This article originally appeared in our monthly newsletter, Fiscal Therapy.
Please subscribe if you'd like to receive similar articles on a monthly basis.
WHAT I’M THINKING ABOUT: Should I Buy or Should I Rent?
Should I buy or should I rent now?
If I rent there will be trouble
And if I buy it will be double
Like a good catchy tune, some age-old questions just never go away — like the chicken and the egg, a tree falling in the forest, and whether to rent or buy. For most city-dwellers, your rent is your largest expense and buying an apartment (if you do) your largest investment. So we’ll take the time to dive into the pros and cons of buying versus renting and how to decide what’s right for you.
The myth: homeownership is how you build wealth
There’s a persistent narrative in America that homeownership is the primary vehicle for building wealth. You save enough for a down payment, get a low-interest mortgage, enjoy your new family home while you build up equity, and then — voila! — thirty years later you have hundreds of thousands to your name in the form of your home. You even got to deduct those mortgage interest payments along the way!
In my experience, far too many people buy a home because they feel like they’re supposed to, instead of determining it’s the best decision for their family.
Like any major decision, whether to buy an apartment must be placed in the context of your current situation, goals, and priorities. Homeownership is a way to build wealth, but not the only way, and not necessarily the best way. An alternative is to take that down payment and instead invest it (ideally in low-cost index funds). So, for example, if you invested $100,000 in the market and let it sit for 30 years, you could expect it to grow (based on historical annual returns of 10%) to more than $1.7 million.
Of course real estate tends to appreciate as well, so it takes some complicated number-crunching (and assumption-making) to determine whether a particular home purchase is financially superior to renting. However, a 2017 study by several real estate economists concluded that, on average, purchasing a home builds less wealth than renting and investing the difference (i.e., the down payment and any differential between mortgage payments and rent). Why? Because the market historically has generated better returns than real estate.
Homeowners also incur large expenses that renters don’t — some anticipated and some not. In a city like New York, for example, maintenance fees, taxes, insurance, and mortgage interest adds up to a similar amount as rent for a comparable apartment (and oftentimes more than rent). Then there’s the unexpected variety of expenses, like repairs, renovation overruns, and co-op assessments. Beyond putting a dent in your checking account, these larger (and often unexpected) expenses also cramp your cash flow, requiring you sit on more cash or otherwise cover the cost in inefficient ways (like credit card debt or liquidating investments at the wrong time).
So is the point that it’s always financially better to rent than buy? No, it really depends on the home, your location, and your financial situation. But don’t just assume you should buy.
The benefits of buying your apartment
Of course, there are some great reasons for buying an apartment. Plenty of my clients have bought their apartment and are thrilled with their decision. But the best reasons to buy an apartment are usually not financial ones. For example, buying apartment can:
Create a sense of home. For some, having an apartment for the long-term, a place your kids will grow up in and come home to, in a neighborhood that you know and knows you, having a home — that’s priceless. Homeownership can provide those roots.
Give you control. No one likes dealing with unexpected rent increases or that looming possibility your landlord will sell. Once you own, you don’t have to worry about that — and, you can renovate however you like! It’s yours.
Force you to build equity. The reason why homeownership does correlate with wealth accumulation is that it forces you to make those mortgage payments and thus build up equity. If you dutifully make your mortgage payments, then after 30 years you’ll own your house outright — a nice sizeable asset. While renting and investing the extra cash may on paper generate more wealth, many renters end up simply spending that difference instead of investing it. If you don’t have the discipline to save and invest, homeownership can help get you on track by forcing you to live below your means to make your mortgage payments.
The benefits of renting your apartment
On the other hand, there are great reasons to rent as well, even if for a season. Renting can provide:
Family flexibility. Not sure how many kids you’ll have, or whether you’ll have kids at all? Rent based on your current family size, and then move later if needed. Need a building with an elevator to accommodate your stroller for a season? Easy enough.
Geographic flexibility. Tired of your neighborhood? Just move. Need to be in a particular school zone (but only for a few years)? Move in, move out. Have a new job way downtown that would add 30 minutes to your commute? Just move!
Professional flexibility. Thinking of starting a business, or perhaps going back to school? You’ll want to lower your living costs to give yourself a nice long runway. As a nimble renter, it’s as easy as signing a new lease in a humble studio. With a 30-year mortgage hanging around your neck, it’s quite a bit harder to make a change.
Liquidity and diversification. If you buy, your primary asset (your home) will be fairly illiquid and all in one basket. But if you rent and invest in low-cost index funds, you assets will be liquid and (ideally) diversified. If you want to use that money to travel, to start a business, or for charitable purposes, it’s easily accessible.
Time. A home is a major asset to care for and maintain. Not only does that come with large costs, but also large investments of time. You need a plumber, a tree trimmer, a new boiler. These things take time and mental energy to research and make decisions.
