We sooner or later all have to decide if we are better off renting or buying a property. We all need to live somewhere. We need a home to bring up a family, or a place where we can be safe and where we can enjoy some privacy. But there are two ways of achieving this. We can rent or buy. Which one is the best option?
If you have arrived at the rent or buy connundrum point in your life, grab a pen and a calculator an lets look at the problem together. On second thought, I might just do the writing and the calculations for you!
Renting or buying in an uncertain future
You don't have to concern yourself too much with questions such as these:
- What's going to happen to property prices in the area?
- What's going to happen to rentals?
- Are we in a boom or a bust real estate market?
- Is there a buyers' market on its way?
People will always speculate about the state of the property market. There will always be conflicting views on the future of real estate. But there is only one fact that you can take for granted: No-one can predict the future.
You will have to accept that your rent or buy decision will be made using imperfect information. Not even those good looking people in the financial pages of the newspaper (you know, the ones with the impressive graphs and even more impressive terms for ordinary things) can have any reliable forecast of what the long-term outlook for real estate will be. And if someone really did know for sure, that information would be more valuable to them if they kept it a secret. They wouldn't tell you about it in a newspaper.
Property values in you area could rise or fall. The economy could grow or shrink. A squatter camp could appear out of the mist. Or the neighbour out of hell could come and live next door to you. You cannot control these things.
If you want to speculate about the future of property, just realise that it is just a fun excersize. Nobody really knows what's going to happen. You'll have to make up your mind regardless of the uncertainty, just like everybody else.
That said, here's a tip: Real estate tends to increase in value in the long run (it might be a very long run) - regardless of what happens in the short term.
Renting or buying and interest rates
The reserve bank's interest rates definitele influence the real estate market. When interest rates go up, house prices generally go down, and vica-versa.
Because interest rates influence property prices, many homeowners are like rabbits caught in the interest rate headlights. They get too preoccupied with the interest rate decisions of the reserve bank. What will happen with interest rates in the future is not something you can know or control. Interest rates could go up like a rocket on new years eve, or they could fall through the floor. If your mortgage loan has a term of twenty or thirty years, not even your mom will be able to give you a clue of what interest rates you might be facing.
The important thing to remember is that interest rates go up AND down. The current level of interest you would be paying should not have a huge impact on your decision to rent or buy. The total amount of interest you will pay over the mortgage term is what is important - not this month's bond repayment.
If property prices are high right now because interest rates are low, would you really be better off than someone who pays less for their house but has to pay high high interest rates? You can work out the various hose price / interest rate scenarios in a spreadsheet, if you like. But the answer is usually pretty similar.
Renting or buying and inflation
Let's not forget about the roll inflation plays. Inflation impacts your ability to repay your home loan. Here's how it works:
Inflation, if you don't know, is a rate reflecting the general rise in prices of various everyday things that we need to live our lives. For example, if a loaf of bread cost R1 last year, but you have to fork over R1.10 for the same loaf this year, we experienced inflation of 10% as far as bread is concerned. But the reserve bank has 'n "basket" of items they take into account to calculate inflation, not just bread.
If inflation is at low levels, the reserve bank will most probably lower interest rates, to give the economy a boost. If inflation is high, the reserve bank will adjust interest rates upward, because the bank has a mandate from government to keep inflation at or below a certain level.
Their logic (very simplified) says that prices rise because people can afford to pay more. Very often, South Africans will take advantage of low interest rates to loan money. They then succumb to the illusion that they have more expendible monthly income and splurge on luxuries.
By raising the interest rate, the reserve bank makes borrowed money more expensive, hoping to dissuade consumers from indulging in credit. They will then have less money to blow, so inflation stabilizes.
High inflation therefore results in higher mortgage repayments, meaning you would need extra cash each month to repay your loan. And low inflation will result in low interest rates, leaving a few rands more in your pocket to save or spend.
O, and lets not forget about the other side of the equasion: Pay rises are often related to the current inflation rate. Workers want to be sure that they will be able to buy what they used to buy with their salaries. Stuff has become more expensive, so they will insist on higher pay rises.
Now we get to a chicken or egg connundrum! What came first? Higher pay rises or higher inflation? Do interest rates rise because folks received higher pay rises? It is possible!
But what I would like you to notice is this: If inflation goes up, your salary will most probably increase accoringly, providing you with that extra cash you need to pay the higher interest repayment on your mortgage. So the interest rate is not quite as important in your decision to rent or buy.
Isn't it sweet how, even though folks may be paying more interest on their loans when rates are high, they often also get big pay rises to compensate? :lol:
Renting or buying and your accommodation budget
What you can afford to pay for accommodation? This is one of the most important factors in deciding between renting or buying.
What does your budget allow? Or have I touched a sore point there? Aaaw, go on, get a piece of paper and quickly structure your monthly income!
You need money to pay for food, clothing, entertainment, retirement savings, insurance, transport etc. How much can you afford to pay for your home?
You can decide for yourself just how much you can pay for accommodation, but a good rule of thumb (and the one banks like to use when deciding to grant you a home loan or not) is to allow no more than 30% of your income for housing. 30% of your income should provide for a comfortable buffer, if things go wrong somehow.
