra money to buy may dispose of that disposable income, they could save the $2,000 difference in a stock index fund like Vanguard Total Market (VTSMX), which over long periods of time outperforms real estate.

Additionally, home prices can fall, particularly over shorter time periods of 1 to 5 years. There is virtually no scenario where buying beats renting if home prices fall, especially factoring in the leverage used in a home investment. Even the Wall Street Journal calculator — perhaps the most advanced of the lot — doesn't handle negative estimates well.

Is it so absurd to want to see the financial damage done buying a beach house that has doubled in value in the last few years if it returns to its 2003 price?

Some calculators have improved in recent months.'s may have become more ridiculous. Now the site just asks some touchy-feely questions about your lifestyle and personal observations on local home price, then it tells you if you should rent or buy. gets an “A” for ease of use by the average homebuyer, but a “D” for its inaccurate financial analysis of which is a better move.

No calculator that I found lets you enter a “job security” value, like how likely are you to be able to make payments on a house one year from now. No calculator has warning pop-ups when you enter a preposterous value for home appreciation, like 15% to 35% a year (as some markets have seen in recent years).

Rents are going up. Like stocks and underlying earnings, this can legitimize higher prices. Buying a home instead of renting is almost always a good idea in the long run. However, you should be comfortable with the risk of losing your ability to make payments for a few months, the chance of home prices declining 10% to 30% in the next few years, and the reality that you can buy a stock index fund with the extra money you would earmark for buying a home — and earn more than the home appreciation rate of return.