Should You Buy Or Rent Your Home?

This article appeared in the September 1992 NAPFA News. NAPFA is the National Association of Personal Financial Advisors. The program used for the analysis is no longer available, but my Buy vs. Rent spreadsheet is. Note that I’m not a financial advisor.

The largest purchase most individuals will ever consider is a primary residence. Home prices in many areas of the United States increased dramatically during the previous two decades, but the 1990’s have been different. However, many people still decide to buy for an increased quality of life. They should know how much more (or less) this costs compared to renting. The first part of this article describes a framework for quantifying the costs of buying vs. renting. The second part covers an example using a commercially available software program.

Let’s start with the more straight-forward cost of renting. You might be renting your home for $900/month and expect the payment to increase by an inflation factor of 3.5 percent each year. One way financial analysts get a handle on the cost of future liabilities is to ask the following question: “How much must I set aside today in an interest bearing account, so that I can cover my future costs when they come due?” This is finding the Net Present Value (NPV) of those costs. The interest rate is called the discount rate, because the future costs must be reduced (discounted) to the amount needed in the account today. Clearly, if your discount (interest) rate is higher, you will need to set aside less to meet future liabilities. Also, if your future cost is 20 years from today, you would set aside less money than for an obligation of the same amount 5 years hence, since there is more time for your account balance to grow.

This raises the question of which discount rate to use. Keep in mind that you will want to use one that represents what you can earn AFTER you pay your taxes. The time horizon, not only affects how long your money will have to grow, but also the interest rates you can receive (5 year US Treasury Notes generally pay more than money market funds). This implies using a different rate for each year’s costs. For example, discount the rent due in three years by the after-tax three year US Treasury Yield, since you can set aside money today and let it grow for three years.

The cost of buying is more complicated because of the tax implications and leverage, but the concept is generally the same. What do you need to set aside today to cover your down payment and closing costs, along with future debt service, property taxes, repairs, insurance, etc.? These liabilities would be reduced by the additional tax benefits from owning a home.

When you sell your property, you will receive a large sum. This is factored into the NPV cost analysis. The assumption is that you can borrow against the future sales proceeds to pay earlier liabilities. This reduces the NPV amount you need to set aside today. If you were to set aside the NPV in an interest bearing account, your balance would go to zero years before you sold. At that point it would be necessary to pay for the costs with other funds. In effect, you would be borrowing from yourself to receive the future sales proceeds.

The following example uses the HOMES: BUY or RENT software package, available for $29 from Real Estate Consultants in Paramus, NJ (1-800-289-6773).

The factors which can affect the buy vs. rent analysis are shown in Figure 1. This table was derived from the program’s Input Screens.

Inflation Rate is applied to Alternative Rent, Home Repairs, Standard Deduction, Itemized Deductions (non-property related), and the programmer specified .315 percent annual property insurance.

The Opportunity Cost is the discount rate (not to be confused with Price Discount). The program allows only one rate to be entered. As an alternative to entering the after-tax US Treasury Yields from one to five years, I used the 2 1/2 year rate (approximately four percent after taxes). This favors buying, since the low Opportunity Cost means your 5th year sales proceeds could not have earned a particularly high rate of return if you had them to invest earlier. Note that I am avoiding volatile Opportunity Cost investments such as stocks, since the returns are not stable enough to keep a roof over one’s head.

The Income Tax Rate to use is your marginal rate. The 28% in the example does not include state income taxes. This is the tax paid (saved) on the last dollar earned (deducted). However, a blended rate would be more appropriate if a significant portion of the additional deductions gained from buying offset earnings taxed at a lower rate. The program takes into account that you will probably lose the Standard Deduction when you buy.

Figure 2 shows the resulting cash flows from the inputs. The net after-tax cash flows for Buy and Rent are shown on the lines labeled 36 and 37, respectively. The NPV (using the input discount rate) of the Buy cash flows is $53,503. The NPV of the Rent cash flows is $51,426. It is more favorable to rent by $2,077. I haven’t shown it, but the program reports this as a negative number, indicating you should rent. I will refer to it as the NPV Benefit (of buying).

Most of the numbers are fairly straightforward with the exception of the $2,622 Tax Savings (Line 7). 1992’s total tax benefits (realized in 1993) are equal to the tax rate (28 percent) multiplied by the sum of the following: points (deducted and paid in the first year); loan interest; property taxes; and non-property related itemized deductions [$4,302 = .28 x ($2,400 + $10,466 + $1,500 + $1,000)]. A downward adjustment of 28 percent multiplied by the standard deduction is made to arrive at the tax savings [$2,622 = $4,302 – .28 x $6,000]. No adjustment is made if the non-property related itemized deductions are greater than the standard deduction.

