Paying rent is throwing your money away!
Executive Summary
A phrase I hear often when asking why someone wants to buy a house is “rent is throwing away money”. I don’t like this phrase for a few reasons. The main reason is that this phrase typically means “I want to build my net worth”. Renting doesn’t stop you from building your net worth and it might actually be a better way to reach financial security than owning a home. Buying a home can also be more expensive that renting due to the many costs of home ownership that aren’t reflected in the purchase price inculding insurance, maintenance, utilities, HOA dues, and other unexpected costs. The main takeaway is that buying a home isn’t a necessity for young lawyers. The decision shouldn’t be about the equity of a home vs the cost of renting. The decision should center around the life someone wants to live and if a home fits into that vision.
“Paying rent is throwing your money away!”
Many people resonate with this phrase when they think about why they should buy a home. No one wants to throw money away. When people think they are throwing away up to 30% of their income on housing costs it can be unsettling.
This phrase is commonly told to people by generations who bought homes in the past. You may have even heard this exact quote from your parents. Homeownership has been a cornerstone of the American Dream since the founding of our country. But is homeownership how you define your American Dream?
Is rent throwing money away?
What does it mean to throw money away? When you pay rent, you exchange your hard-earned dollars in exchange for a place to live. We all need a place to live.
When you pay to rent a home, you are not throwing your money away! Throwing your money away is like taking a pile of cash and putting it in the garbage bin to be incinerated (which under 18 U.S.C. § 333 is a crime punishable by law).
You are not throwing away money when you buy groceries. To purchase an orange, you exchange dollars for something that benefits you.
When you rent a home, you exchange money for something that benefits you. The benefit you receive is a roof over your head, a place to relax and enjoy your free time, and a home that friends and family can be invited to.
So renting is not throwing money away. Instead, the phrase is a way of saying that you are not using your money to build your net worth. To better understand if rent is helping us build our net worth, we have to understand an economic concept called opportunity cost.
Opportunity cost
When you eat at a restaurant, you spend money on the food you eat. You can also choose to spend that money on movie theater tickets, groceries, or gas for your car. But you do not have enough money to spend on everything. We only have a limited amount of money, so you have to choose to save or spend your dollars on something other than all of your other options.
Opportunity cost is the loss of potential gain from every other alternative after you have selected one alternative.
When you are renting, you are choosing to spend money on a place to live instead of spending that money elsewhere. But we all need somewhere to live. So we incorrectly assume that if we are choosing to rent a home then the only other alternative for that money is to buy a home.
This assumption is incorrect because it assumes that you will pay the same by renting as you will when you buy a home. It’s very common for these two alternatives to cost different amounts. So not only is there an opportunity cost between the benefits of renting or buying, but also the opportunity cost of choosing what to do with the difference in money spent.
What is home equity?
Buying a home requires a lot of money. If you want to buy a $500,000 home, you either need $500,000 in cash or you can buy a home with the combination of a down payment and a loan (mortgage). Together the down payment and the mortgage add up to the $500,000 you need to buy the home.
With a mortgage you’re no longer paying the landlord to live in a home, you are paying the bank. Your monthly mortgage payment will pay off the mortgage in 15 or 30 years.
When you pay your mortgage, you won’t end up paying exactly the amount of the mortgage. That is because a mortgage has an interest rate. This interest rate adds to the total amount you will pay for your home. Currently, the average interest rate for a 30-year mortgage is roughly 3%. If you have a 20% down payment ($100,000) for this $500,000 house, then you will have a $400,000 mortgage.
After making your monthly mortgage payment, you would pay roughly $600,000 ($400,000 for the original mortgage amount and $200,000 in interest). Plus you paid $100,000 as a down payment. In total, you would pay roughly $700,000 to buy a $500,000 home.
Well, that seems like a bad deal.
But it might not be bad. That is because a home's value might also increase over the 30 years you are paying for the mortgage.
There is no way to know what the future value of a $500,000 home will be in 30 years so instead we will look at how much a $500,000 home would be if we had bought it 30 years ago. [Note this is using historical data so it won’t predict the future value of a home if you bought one today.]
Using the S&P/Case-Shiller U.S. National Home Price Index, an index used by the Federal Reserve to measure how home prices change for 20 major metropolitan areas, from January 1, 1991, to January 1, 2021, the price of homes have increased by 3.13 times. In this example, our $500,000 home in 1991 would be worth $1,565,000.
