Buying vs Renting (warning long post)

jamesmorgan

I have read quite a few articles on which is financially better – to rent or buy, but always have a concern that the author has a vested interest. Recently my daughter who graduated this year expressed a desire to buy a house as soon as possible as she saw renting as dead money. My initial reaction was positive, partially as it echoed my own thoughts 30 years ago when I bought my first house a year after graduating (a decision I have never regretted). However, this decision was based on a simple gut feel that buying must be better than renting. I never did any proper financial modelling. Now, thirty years wiser I also recognise that there is a lot of dead money in buying (mortgage interest, repairs etc) so I thought it would be useful for me to try to pass my advice onto my daughter through a proper financial model.

As with all financial models, the key aspect is the assumptions made. Anyone with knowledge of compound interest recognises that a small difference in an assumption can have a massive impact after 20 years. For this reason I tried to document all assumptions as fully as possible. The other key point is that this exercise only looked at the financial aspects of the decision. For me personally, the non-financial benefits of buying (security, authority) greatly outweigh the benefits of renting (flexibility). Finally I tried to present the result as making a bet on one of two possible outcomes. I have always used this approach to simplify decision making. I first came across it with endowments, when my financial adviser explained that taking out an endowment was making a simple bet that investment returns (after costs) would exceed mortgage rates.

Scenario:

Option 1, buy a house (worth £120K in today’s market). After 7 years sell and buy house2 (£150K in today’s market). After 7 years sell and buy house3 (£180K). After 7 years, sell and analyse money kept from house equity.

Option2, rent exactly the same house as would have purchased above, changing house every 7 years. Any money saved from renting is invested in a low cost tracker held in an ISA. At the end of the period analyse money held in ISA.

Assumptions:

a) HPI = Wage Inflation = 3%

This is probably the biggest assumption. Over the past 25 years, HPI has been approx. 4.4% (source Nationwide, average HP £57K 1988 vs £167K today) and wage inflation 3.9% (source ONS, average salary £8853 in 1988 vs £23244 today). These compare with RPI of 3.3% over the same period. However, I think over the next 25 years we will continue to see downward pressure on wages due to competition with emerging markets. I also believe that HPI has been able to run higher than wage inflation for 2 reasons – the move towards using 2 salaries to buy a house rather than one, and a decline in interest rates. I think these two factors have now stabilised and over the long term HPI will be driven by wage inflation.

b) Mortgage interest rates = 5%

Having lived through the interest rate volatility of the 1990’s, I have always tried to minimise risk in this area by using 5 year fixed rates. Over the last 20 years, 5 year fixed rates seem to have been around 5% - sometimes a little higher and sometimes a little lower (currently around 4.5% for a 90% mortgage)

c) Rental yield = 6%

This seems to reflect most recent reports and also ad-hoc comparison of local rents in comparison with local house prices.

d) Investment returns = 7.2%

This assumes market growth of 7.5% (derived from 2.5% inflation, 2.5% growth and 2.5% dividends) and a TER for the tracker of 0.3%

e) House moving costs, solicitor (buy) £350, solicitor (sell) £350, survey £500, Mortgage Fees £1000, Stamp Duty 1%, EA Fees 1.5%

All fees grow in line with wage inflation

f) Rent moving costs, letting fees £350, deposit loss = 33% of deposit

All fees grow in line with wage inflation

g) House maintenance = 1% of current house price

This seems to reflect best practice and my own experience. House maintenance includes all repairs, improvements and servicing that a landlord will normally be responsible for on a rented house.

h) Other housing related costs (eg removal, life insurance) are the same for renting or buying

This is perhaps over-stated for the renter, but I’ve assumed that the renter and buyer live exactly the same lifestyles.

i) House1 is purchased with a 90% mortgage. The renter uses this deposit as their first payment into their investment fund. House2 is purchased with equity released from House1 and any capital paid off from Mortgage1 (approx. 17% after 7 years). House removal costs are derived from savings over the 7 years. The renter uses the difference in removal costs as another payment into their investment fund.

Results:

After the 21 years, the house buyer has built up £201K in equity in their house (the house then being worth £334K). In the same period the renter has built up £72K in their investment account. Parity between the 2 approaches comes if HPI is 1.2%. Buying a house is financially better than renting is placing a bet that HPI does not exceed 1.2% over the next 20 years.