How to be smart if you do decide to buy
The most satisfied homeowners I’ve seen as a financial planner are those who wait to buy until the flexibility of renting is no longer a big benefit for their family. Both the financial and non-financial factors need to align in favor of buying.
If and when you do decide that buying is the right path for you, here’s how to be smart on the financial aspects.
Save much more than 20% of the purchase price. A typical down payment is 20%, but you’ll want more than that on hand. Add at least 5% to your savings goal to account for closing costs, moving expenses, and new home purchases. This last area, new home purchases, can be a massive source of spending. You just bought a home and you want it to feel like home ASAP. I see quite a few first-time homeowners with a lot of credit card debt. Why? They only saved 20%, drained any emergency savings they had during closing, didn’t think through all the things they’d need to buy post-move, underestimated ongoing expenses, and ended up in credit card debt.
Build a larger emergency savings fund. For any homeowner, I want to see 6 months or more of expenses and debt payments in emergency savings after you close on the house. Do not spend all of your cash on the home purchase. More than ever, you need those rainy day funds after you close. Your spending is more variable as a homeowner (you never know when a large repair or co-op assessment will hit), and you’re locked into that mortgage. A renter who falls on troubled times can quickly pick up and move, but not a homeowner. Without that financial nimbleness, your emergency savings fund is what acts as your buffer between you and debt in the event of financial hardship.
Create a home repair fund. Your home will experience routine wear and tear, and large (and expensive) appliances will need to be replaced. There’s also the occasional disaster (think flooding, mold, cracked pipes, etc.), which may not strike in the current year but eventually will — and you need to be prepared. Set up monthly transfers into a savings account dedicated to home repairs. If you have a string of minimal-repair years and the balance gets too large, you can sweep extra funds into another savings or investment account (or reallocate to a home improvements savings account), but keep the monthly savings going — you’ll thank yourself when that disaster does hit. As for how much to budget, the amount depends on the value and location of your home. You can use your homeowner’s insurance deductible as your budget target, or otherwise for my city-dwelling clients I like to see annual savings of $5k (at a minimum) for home repairs.
Live below your means, plan your budget, and exercise spending awareness. These essential habits are important for everyone, but they’re especially important for homeowners. Because your cash flow tends to be more variable and hard to predict as a homeowner, you need more margin and awareness to ensure you’re able to adapt and stay ahead of expenses.
Don’t buy just for the tax breaks. A common misconception is that tax deductions are a major tipping point that sway the balance in favor of home ownership. That’s just not the case. Tax breaks for homeowners are now more limited under the Tax Cuts and Jobs Act of 2017. These changes are particularly unfavorable for most NYC homeowners. And while you may have a slightly lower tax bill, you’re still paying a large expense by way of mortgage interest. I recommend looking at the tax break as simply a discount on your mortgage interest. For example, if you have a $750k 30-year mortgage at 3.5%, you’ll pay about $26k in interest in the first year of your mortgage. At an effective federal tax rate of 25%, your tax break is about $6,500, reducing your $26k expense to $19,500. This by itself shouldn’t be making the decision for you.
So where do we end up? From a financial standpoint, sometimes buying makes sense and sometimes renting makes sense, and you can run your own numbers or get a professional to help you. But the best reasons to do one or the other are usually non-monetary. The decision depends on your life circumstances, values, goals, and financial habits. So before you assume you should buy (or rent), approach the decision with intentionality and take the time to work through those questions.
What I’m Reading
Are New Graduates Happier Making More Money or Having More Time?
By Ashley Whillans, Harvard Business Review
Would you rather have more money and less free time, or the other way around? That’s the choice many of us make (consciously or not) in picking our career path. Would it change your mind to know that people who value time over money are generally happier? That’s the thrust of a new study conducted on 1,000 new graduates over a two-year period.
Our results provide strong evidence that valuing time puts people on a trajectory toward job satisfaction and well-being. Why? After graduation, students who valued time over money made career decisions for different reasons. Whether they chose to enter the workforce or enroll in graduate school, they were more likely to report that they were working at something they “wanted to do” as opposed to something they “had to do.”
Interestingly, those who value time over money appear to work just as hard and make as much money — but they’re doing it in jobs they find more enjoyable.
If You Don’t Save Enough, Perhaps You Have ‘Exponential Growth Bias’
By Shlomo Benartzi, Wall Street Journal
Quiz question: If you save $400 per month in an account that earns 10% annual interest, how much will you have after 40 years? After doing the math, most people come up with $211,200 ($400/month x 12 months x 40 years x 1.10 in interest). But the actual answer is $2.5 million. That massive difference is due to compound interest — the interest on prior earnings that snowball over time to exponential growth. Human beings, unfortunately, have a tendency not to recognize this exponential growth in everyday decision-making. This results in people delaying savings (because they think they can catch up) and carrying unwise debt (because they don’t recognize how the interest they owe really adds up). So particularly when it comes to savings and debt decisions, be sure to work through the implications of compound returns — and use a handy online calculator.