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Renting versus buying a home

Renting vs. buying a house is a major consideration for many people. In this video we break down the considerations that go into calculating whether renting a house or buying a house is the best choice for someone. Created by Sal Khan.

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Video transcript

Narrator: What I want to do in this video is give ourselves a framework for thinking about the rent versus buy decision for a home. The key takeaway I hope you have after this video is there's not just a simple right answer, that it's always better to rent or that it's always better to buy. For full disclosure, I own a house and I bought it for a whole series of reasons, some of them emotional, some of them potentially economic. It depends on your personal context, where you are in your life, and what part of the world you live in, and what the economy is doing at that moment, and what rents are versus what housing prices are. Hopefully this video will give you a framework for at least how to think about them. Let's say this house in on the market, and it's on the market for rental at 1,500 a month. 1,500 per month, which is the same thing as 18,000 a year. 18,000 a year; so, that's one option that you have. Let's say there's an identical neighboring house that's on the market for sale, and you are in a position to buy it. Let's say that house is $400,000, is the price that you can get it at. You don't have $400,000, you're going to have to borrow some money. You saved 100,000 for your down payment. 100,000 down payment. Down payment. You're going to have to take the remainder out as a loan. You're going to take out a 300,000 loan. Now, a traditional mortgage, one that has a fixed term; maybe it's a 15 year fixed mortgage, or a 30 year fixed mortgage. Every month you pay your mortgage bill, and some of it goes to, in a traditional mortgage, some of it goes it towards the loan and some of it goes to pay down the interest, and the rest of it will go down to pay down the loan. For example, let's say that your mortgage payment is 1,800. 1,800 per month. Early on it might be disproportionately interest. It might be, say, 1,500 a month in interest and $300 to actually pay down your loan, to actually pay down this $300,000 loan, and then as that loan is paid down near the end of the term of your mortgage it might have gone the other way where each month you're paying much more to pay down your loan. Maybe by that time it's 1,500, and the interest, since it's interest on a lower amount by that much because you've paid down the loan so much, your interest might be lower. This would be a traditional process of a traditional mortgage. To simplify our analysis, I'll assume that you're taking an interest-only loan; a loan where you're only required to pay the interest portion of it, and you could pay down your loan as you want to. Let's say that this is interest-only. This is going to help just simplify things, and obviously if we want to get really detailed we'd probably have to get a spread sheet out to really analyze things and see how the interest payment changes as we go through the life of the loan. Let's assume it's interest-only at 6%, 6% interest. Interest-only at 6% interest. That means on an annual basis, you're going to pay 18,000 in interest. 18,000 in interest; 6% of 300,000. 18,000 in interest. Now, depending where you live and what your income level is, in a lot of places, you can deduct mortgage interest from your income, so this doesn't mean that you get all of the 18,000 back, this is saying if you're making 100,000 a year, instead of paying, say, 30% on 100,000, you're now going to pay your taxes on 100,000 - 18,000. Your taxable income would go down to 82,000. You'll save, roughly, your tax rate as a percentage of this. Let's say you save, roughly, a third of this on reduced taxes; so, that's reduced taxes. So, your effective interest that you're paying after the tax break, let's say it's $12,000. $12,000 is out-of-pocket, or the effective. Effective cost of interest. Cost of interest. We're not done; we know that there are costs of home ownership. You'll have to pay, usually, some type of property tax. Let's say it's 1% property tax. 1% of 400,000 would be 4,000 in property tax. Property tax. You, of course, have to upkeep the house. Maybe you have a gardener. maybe you have to repair things, you get things painted; who knows what it might be. These are things that you usually would not have to pay if you are renting; so, let's say, although it might be different, once again, depending on the situation. Let's say there's 2,000 a year. 2,000 per year in upkeep. In upkeep. Now, the reason why I listed all of these things, and obviously we can go into more depth and more detail and think about other things that are more particular to different circumstances, but this is a list in either of these cases, are the things that are essentially are going out the door. If you're renting, that $18,000 a year, that's just going out the door; that's what you have to pay for the benefit of living in this house. If you buy, things that are just going out the door are your effective cost of interest, your property tax, your upkeep. This will all add up to, let's see, 4,000 + 2,000 is 6,000 + 12,000 is 18,000. 