For UK HPI, I believe the standard deviation is around 7.6%. Put this another way, for any given year you can be 95% confident that HPI will be between -12.2% and 18.2% (assuming a mean of 3%). Alternatively over a 20 period, you can be 95% confident that returns will be between -0.4% and 6.4%, or you can be 68% confident (ie 1 SD) that returns will be between 1.3% and 4.7%. In 16% of cases, returns are lower than 1.3% so the renter 'wins' over the buyer.

One of the risks with buying your own house is if you need to move more frequently. I therefore re-modelled with moving more frequently than 7 years. It is only if you need to move more frequently than every 2 years does the renter win.

Conclusion:

Overall I can recommend to my daughter that she is more likely to be a financial winner buying than renting. The easiest comparison I made was that it was like rolling a dice. If it comes up with a 6 the renter wins; all other numbers the buyer wins.

anselld

You feed in a lot of assumptions into a mathematical model and you have got ..... an assumption! The assumption is mainly driven by what future house prices and interest rates will be, which nobody knows.

I would personally agree it is better to own than to rent in the long term, unless your priority is mobility, but I don't think you can prove it convincingly.

martinsurrey

I agree with your result, but like everyone one I guess I would have some differrent assumptions.

main one being investment returns, I cant see ISA returns being 50% higher than mortgage rates, over the long term unless you have some seriously risky assets in it, in which case you are ignoring that risk.

but I agree that the way the UK market works ATm, buyers win unless the market tanks long term.

Kynthia

I applaud your intentions to not just assume that buying is better than renting but to actually consider the numbers. Also I agree with you that long term buying is usually finacially better than renting. However I'd be really interested in an analysis that looked at whether those in their 20's should buy or rent.

This is more of a short term analysis and would include many more non-financial factors and assumptions. Personally both my husband and I bought flats in our mid 20's, and after 7 years I sold at the buying price and after 10 years my husband is only getting £5k more. You are less likely to have more than a 5% deposit at that age meaning higher mortgage interest rates and more chance of negative equity. You are more likely to want to relocate for work or due to meeting a potential life partner meaning you need to sell quicker than expected or take the risk of letting the property. You are also more likely to outgrow your property due to having bought a flat but now have children. They are more likely to buy with a boyfriend/girlfriend they haven't been with for more than 2-3 years and then split up causing difficulties. Also many would rather have freedom in their 20's to use their money to travel, socialise and have the freedom to live other places. Obviously all if this doesn't apply to everyone but peoples' live probably change the most between 23 and 33 and perhaps many would be better off with the flexibility of renting while saving to buy a house in their early 30's.

franklee

I agree with Kynthia.

Why oh why is it so common for people to model this over 20 years as if people have to choose renting OR buying and stick to it?

The transaction costs of moving house as an owner are far higher than as a renter. There's stamp duty which in the south would be way more than your figures, after 14 years I'd expect to have been in a property well above the 250K stamp duty threshold. So if the person is likely to move in the short term then rent. If they are going to stay put for the long them then buy. If your daughter chooses to rent there is no obligation for her to sick to that one choice for 20 years!

jamesmorgan

franklee wrote: »

Why oh why is it so common for people to model this over 20 years as if people have to choose renting OR buying and stick to it?

The advantage of modeling over a longer time span is that you can see over a year by year basis the difference between buying and renting. After 4 years, both are almost exactly the same. The real benefit from buying comes from the gradual payment of capital. After 20 years the buyer is paying £900 in mortgage costs vs £1600 for the renter. However, this benefit only comes after buying for a long time period. If you delay the purchase for 10 years, then you have to wait a further 20 years before you see the same returns.

It is a bit like pensions - the earlier you start the bigger the benefit. However, this needs to be balanced with higher costs if you move frequently. Whilst the model shows the buyer still makes more money than the renter moving every 3 years, a safer approach would only be to buy if you plan on staying there for at least 5 years.