Paying roughly $700,000 over 30 years to end up with a $1,565,000 asset appears to have been a good investment.
Keep in mind that in the above example, I used an interest rate of 3%. In 1991, the average interest rate for a 30-year mortgage was 8%. So in 1991, if you had put down a $100,000 down payment you would have paid over $1,000,000 to pay off your mortgage with interest plus your $100,000 down payment.
Now paying more than $1,100,000 for a $1,565,000 home still leaves you with more value than you paid. But would there have been a better use of your money?
(This example leaves out refinancing which I hope to write about another day but would make this simple example more complex than it has to be.)
The point of this example is to explain what home equity means. At the end of 30 years in this example, your net worth would include a $1.5 million home.
A home is more than your net worth
A home is not just an asset we can put on your net worth statement. It represents a lot more than that.
A home is also a way to express yourself. If you want to install a pool, go for it! If you want to renovate your home to include a bigger closet, knock down that wall! A home gives you control over what you do to your property because you own it.
When you rent, you have to get approval from your landlord to change anything substantial. Having the freedom to make your home how you want it is valuable.
A home can also mean security. When you own a home, it means that a landlord cannot refuse to renew your lease. Knowing that you own a home and you can live there as long as you want (assuming you pay off your mortgage) is a great feeling.
But owning a home does not mean that you will be able to afford that dream vacation, retire early, start that business you’ve been thinking about, or that you will be able to afford your lifestyle once you retire. To be able to afford a place to live and everything else that you want out of life, you need financial security.
Sometimes people equate owning a home with financial security, but a home does not give you financial security. It only gives you financial security in one part of your financial life. For a lot of people, they would forgo owning a home if it meant that they still had a place to live AND they could live their dream life.
Financial security
When a financial planner knows how you envision your dream life, they will look at a lot of different factors. A significant factor is your net worth. Do you have enough assets (money) to afford everything you want in life?
A home can be a great way to add to your net worth. But if the only asset on your net worth statement is a home, you cannot achieve much else because spending on anything else would require you to sell your home for the cash to fund your other goals.
A home can be a part of financial security but you won’t be financially secure with just a home.
Diversification gives you the best chance to be financially secure
It is a well-known principle in personal finance that having all of your money in one stock is risky. If you put all of your money into Enron, you would have been rich...until you weren’t. Putting all your eggs in one basket puts you at risk that all your eggs fall out of the basket.
It is generally believed that by investing your money in many different assets, you will have a better chance of increasing your net worth. Some investments may do poorly over time and others may do exceptionally well. The hope is that the investments that do well exceed the assets that do not perform as well.
A home is an asset just like a stock of a single company. If all of your net worth is in your home, then your net worth will go up or down depending on the value of your home.
If you have $200,000 in assets that include a 401(k), IRA, investment account, and an emergency fund then your net worth is hopefully diversified across many different assets. If you take $100,000 of that to buy the $500,000 home mentioned earlier, you have just increased your net worth by $500,000. In this example you would have $600,000 in assets ($200,000 - $100,000 down payment + $500,000 home). To go from $200,000 to $600,000 in assets doesn’t seem like potentially a bad situation.
Let’s break your assets down. You have $600,000 in assets: $100,000 from your previous net worth (remember we used $100,000 as a down payment) and you have a $500,000 home. After buying the home, the home is roughly 83% of your total assets. That is not a diversified portfolio.
Initially, your future net worth will be largely dependent on the value of your home. Hopefully it goes up, but as we saw in 2008, home prices do not always go up. Would you feel comfortable if 83% of your assets were worth less than what you bought them for?
How do homes perform compared to other assets?
Residential property is one asset out of many different types of assets. Other asset classes include stocks, bonds, and precious metals. Each of these asset classes consists of many different types of sub-asset classes. Even the real estate asset class is comprised of different asset classes besides residential property. Commercial buildings and raw land are two other types of real estate along with many others.
This blog is not going to show how every asset performs compared to home prices. Just know that residential home prices have lagged the price increases of other asset classes, but past performance is no indication of future performance.
So why do people talk about home ownership as a superior investment?
