Figuring out whether you should rent or buy your home is a big decision, and it’s something nearly everyone will have deal with at one point in their lives. I’m going to discuss this question through the lens of someone who doesn’t have the financial ability to go out and pay cash for a house; that is, renting is compared to a mortgage.
For those that do have the ability to buy housing outright, you likely may not want to tie up all your capital in a property without using some form of leverage anyway, as you can probably make it work harder for you elsewhere – like as a deposit on another investment property, or in the stock market invested in good quality low fee index fund ETF or LICs.
‘Rent money is dead money’
Rent money is dead money is a pretty common term that gets thrown around in the debate between whether you should rent versus buy. Like anything, you should factor in who is saying something as well as the intent behind what they are saying. In my experience, this is a phrase commonly coined by builders or mortgage brokers trying to promote their business and gain clients.
If rent money is dead money, then isn’t interest dead money too? Over a standard 25 year home loan with today’s average 3.5% interest rate on a $500K property, you will actually pay $750K over the period of the loan meaning you’ve been hit with a whopping $250K interest bill!
Of that, you’ll be paying on average $557 per week, every week, for the life of the loan. If you’re buying to live in your home using a standard P+I mortgage, a small (but increasing over time) portion is paying off your principle loan amount, and slowly building your equity. This is kind of like a forced savings plan, but where you can’t do anything with the money
There are some desirable qualities of a mortgage
- Fixed loan amount
- Loan is in today’s dollars and inflation erodes the future value of the loan
- P+I loan pays down principle at an increasing rate, building equity
- You control the asset from day one and benefit from any Capital growth
- May only have to provide a very small deposit (although 20% is usually the gold standard)
At the end of the day, cash-flow is always king. Regardless if your buying a property to live in or as an investment, maxing out your serviceability and spending a high amount of your income on a mortgage is not a good idea. This means you might be cash-flow poor, and the risk of interest rates rising could mean that can’t you afford your repayments. In this situation, you will be forced to sell, likely at a loss!
Why buy a home
- Security for you and your family
- Potential opportunity for Capital growth
- Primary Place of Residency capital gains tax exemption
- Don’t have to deal with a landlord – no spot checks or inspections!
- Can renovate to improve quality of life or add value to the property
- Choose where you want to live
- Lower cost of living than owning – no need for building insurance, rates/land tax etc
- No risk of interest rates rising causing mortgage stress
- Known cost to you each week
So why choose between one or the other when you could do both? You could buy an investment property somewhere where the rental returns are much higher giving you a positive cash flow, and then rent where you want to live. In expensive cities, the rent is almost never in line with rental returns of cheaper areas – meaning you can easily have a great quality of life with an awesome place to live and still be living well below your means.
Cost of renting v owning
For example, I rent a 1 bedroom apartment in Sydney. It was brand new when I moved in, and the agents had it listed at $430 a week. When I crunch the numbers of what it would cost me to own (with all the hidden costs fleshed out and included), it comes out to just over $530 per week on a 3.5% interest only loan. And what do I get for this extra cost? Stress over interest rates rising, expensive strata fees and cost of repairs, and to make up for all that lot I get exposure to some capital growth? Unfortunately the Sydney apartment market has been quite speculative and seen a downturn in price due to a major oversupply – just like other capital cities. Personally, I would leave the city apartment ‘investing’ to the negative gearing ‘specialists’ (or should that be ‘speculators’) and focus on a cash flow positive detached house or duplex investment property instead.
So are there any good cash flow investment properties, and can you get capital gains on them? The answer is yes, but you will need to do your homework. On average a cash flow positive property may experience less capital growth than expected with the more speculative negative gear ‘capital gains’ investment properties that seem to be so popular with high income earners for tax dodging. A decent cash-flow positive property will more likely experience the average capital growth rate of around 3-4%, which means it should outpace inflation and give you a slight increase in equity. Its easy to say, but difficult to do – you simply have to get out, do your research and see if the deals stack up.
Costs of purchase and ownership
There area lot of hidden costs and high cost barriers with properties, especially so investment properties. For example, purchase costs include stamp duty, expensive inspections and legal fees. Similarly, when you sell a property you will incur an agents fee of around 2-3% of the sale price, listing fees, legal fees and capital gains tax on any profits you make.