Once again, we cannot predict the future. But we can make plans to allow us to withstand a lot of bad weather.
We now know what you can afford, so lets carry on:
The cost of renting compared to buying
Would it be worth buying a house? Lets work it out!
You may have heard of investment "PE" or price-earnings ratios before. The price earnings ratio for an investment is simply the cost of the asset devided by the annual earnings it generates. PE is a ratio which investors use to calculate if a stock is worth buying at the current price. Well, the price vs. rent comparison is the closest thing to PE you will find where owner occupied residential property is concerned.
We want to know if it's cheaper to buy or rent. And the cheaper option is generally the better one.
Let's look at a couple of examples to get the idea:
House A
Price: R1 000 000
Rent: R5 000 pm x 12 = R60 000
Current interest rate: 13%
Interest on R1 000 000 loan for one year: R130 000
In this example, buying the house would cost more than double what renting it would cost. Here renting wins. A lot of factors would have to change before buying House A property could be considered more financially attractive than renting it.
Note: Have you noticed that we try to keep our calculations as simple as possible? We compare the rent for a year with the interest payable for a year, because it is money you cannot get back. People say rent is money down the drain, but if that's true then so is interest. It is the cost of renting and buying. Whether you're giving it to the landlord or the bank doesn't really matter, does it? It's money you'll never see again.
Use the prime interest rate for your interest calculation, because we're not taking the effect of compound interest into account here! Other factors, such as maintenance costs and property taxes in your area should also be taken into account, but in the spirit of trying to keep things simple, we are assuming that those factors don't have too big an impact.
Hey, that was easy enough, wasn't it? Let's try another one:
House B
Price: R500 000
Rent: R5 000 pm x 12 = R60 000
Current interest rate: 11%
Interest on a R500 000 loan for one year: R55 000
In this example buying is the winner, but only barely. You might have to do a bit more indepth research about the taxes and maintenance costs on this property. But buying this property would not be a bad option.
See how easy it is? You can use this simple technique to quickly work out which option would be cheaper. So, you can now esily compare renting vs. buying.
Here is another renting vs. buying calculation for you to try:
House C
Price: R 750 000
Rent: R7 000 pm x 12 = R84 000
Current interest rate: 9.5%
Interest on a R750 000 loan for one year: R71 250
Hey! What do you know? Buying wins again!
*** highlight the text to see the answers! ***
Renting or buying and opportunity cost
Yes, yes, yes! I know! We haven't taken the impact of a deposit into account.
If you haven't already, think about it: If you have a 50% deposit to put down on House A, you would pay a whole lot less interest, because the mortgage would be half the size. The interest will only be calculated on the remaining R500 000 loan.
Yeah. Unfortunately the calculation is not quite that simple, see. The thing is, if you take the R500 000 cash out of an investment of some kind, you will lose out on the income that the capital could have generated.
This is the hidden opportunity cost for investing the R500 000 in your house: If you tie up R500 000 in your residence, that's R500 000 that you can't use for something else. If the R500 000 could realistically be earning 11% during that time, the opportunity cost would be R55 000. So, this amount has to be added to the loan interest in your renting vs. buying calculation.
Renting or buying and risk
Yes, the saying says "safe as houses", but it also warns not to "put all your eggs in one basket". Investing all your wealth in a single asset is risky - even if the asset is your own home.
If something goes wrong (and they do sometimes), would you be able to absorb the loss? Flooding, fire, earth quakes, job-loss, health problems, recession, a drop in property values, etc can result in your beautiful home costing you big money.
There is also a liquidity risk when investing in real estate, because a property is not as easy to sell as say stocks. You also cannot usually sell just part of your house. You will have to sell the whole thing to get your hands on a portion of your capital.
Before you decide to buy a home, make dead sure you are willing to accept the risks.
The good news is that there are ways to reduce the risk of losing big chunks of your hard earned capital. A house can be insured against many disasters, at a relatively low fee. You can reduce some of the risks of home ownership by choosing your area and your property very carefully. And if house prices drop, they seldom drop dramatically, and if they do drop dramatically, they usually don't drop to zero, so you should be able to recoup some of your capital, or ride out the tide and wait for the real estate market to turn around again.
If you need to access some of the equity in your house, you could also make use of a mortgage, instead of selling the house just to free up a few thousand rand.
Am I renting or buying?
I am partial to buying. I'm sure you might have noticed that. But you know what? I'm currently renting!
I unexpectedly moved from Bloemfontein to Mossel Bay. I did buy my own house in Bloem, years ago. So why did I not buy again in Mossel Bay? Because my renting vs. buying calculation showed that renting is the better option at this stage. That does not, however, mean that I am not keeping my eyes peeled for the right property at the right time.
I like living in my own home. I like the fact that I can make and break as I like. I like falling in love with my home, and knowing that it belongs to me. And I especially like the fact that it becomes "cheaper" to live in your own house as the years roll by.
I will definately buy again - when it makes sense. In the meantime, I still own the house in Bloemfontein, and it is earning an income. So, I'm not loosing out on the capital growth taking place in the market.
Oh, and the extra cash flow actually looks very good on my income statements... :)
But that's me. What are you going to do? Rent or buy?