Going back to the prior example, buying a home for $500,000 and 30 years later valuing it at $1.5 million seems like a great investment. After all the initial 20% down payment was only $100,000. But when you include the mortgage payment with interest over the next 30 years, your annual return is around 2-4%.
In absolute terms, a home’s value increasing by $1 million seems great, but when you calculate how much it’s value grows each year relative to how much you are spending on just the mortgage, it’s returns are less than spectacular.
Buying a home will not make you the next great investor. Instead, buying a home seems like a better investment to some people because it benefits from two financial concepts: leverage and illiquidity. Leverage is when you buy something using more money than you have. For a mortgage, your 20% down payment allows you to buy a home for 5 times more than your down payment alone would buy.
Illiquidity is a term to describe how hard it is to sell an asset. If you were to sell a well-known stock, you could reasonably expect to sell it in a short amount of time. A home cannot sell in minutes. It is a longer process where you need time, money, and effort to find another buyer. This discourages people from selling.
Research has shown that when people panic sell assets, especially in the stock market, they may likely end up performing worse than if they had just not sold in the first place. Since homes are illiquid compared to stocks, this has worked in favor of a lot of people.
Before choosing to buy a home, consider that it may not be the best investment if all you really want is to be financially secure. The opportunity cost of putting a substantial amount of your net worth into a single asset may be greater than the cost of the rent. It also means that your future financial security is heavily tied to the performance of one subsection of all the investable assets available.
Rent is the maximum you pay, a mortgage is the minimum you pay
If you are currently renting, you may have put in a maintenance request. Sometimes it may just be a leaky faucet. Other times it may be that a pipe broke and your whole home is flooded.
When you rent, these maintenance expenses are paid by the landlord. When you own a home, you are responsible for paying these expenses. You will not know what your future home maintenance costs will be, but you can be quite sure that there will be future maintenance costs.
Maintenance is not the only cost you have to consider as a homeowner. A list of a few others includes:
Property tax
Home insurance
Utilities
Closing costs (2-5% of the mortgage amount)
HOA fees
When you rent, you should still have renters insurance but it will be cheaper than homeowner’s insurance.
Sometimes utilities are included in your rent payment but they will not be included in your mortgage payment.
When deciding between renting and buying a home, you should be aware of the additional costs that are included with owning a home versus renting.
Should I buy a home?
To some readers, this blog post may feel like I don’t believe you should own a home.
Well here is a surprise: I plan to own a home in the future.
This blog post is intended to argue against the phrase that renting is throwing away money. Choosing to rent or buy a home is much more complex than this simple phrase makes it out to be.
You need to consider not only your future financial needs but also your current financial needs. Ultimately, you will be the one who decides if you want to rent forever or buy a home.
What are your life goals?
When you envision your dream life, what does it look like?
Are you traveling to different cities or are you deeply exploring your city?
With remote work becoming more accepted in the job force, working a job is no longer dependent on living in the same city as the office.
If you would like to spend time working from other locations, buying a home may keep you tied down to one location. Meanwhile renting provides you the opportunity to live in many different locations more easily.
If you are living in a great city and you want to deeply explore it then buying a home may be a better decision. There are so many things to do in your own backyard. Buying a home pushes people to learn more about the area they live in. You will find local spots that you might not learn about if you were temporarily renting a place nearby.
Is moving to different locations part of your life or do you see yourself living in your current city for a long time?
A rule of thumb is that you should not buy a home unless you plan to live there for at least the next 5 years.
If you are not sure that you will be in a city for the long term, then renting may give you more flexibility in your current living situation.
Once you have found a city that you intend to live in for more than 5 years, buying a home may make more sense.
Do you want to start your own firm or go back for more school?
A mortgage is due every month regardless of your income. Unlike renting where you can move into a cheaper home, a mortgage is hard to change, and there is no guarantee you would be able to get a lower monthly payment.
If you have always wanted to start your own firm, you may not make a profit initially. Can you afford your mortgage payment if you don’t have an income for 6 months, a year, or even longer? If this is something you might want to pursue in the future, a fixed mortgage payment could discourage you from pursuing this goal.
These are all important questions to ask yourself when deciding on buying a home. If you are considering buying a home but it’s not a part of your dream life then you might be better off renting.
This decision is not about whether you are throwing money away by renting. This decision is about whether buying a home is aligned with the life you want to live.
