Everybody needs a place to reside, but unlike some of life’s other essentials, like water or food, which are generally cheap and easily sought, the purchase of property tends to be complex and expensive. Consequently, the decisions around whether to rent or purchase property can be some of the most important decisions a person can make in their lifetime. This article explores why this is the case, looks at how a logical decision can be made, and highlights several things you need to know if considering taking out a mortgage.

Buying Vs Renting

This decision is important for several reasons. Property is generally very expensive, and the large amounts of money warrant great caution and investigation as opposed to smaller purchases, such as a TV or car, whose purchase may only take a few hours or days to research and make a decision on. The high expense means that any loan taken out to pay for a property can often take decades to repay. Property prices are generally both susceptible and contributory to broader economic fluctuations – meaning that a “spiraling” effect can occur when both the broader economy and the property market are in decline. Ultimately, the decision to buy (or not buy) can affect individuals’ net worth by potentially hundreds of thousands of dollars. A good decision, for example, may allow someone to retire early, or it could make available several hundred dollars extra per week to be spent on oneself rather than an unnecessarily high mortgage repayment.

Spiraling of the property market and broader economy happened during the global financial crisis, which showed that property values are not always as solid as the ground on which the property is built: US property prices, for instance, are still down 27% from their peak around 2007[1]. A significant fall in the property price can leave a home owner in negative equity, meaning that the loan taken out to buy the property becomes greater than the price of the property.

Long term buyers may not be concerned that the market value of the property has declined if the asset is providing shelter for themselves and their family, but problems can arise if the owner is forced to sell, which is what can happen if the owner falls into arrears on their mortgage and can’t meet the repayments. If this happens to a significant number of mortgagees at the same time (for example during mass lay-offs during an economic downturn), and they are all forced to sell at the same time, it can cause a large increase in the supply of property on the market and this can cause a significant, and often sustained, drop in the general price of properties.

Mortgage Mathematics

There are many advantages and disadvantages to both renting and buying property. For example, when purchased, a property’s occupants are not prone to being asked to leave on the whim of the landlord as renters may be. On the other hand, various econometric studies have found that those who buy their home experience higher unemployment than those who rent (controlling for other factors, such as education, age etc), which is likely due to home-owners being less mobile than renters. Transfer costs for purchasers tend to be significantly higher than for renters, in both financial terms (taxes, legal costs) and administratively. Due to the high costs involved in buying and selling property (compared to the costs of changing a rental property), renting tends to offer greater flexibility, but less security, than does buying a property.

Many of these factors are subjective, and so they will not be the subject of this analysis. Instead, it is useful to assume that a rental property is a perfect substitute for a purchased property over any given time period, that is, that someone would not mind whether they have to rent a property for a year, or whether they buy the property and move in for a year. This will allow an analysis to focus exclusively on the financial factors that distinguish renting from buying.

Upside Potential Vs Downside Risk

While some real estate bubbles burst in recent years, many economists point to buoyant markets like those of France, Australia and Canada, and claim they may be next in line to experience a property price fall. The Economist, in comparing property prices to incomes and rents, finds the Canadian property market overvalued by 71% against rents and 29% against incomes. This may indicate that the potential for a significant decrease in prices is high.

As an example, suppose an individual has no savings, and can either take out a 100% mortgage, or rent. Suppose the property is priced at $500,000, the rate on mortgages is 4% p.a., and the rent on the property is $15,000 p.a. If the individual were to take a mortgage out on the property, they would pay $20,000 per year in interest (not reducing the principle of the loan), whereas if the individual were to rent, they’d only pay $15,000. Assuming all other things are equal; renting is by far the better option in this scenario, as the individual gets the same property for the same time for 25% less.

One may raise the fair point that property prices may increase, so even if annual interest on a loan exceeds the rent, this could be more than made up for if the property value were to increase during that time, and this is a valid point, and could be a beneficial strategy if the buyer is confident that the property price will rise by enough to cover the extra money being paid in interest over rent. If, however, property prices were to fall, the purchaser would suffer the burden of an interest repayment in excess of the rent as well as the loss in property value, which amounts to a double financial blow.

Renting property VS renting money: assessing volatility

A less common but often helpful way of looking at whether to buy or rent can be to assess whether to rent the property or to “rent money” (since interest must be paid on borrowed money used to buy the property, and this is similar to the rent paid when renting a property; hence “renting money” is an equivalent way of looking at a mortgage). When renting a property, it is common for the landlord to increase rents in line with inflation, or by more if supply and demand justifies the increase, but it is uncommon for real increases in rent to exceed about 5% p.a. The same cannot be said for the changes in the interest rate, which is the cost of “renting” money.

When money is borrowed, it is done so at the nominal interest rate, which typically moves in line with the cash rate – the interest rate set by the central bank. When the central bank changes the cash rate, banks will typically pass on the changes to mortgagees: for those with fixed-rate mortgages it may take several months or years for the changes to come into effect, but for those on floating-rate mortgages the changes can take place almost immediately. Examination of the nature of the changes reveals an interesting, important, yet little known fact about the changes in the cost of renting money (i.e. the cost of the loan): that it can be significantly more volatile than the cost of renting the property.

With little notice, the central bank can increase or decrease the cash rate, which in-turn causes banks to increase or decrease their prime lending rates, meaning that the amount that mortgagees have to repay on their mortgages increases or decreases. The central bank reviews rates periodically, and rate changes can take effect almost immediately following a change. The Bank of Canada, for example, changed interest rates from 2.5% in August, 2005 to 4.25% in May 2006.

These changes may sound small, but the impact on a typical mortgagee with a $300,000 principle and a twenty-year amortization term (assuming mortgage rates 1.25% higher than the cash rate – this is known as the interest margin – the money that a bank makes on the loan) would equate to an increase on their monthly repayment of $285 – from $1,778 to $2,063 – an increase of over 16%. For those with larger mortgages and longer amortization terms, the increase is even more pronounced. Not only is this a substantial increase, but the change can occur quickly; for floating-rate mortgages the changes can take place as rapidly as the changes in the cash rate.

Weighing it up

When making potentially the biggest financial decision of a lifetime, it is important to understand the impact that changes in the economy (including interest rates fluctuations and property price movements) can have on your overall situation, including the impact on cash-flows, and on overall net wealth. Making the right decision as to whether to buy or hold off and rent can have a substantial impact on the standard of living you enjoy now, and into the future. Always consider consulting with your financial advisor before making major purchases.

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