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The Once in a Lifetime Mother of All Decisions: Buying or Renting?
At least once in life, everybody will reach the decision point whether to buy or to continue renting an apartment or house. Considering the high investment amount, potential involvement of a bank for financing a mortgage and its required long lasting commitment, it makes sense to rack your head about the pro and cons of buying versus renting real estate.
Is the dream of owning a home always the better choice - as often heard? When does it make sense to rent? How do I find out what is financially more appealing? Soon it becomes clear that the renting-versus-buying decision is a very complex one.
Real Estate Investing from Diversification Point of View
Before crunching the numbers for finding the answers to above questions, there is another important aspect to be considered: your existing asset allocation. From a risk perspective it is more than plausible that not all eggs should be put into the same basket. With regards to real estate there is a high likelihood to exactly step into that trap, except you are able to keep other assets like your securities deposit or time deposits besides financing your mortgage. If you need to liquidate your securities deposit in order to achieve sufficient level of equity, you put all eggs into one basket (if there are no other assets). Then, in case of oversupply of new real estate projects, an economic downturn (e.g., see real estate crisis in the US in 2008), rising interest rates, unfavourable changes in the environment of your property (e.g., environmental pollution, loud neighbourhood, etc.) or even regional crisis like the war in Ukraine you might experience severe price erosion.
Investments into real estate are not as safe as the "concrete gold" expression describes them. Therefore, it could make perfectly sense to consider renting and investing into other asset classes for diversification purpose.
The Cost of Financing - via Bank Loan or Investing Own Funds
When buying real estate you either pay out of your pocket or you need to finance via a bank. Either way there are costs linked to that:
Financing via a bank means paying interest rates - depending on the conditions either at a fixed interest rate for a fixed period of time or in most cases the interest rate is linked to an interest rate benchmark with a small markup. Let's do some simple maths: Apartment price: 115,000 EUR Buying costs (notary, taxes, fees, etc.): 5,000 EUR Total amount: 120,000 EUR Equity from savings: 30,000 EUR To be financed via mortgage debt: 90,000 EUR Assumed fixed interest rate: 5% p.a. Initial repayment rate: 3,0% in about 20 years the mortgage debt will be repaid at a monthly rate of 600 EUR Total amount of interests paid: 51.533,58 EUR
That's a whopping 57% of the initial debt amount of 90,000 EUR!
Investing only your own funds goes along also with costs: opportunity costs for not investing into time deposits, equities, bonds other asset classes. For a time period of 20+ years it is absolutely reasonable to consider a yield of 4% p.a. as achievable (e.g., a globally diversified securities portfolio did generate in average even around 7% p.a.). Let's do some simple maths again: Initial investment amount: 30,000 EUR Assumed yearly increase in value: 4% p.a. Total expense ratio: 0.5% p.a. Investment horizon: 20 years Total amount after 20 years: 59.496,49 EUR (even after costs!)
That's almost doubling your investment amount without doing anything - just invest/buy and hold for 20 years! At 7% yearly return you would end up with more than 3 times of your initially invested amount (105.099,97 EUR). How nice is that!
Financial Comparison of Renting Versus Buying
Now let's go one step ahead and compare renting vs. buying for the same apartment.
In below 1st scenario, every month our household has 1,000 EUR for real estate expenses at disposal (either for rental payment or financing a mortgage debt and utilities etc.). While the buyer should not forget about maintenance and insurance costs as well as other non-financial obligations (yes, property entails obligations!), the tenant does not have to care about that.
Maintenance costs will be (hopefully) lower during first years but average around 1-1.5% p.a. from the total building/ apartment costs (here: 120,000 EUR).
Money left over at month-end will be invested at 4% p.a.
In scenario 1, renting would be slightly more favourable than buying (higher value), as the initial equity of 30,000 EUR and any EUR not spent during the month is being invested at 4% p.a. The compound interest can develop its impressive effect on the investment result over a time horizon of 20 years.
In order to appease possible critics regarding lack of price increases for costs as well as value of the real estate property, in scenario 2 there are moderate rates of increase considered for disposable income (salary increases), rental / maintenance costs as well as the apartment value itself.
In scenario 2, buying would be the better option purely from an economic point of view. However, the only 2 scenarios show already that the result very much depends on how prices will develop (not only market price for the real estate property) and on the yield generated by investment alternatives. Therefore, let's run a last calculation - all else equal as in scenario 2 - with an increased yield for alternative investments: now 7% instead of 4% p.a.
The difference in total value after 20 years does speak for itself: almost 60,000 EUR more on your balance sheet when renting (440,770 vs. 384,961 EUR).
Examples above show that from purely financial point of view it very much depends on how much you have to finance, what is current and future interest level, also how luxurious you want to live (location and size of property) and what the current price level on the real estate market in the targeted area is.
Buying Versus Renting - Free Tools for Running Your Personal Scenario
To find out what might be financially more appealing for yourself, just run your personal scenario:
www.zinsen-berechnen.de offers all kind of helpful financial planning and calculation tools for free, also a specific calculator for comparison of renting vs. buying
TheUpshot from The New York Times: Running various scenarios with different input data, the interactive tool indicates which option might be more favourable.
Buying Versus Renting - Other Aspects to be Considered
Rather buy if | Rather rent if |
you are sure you want and will stay in town | you have to change location often (e.g., due to job), e.g. every 5 years |
you like to take care of your property (cleaning, painting, repairing) | you love your personal freedom (no maintaining of property - just call the landlord/lady if something got broken) and just want to use an apartment/ house |
you found the perfect piece of real estate for an attractive price and your assumption is that prices will continue to go up | you pay more than 25 times of yearly rent (equals <4% yield) ==> e.g., invest regularly into a globally diversified securities portfolio for higher return |
you can cope with the financial burden for a very long period (unemployment? divorce? illness?) and interests for mortgage debts remain low | you do not sleep well with a mortgage debt |
you do not want to diversify your portfolio | you want to better diversity your investments into different asset classes |
Disclaimer: The scenarios or investment products presented above should not be construed as investment advice. All investments involve some level of risk, and past performance is never a guarantee of future returns. As always, do your own research in order to validate and better understand the underlying risks.
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