Brock_and_Roll

I prefer to use my "gut-o-meter" - the floatation of Foxtons this week for £600m is IMHO as good a sign of the top of the market as you are likely to get!

franklee

jamesmorgan wrote: »

One of the risks with buying your own house is if you need to move more frequently. I therefore re-modelled with moving more frequently than 7 years. It is only if you need to move more frequently than every 2 years does the renter win.

jamesmorgan wrote: »

Whilst the model shows the buyer still makes more money than the renter moving every 3 years, a safer approach would only be to buy if you plan on staying there for at least 5 years.

For a property of say 300K, the rent would be say 1,000pcm where I live (typical rental yields here are 4%). The stamp duty on that property is 9K. The estate agent fees to sell would be say 1.5% or 4,500. Paying that again after just three years isn't cheaper. I repeat for owning that property for just three years I'd have to pay thirteen and a half thousand pounds on stamp duty and agent fees alone, more than a years rent. If you want the dead money that's it.

I suggest your arguments are flawed as they take the messy complicated thing that is life and simplify it into a restrictive model. It is overly relying on HPI which varies widely. Your average covers up a decade of practically no HPI (even falls) preceeded by a boom. The timing of the market is going to make a vast difference. I especially disagree with your two year claim I've quoted from your OP.

I suggest your daughter should look at what she needs the next property for and choose appropriately to that. Renting while young free and single can be a good idea. You haven't even considered her lodging in a house share which can be an excellent way for a young person to live flexibly and save money towards a deposit to buy when she is ready to settle down.

stereohaven

Fascinating maths, way beyond what I can understand I'm afraid.

All I know is that to buy the modest house I rent I would need to find £26k deposit, the best part of £8k in stamp duty and an additional £500 per month over what I pay in rent to cover a repayment mortgage.

I cannot move to a cheaper part of the country for family reasons and I cannot buy anything smaller than we already have, so I don't need sophisticated financial modelling to tell me that buying instead of renting isn't going to happen any time soon, if ever at all, regardless of what is "best value".

Life and it's differing family circumstances cannot be replicated in a spreadsheet I'm afraid.

franklee

I agree stereohaven. Where is the OP's daughter who graduated this year going to get the deposit money from? What salary will she need to afford a house as a single person on her own? What salary multiple will she need to borrow?

In looking at house buying with the same analysis as an investment the OP is failing to differentiate between investment and debt. If the daughter falls on hard times and can't keep up the payments into the investment ISA she can stop paying. However if she's in mortgage debt that option isn't available she needs to keep paying the mortgage through bad times as well as good.

The OP assumes the house buyer can always sell up and cover her costs, a risky assumption when the consequences of repossession are so far reaching. The OP ignores we are in uncharted waters as interest rates of 0.5% base rate are unprecedented so we do not know how that will unwind. I'd suggest anyone buying needs to be sure they can afford the debt and can weather any house price drops that may occur when interest rates return to a more normal 5-6%. The house price to salary ratio is still alarmingly high, the market has been propped up by low interest rates. I'm not saying prices will drop, I'm saying the buyers needs to accommodate the risk they might.

jamesmorgan

Many thanks for the various items of feedback so far - I welcome them all. The main point to stress is that having a financial model doesn't take away the decision making process from her, but it enables her to make it with more knowledge. She can also very quickly change assumptions and see the impact on the model. If she is likely to live in an area where house prices are £300K and rental yields 4%, she can plug this into the model and see that rental is likely to be a better long term prospect than buying.

Based on the current assumption of where she is likely to be living (Midlands) the model projects that she is better off buying and the sooner she makes this decision the better off she is. Based on this information she can plan her home owning strategy. She thinks it will take about 3 years to save the required deposit etc for her first house. This is only achievable if she makes sacrifices over those 3 years. She is currently living in relatively cheap accommodation which will enable her to save the required money. She believes this type of sacrifice is worth it, but only if she can see the financial benefits from home ownership. Many of her peers are spending more of their salary on renting. This gives them a higher standard of living now, but delays (possibly indefinitely) their ability to buy their own house.

The key point in sharing my original post, was not really to highlight the answer (and as many posters have rightly pointed out, this depends very much on the assumptions you make), but to share the process. The new generation are going to face a tough time regarding home ownership decisions. My generation felt comfortable making decisions based on gut feel. I think we need to help the next generation with as much support as we can to make informed decisions and in particular to understand the risks associated with whatever decisions they do make.