18,000. Just like that, it looks like our annual costs that are just going out the door, given the assumptions, in every different circumstance you're going to have different assumptions, so this is just a framework. Your what's going out the door is $18,000 a year in either case. But, we are not done yet. In this case, we didn't even talk about what we're doing with our $100,000. Over here we had to use it for our down payment. Over here we still have $100,000 invested. 100,000 invested, so we're going to get some income from this 100,000 that we wouldn't have gotten here, and it depends what we're doing with it, if we have it in a really safe bank account, maybe we're getting 1% or 2%, but maybe we're investing it in a portfolio of things and getting 4%, or who knows what we're doing here, but we need to think about what we could have gotten from that down payment; from investing this incremental money. Let's just say, for the sake of argument, that you get a 2% return. At 2% annual return; so you're getting $2,000 in investment income. Investment income, from that $100,000. Your actual out-of-pocket, if you were to net your income benefit that you didn't have to, or the investment return that you didn't have to use up on the down payment, that netted against your rent and now you're 16,000. Now you're 16,000 out-of-pocket. 16,000 cost per year. Now, the way that I rigged the numbers for this video, it turns out that for this individual, purely on the economics, purely for this year, as we'll talk about in a few seconds, things might change in the ensuing years, but purely for this year, if we can assume these numbers, it actually might make sense to rent a house. Of course, this analysis completely changes depending on how these numbers change; if this house were cheaper, if you got lower interest, whatever it might be, and all of a sudden, this number might look better. If the rent was a lot higher, this number would look, similarly, would not look as good. If your return on investing weren't that good, this number would be higher and it would not look as good. The key thing to realize is just try to analyze what your actual out-of-pocket costs are. Well, look, just psychologically, when I'm doing this mortgage, at least it's forcing me to save; and that's true, it is a forced saving that's happening here. But, in theory, you could do it here. The equivalent amount that you would have paid for interest, or the interest portion of your loan, that's your rent, and above and beyond that you could just save that $300 a month, and put it into your investment pool, and after 30 years, you might very well have a good amount of money there collecting a lot, or generating a lot of income. There's no very clear-cut answer that renting is always better than buying, or that buying is always better than renting. It really depends on the circumstances. This is a back-of-the-envelope version; in future videos we'll do a more in-depth version. But, other things that we should think about beyond just the numbers are the intangibles. Let's just think about those in a second. Let's think about the intangibles that favor renting, and the intangibles that favor buying. The biggest reason, and this is why we bought a house a few years ago, is for buying their stability. There is stability. You might get a great deal on a rental, and the owner takes care of it, and it's in a great neighborhood, but maybe they want to rent it out to someone else or maybe they want to move into the house themselves and then you've got to move. If you buy a house, as long as you pay the mortgage, or you pay off the house eventually, you're pretty much, and you can pay the property taxes and things, you're pretty much guaranteed that you can stay there. Another reason that you might want to buy is rents are unpredictable; rents could go up. Rents could go up. If you're in a really rapidly rental appreciating market, say, some place like Manhattan or San Francisco, it's nice to be able to say, "Oh, look, I got "a fixed mortgage payment; this is what I got to pay. Once I pay this thing down, I don't have to worry about the craziness of what rents might do because the economy is, because so many people want to live wherever your house might be." Then, another thing, and once again, this isn't an exhaustive list, is that you can customize, and you can make improvements. Back when my family was renting, I can't tell you how many places we saw that looked really nice if they had just changed this bathroom a little bit, or if they just changed that kitchen a little bit, or if they did not paint that one wall yellow. When you buy a house you can make those same improvements. All the intangibles aren't just on the buying side. They could also be on the rental side. If you're just settling down in an area and you want to figure out the lay of the land, you might not want to commit to one neighborhood or one house without understanding things better, so you might want to have the flexibility. Flexibility of renting. To keep buying and selling houses, there's a lot of costs involved, especially when the cost of the brokerage fees and whatnot; so, you might like the flexibility, you get into a 6 month lease, 1 year lease. Once you understand things, then you might want to buy a house or then you might want to rent in another neighborhood, and as we saw earlier in the 2003 to 2008 period, sometimes you have housing bubbles, and sometimes these economics go way out of wack and housing is just over-priced. Housing over-priced relative to Housing is over-priced relative to rent. Once again, big takeaway, it all depends on the context. Hopefully this gives you a little bit of a framework for thinking about the rent versus buy decision.