Capital gains taxes on sales proceeds are assumed to be deferred long enough to have a negligible impact. If this is not the case, the appreciation rate can be adjusted so the Sale of Property item (Line 10) equals the after-tax proceeds. Also, a six percent sales commission is assumed.

The program generates what-if scenarios on 14 of the input variables. For instance, you might like to know how different appreciation rates (0%, 1%, … 11%) affect the NPV Benefit. Depending on the computer you have, this could take several minutes, but it is useful to see how sensitive the NPV Benefits are to various factors.

It’s not necessary to generate all the what-if scenarios to see how changing inputs affects the analysis. A special feature allows view changes in the NPV Benefit on the right half of the screen as you change inputs on the left half.

Millions of people decide whether to buy or rent based on non-financial reasons. An increased quality of life is a great reason to buy a home. Unfortunately, many use so-called gut instinct to say the purchase also makes sense financially. Tax benefits and appreciation are frequently mentioned. I believe the Net Present Value (NPV) framework for quantifying the costs of buying vs. renting provides the conceptual tool financial advisors need to explain what’s really going on. The availability of an inexpensive software program to do the analysis makes it easier to provide this service to clients.

Figure 1

DATE TO BEGIN CALCULATION 1992 Year Opportunity Cost 4.00%
JAN Month Year You Plan to Sell 1997
Income Tax Rate 28.00%
PROPERTY: Itemized Deductions $1,000
Price Discount 0 (Non-Property Related)
Purchase Price $150,000
Property Tax Percent 1.00% ECONOMIC:
Property Tax Increase/yr 3.00% Inflation Rate 3.50%
Home Repairs (yr 1) 1.00%
Appreciation Rate 3.00% USES:
Lender: Loan Origination Fee 750
FINANCE: (1=conventional; 2=variable interest) Appraisal & Credit Rep 250
Loan Type 1 Inspection Fee 75
Year 1992 Document Preparation 125
Interest Rate 8.75%
Number of Points 2 Title: Title Search 400
% Downpayment 20.00% Title Insurance 400
Loan Period (Yrs.) 30 Transfer Tax 0
Recording Tax 300
Your Std. Tax Deduction $6,000 Expenses: Survey 125
Alternative Rent $900 Other 0

Figure 2

Year: 1992 1993 1994 1995 1996 1997
4 SOURCES: Down Payment $30,000
5 Construction Loan $120,000
6 Land Loan $0
7 Tax Savings $0 $2,622 $1,892 $1,830 $1,765 $1,696
8 Company Reloc. Contrib $0
9 Your Savings $5,298
10 Sale of property $0 $0 $0 $0 $0 $163,458
12 TOTAL SOURCES $155,298 $2,622 $1,892 $1,830 $1,765 $165,154
14 USES: Land $0
15 Construction/ purchase $150,000
16 Lender: Points $2,400
17 Loan Origination Fee $750
18 Appraisal & Credit Rep $250
19 Inspection Fee (new home) $75
20 Document Preparation $125
21 Title: Title Search $400
22 Title Insurance $400
23 Transfer Tax $0
24 Recording Tax $300
25 Expenses: Survey $125
26 Other $0
27 Property Tax $0 $1,500 $1,545 $1,591 $1,639 $1,688
28 Property Insurance $473 $489 $506 $524 $542 $561
29 Mortgage Insurance $0 $0 $0 $0 $0 $0
30 Pay off loans $0 $0 $0 $0 $0 $114,827
31 Debt Service on Mortgage $0 $11,328 $11,328 $11,328 $11,328 $11,328
32 Home Repairs/ Assoc. Dues $0 $1,500 $1,553 $1,607 $1,663 $1,721
34 TOTAL USES $155,298 $14,818 $14,932 $15,051 $15,173 $130,126
35 YEAR 1992 1993 1994 1995 1996 1997
36 CASH FLOW BUY ($35,298) ($12,195) ($13,040) ($13,220) ($13,408) $35,028
37 ANNUAL RENT $0 ($10,800) ($11,178) ($11,569) ($11,974) ($12,393)
38 CASH FLOW BUY MINUS RENT ($35,298) ($1,395) ($1,862) ($1,651) ($1,434) $47,421