Buying off the plan or building can be fraught with hidden fees, as builders usually wont include the cost of landscaping, drainage, driveways or fences in their ‘complete package’. At every step of the way, someone is there ready to sneak their hands into your biscuit tin!
I’ve found a good rule of thumb with ownership is its about $100 a week in Australia for a standard 3-4 bedroom home. And don’t expect this to be a passive investment – not at all. You will need to spend considerable time and effort managing your property, even when factoring in paying a full time property manager (that likely charges $1000 per year plus 10% of the rent).
Cash on cash return
Another factor to consider is your cash-on-cash return, and not just the rental yield as compared to your interest only repayments and other holding costs. Realistically, you’ll need a 20% deposit to avoid Lenders Mortgage Insurance and to secure a good mortgage rate, so you’ll be tying up a decent amount of cash in your investment property.
From my numbers, I’ve found good IPs in Australia that can cash flow about $10 a week and cost around $300,000. That requires a $60K deposit, as well as about $10K in fees. So if your making 3% capital growth and $520 annual cashflow, that’s a cash on cash return of 13.6%. Not bad – but if there is no capital growth (you shouldn’t bank on it) your return drops to about .7%.
Rentvesting Mk 2
So living below your means is the name of the game to generate your surplus for investment, but if you don’t have a deposit saved up, cant find a sweet cash flow positive investment property or you just flat out don’t want the stress or risk associated with owning property, then what should you do?
Consistently buy a high quality, low fee index fund ETF or LIC. There is a slight difference between the two, and my preference is the straight ETF like Vanguard total US market or Vanguard Australian shares, due to their lower fees and simple automated trust structure. Having said that, there is a few outstanding LICs with really low fees (AFIC ASX:AFI is $14 per $10,000 invested per year) that have great performance history.
On average shares have provided a higher return than property, around 10%, and are truly the only form of passive income. I receive my dividends twice a year, print off a tax statement once a year and hand it my accountant. Thats all I would have to do if I wanted – but I have a regular reinvestment plan (called DCA the Dip!) so I log in to my broker and purchase a new parcel of index funds every fortnight.
With an investment property can leverage with a mortgage and then hopefully see some good returns for the risk you have taken with the leverage. I would never advocate leveraging with ETFs (called margin loans). In the example above, with a realistic below 3% average capital growth, leveraging rewarded you with a Cash on Cash return of something below 13.6% (and only $520 of that was income taxable, which could be offset by further deductions such as depreciation on the house).
If you simply took that $70K you used to acquire the house, and buy ETFs, on average you’d get about 10%. So that might be $7000, split between dividends and capital growth of the shares. Like property, capital growth on share is taxed (and if you hold for more than 12 months you get a 50% Capital Gains tax exemption). Similarly, the dividend is like the rent of the investment property, and is taxable as income. Australian shares usually come with franking (tax) credits because they have already paid tax on the companies earnings at the corporate rate – this means your dividends likely will have a significantly reduced tax burden.
The crux of it is that whilst a cash flow positive house by definition is making you money, the capital (deposit and buying fees) you had to use to secure the mortgage might be better invested elsewhere if you don’t get the capital growth your aiming for. Housing market crashes are a fact of life and just like the share market the property market is cyclical, but will over time go up. If there is growth, you might be able to make more money than you would if you just bought ETFs by taking advantage of leverage and borrowing money from the bank to control the investment property with a mortgage. Whether you get growth or not comes down to buying the right house, in the right area, and paying the right price. All very important skills that take years to learn and sharpen.
In summary, the decision as to whether to rent or buy is a pretty personal one. For me, I love the flexibility and low cost that renting gives me. It lets me rent an awesome apartment at a significant discount than what it would cost me to own, especially when factoring in the risks of ownership and the pretty grim capital growth prospects for inner city apartments in the over-pumped Sydney property market at the moment.
I consider myself a rentvestor, so I still actively engage in investing. This is mostly through index investing in ETFs but also through the pursuit of cash flow positive, reasonably priced rental properties in ‘cooler’ markets such as regional towns and smaller capital cities. I think this is the best way I can risk manage my approach to reaching FI and getting FIRE’d!
Whats your take? Are you an experienced property or share market investor, and do you rent or buy based on your current living situation? Let me know below!