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6:54 pm - Tuesday September 27, 2016

Should you Rent or Buy a Home ?

| Home Finance and Mortgage | Rating: 4.5
by Numan

There are many psychological aspects to the question of rent or buy. While these may be debated in length it is important to get the financial part of the question right.

In this article I will examine the financial aspects of the decisions in the form of the alternative ‘loss’ in each option (Rent Vs. Buy). We are not always aware of the entire financial picture. There is also one more very unique psychological motivation that I think should be discussed.
When addressing a financial question we should isolate those variables which can be measured and compared. We should regard a house as every other asset and ask ourselves which way to purchase the asset is most desirable financially.

In order to compare the two options we must first have a basis of comparison. Evaluating rent or buy, financially can only be made by considering the same asset, of course. Thus, we shall look at two alternative paths to own a house in a certain period of time”:

Option A: Buy the house today and live in it for that period. Henceforth the BUY option.
Option B: Rent the house today and buy it in the end of the period. Henceforth the RENT option.

Option A:
Let us look at the expenses at the BUY option or option A. Let’s assume our future home owner buys a house with the common combination of equity and mortgage. His ‘losses’ would include:

1) The most obvious would be the interest part of the monthly mortgage payment which is ‘throwing’ money away the same as when paying rent.
2) A bit less obvious would be the optional return on investment on his equity. Say our home owner would have invested his money in stock. This alternative investment could have potentially yielded return which is lost when invested in a house (to be gained, possibly, by a rise in house prices).
3) The costs of the house purchase deal itself (Real estate agent’s commission, lawyer etc.)
4) Home maintenance and improvement expanses during the period in which he lives in the house.

What about his potential gain ? In the BUY option our home owner has a great potential gain as his investment in the house is a leveraged investment (An investment made with a combination of equity and debt). His possible gain extends to funds he didn’t have in the first place. Lets look at an example: Say our home owner had invested his equity of 100K US$ in stock which yielded a 5% return of 5,000$. Now let us assume his house has yielded the same return (5%) but was purchased with a combination of equity (the same 100K US$ as before) and mortgage (say another 100K US$). His return on investment is now 10,000 US$ (with some paid as mortgage interest but in a relatively low interest rate). Notice the return on his house is gained also on the debt or mortgage part of it (Higher absolute return).

It is important to note that this potential gain is also a source for potentially greater loss since in the case of loss on his investment our home owner is left with mortgage payments unaffected by the devaluation of his property.

Option B:
Let us now examine the ‘losses’ in the rent option: In this case there is the obvious ‘loss’ of the rent paid each month. But there is also the ‘loss’ of the potential gain on the house as an asset. The potential gains for the rent option are:
1) Return on equity not invested in a house but in stock or bond.
2) Return on funds not paid as mortgage payments (Balance part of the payment) and saved to purchase the house at the end of the period.

When comparing the two alternative we should always compare them for the same asset and for a set period of time in order to achieve true comparison.
Finally we should always take into account the psychological aspects of house ownership vs. periodical rent. I’d like to dwell on one unique psychological aspect: The motivation to save. In the buy option our home owner is forced to save in the form of timely mortgage payments. In the rent option our home owner needs some discipline in order to save the money for future house ownership. As available money always has its uses the mandatory part of the mortgage is an excellent motivator for the less disciplined savers. 

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