Financial Security is more than your net worth
Financial security is not the same for everyone. Financial security can be analyzed and forecasted but financial security is as much a feeling as a number.
If you have all of the money in the world but you’re still afraid to quit the job you hate or to pay for a dream vacation, you are not financially secure.
Deciding to rent or buy a home by considering only financial considerations ignores the emotional side of this decision.
To be truly financially secure, we need to feel comfortable with our decision. If buying a home helps you feel successful and more confident in your daily life, then that should be accounted for in your decision. If renting empowers you to travel and live in different places, that should be accounted for too.
When we are deciding between buying and renting, we need to ask ourselves “Why do I want to buy a home?”. If the answer is “rent is throwing money away” then you are viewing it only as a financial decision. If your “why” is about something more than the financial side of the choice then you still need to consider the financial aspects of the decision, but that should not be the only factor in your decision.
Making financial decisions that bring you peace of mind and that allow you to afford your dream life is how you truly achieve financial security. Only solving one aspect of financial security will leave you without any financial security.
I still want to buy a home
That’s great! If you read this whole post and you still feel confident that you want to own a home then that is a goal you should work towards.
When you buy a home, you need to be aware of a few considerations.
First, a real estate agent and a mortgage broker are incentivized to put you into the largest home you can afford. A mortgage broker is usually paid based on a percentage of the loan amount. So if you can afford a nice starter home and pay a 20% down payment, the mortgage broker will make less money than if you buy a larger home where you can only afford a 4% down payment.
A real estate agent is also paid based on the size of the home. When you buy a home usually the real estate agent is paid as a percentage of the selling price. If you buy a more expensive home, their commission is larger.
This does not mean every real estate agent or mortgage broker will try and put you in a more expensive home than you can afford, but it should give you pause if you are told you can afford a home of $xxxx amount with only a 3-4% down payment.
Second, with an FHA loan you may be able to buy a house which you may not be able to afford in the future. FHA loans can require as little as a 3% down payment. While this means that you can buy a home much sooner than you would with a 20% down payment, it also means that you will have a significant loan to pay off.
Remember in the example above where we looked at a $500,000 home with a 20% down payment? The mortgage on that home was $400,000. This is a large loan for many young borrowers. With a 3% down payment, that $400,000 loan is now $485,000. If you own a $500,000 house and you owe $485,000, even a slight downturn in housing prices will have you paying a loan balance that may be larger than the actual value of the house.
Keep in mind that this larger loan balance also has to pay interest on a larger amount. This means you will pay even more for the home over the lifetime of the mortgage.
Third, if you don’t buy a home with a 20% down payment, you will have to pay Private Mortgage Insurance (PMI) until your loan balance is 78% of the original loan amount. The annual cost of PMI ranges between approximately 0.5%-2%. This can be a significant added cost to your monthly mortgage payment.
If you buy a home with only a 3% down payment the mortgage payments are likely as large as you can reasonably afford. Once you include the monthly cost of PMI and the other home costs listed above, you may not be able to afford your home.
Finally, if you truly want to buy a home then prove it to yourself. Don’t buy a home unless you can afford a 20% down payment. This is for two reasons. The first is that saving up a 20% down payment takes discipline. This is a substantial amount of money and it may take years to save for.
Over the years of saving for a 20% down payment, your goals and priorities might change. By saving until you have 20% as a down payment, you will have more confidence that you are buying a home for the right reason.
The second reason is that a 20% down payment limits how large of a home you can buy. People get into financial trouble when they buy a larger home than they can afford for the next 30 years. If you only look at homes where you can afford a 20% down payment, you will be more likely to avoid foreclosure, delinquent mortgage payments, and bankruptcy.
Buying a home does carry risk and the reward for taking the risk can be great but that risk can also ruin your chances at future financial security. The best thing you can do to achieve financial security is to limit the risk of financial ruin.
The choice between renting and buying a home is a complex decision to make. Many financial and personal factors need to be considered. Unlike a mortgage broker and real estate agent, the Developing Financial planning fee is not influenced by whether or not you buy a home. Instead, the Developing Financial Process is built to consider all of these factors to assist you in making the best financial decision based on your goals. Schedule a free Meet & Confer meeting today and have more confidence that whether you rent or buy a home, you are making the right financial decision.
Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.