[Preamble: in this post, I’m making two observations about the rent or buy debate. The first is about the common misconception that ‘owning a home’ means you don’t pay rent (having a mortgage always involves some ‘rent’ in the form of interest). The second is about a factor that doesn’t often get spoken about – what happens when you trade-up your home a few times. I hope it’s helpful. Also, I refer you to the (recently updated!) Rent or Buy calculator – which I’m still very proud of.]
Whenever you wade into the Rent or Buy argument, you almost inevitably run into the “I’m not paying for someone else’s mortgage*!” way of thinking. And then someone responds with “But unless you’re buying your house upfront for cash, then you are still paying rent.”
*or a home loan. The two terms mean the same thing.
The equivalence is something like this:
my rent = someone else’s mortgage
my mortgage = rent paid to the bank
my rent = someone else’s rent paid to the bank
And the cycle is only broken when there is no longer a home loan in the equation:
my rent = someone else’s income
But that is a lot of words. So let me try and illustrate this with numbers.
Assume a home, with a rental and a mortgage
To keep it simple, let’s say that you have the following options:
- There is a house on the market for R2 million.
- You can rent it for R10,000 per month.
- Or you can get a 20 year home loan, at 9%, with no deposit required (meaning that your monthly morgage payments would be ±R18,000).
For the time being, let’s ignore all of the other costs – transfer duties, home repairs, estate agents, etc.
The question is: of that R18,000 monthly mortgage payment, how much of that is ‘rent’ to the bank, paid as interest?
Fortunately, that’s just an amortisation table. So in the first year:
That is, in your first year of living in the house, you could either:
- Pay a total rental of R120,000 (R10,000 per month) – which might well be a contribution to someone else’s mortgage; or
- Pay rent to the bank (interest) of R178,480 – which is your own mortgage.
Of course, you would also have saved some money in home equity: R37,454.
But if you were diligent, as a renter, you could have saved: R95,934 (being the difference between the mortgage payments and the total rental).
At what point do you start to save money as a home-owner?
Over time, there is a crossover point – because rentals tend to increase, but mortgage repayments are fixed for the entire duration of the home loan.
So let me graph that for you (and I’m going to assume annual rent escalations of 5%):
Basically, you need to have lived in a place for around 6 years (in this example) before your rental payments overtake the ‘bank rental’ that you’re paying in the form of interest.
And in terms of cumulative savings?
Well, this is the trade-off:
- Renters can save all the upfront costs of home ownership (transfer duty, conveyancing, etc), the difference between the rental and the mortgage repayments, and earn a return on their savings; but
- Home-owners earn the capital appreciation on the full value of their home.
In the early stages of a mortgage, when most of your repayments are interest-related, you’ll almost certainly be paying more to the bank than you’re earning in home equity.
But over time, that also gets overtaken. So let me run with a few numbers here as well:
- R200,000 of upfront costs of home-ownership.
- Capital appreciation on the home of 4% (which is about where it stands in SA today, on average).
- Investment returns of 7.5% (I used the Allan Gray Balanced Fund benchmark).
This brings us up to roughly that 9 year mark – where renting and buying amount to roughly the same thing.
Now obviously, these variables are constantly in flux – and small differences can make a dramatic difference.
But I think that there are a few general principles that you can draw from this.
General Principles of Renting and Buying
- If you’re planning to stay in a home for a short period (only a few years), then it rarely makes sense to buy the house with a home loan.
- But if you’re planning on living in that home for many years to come, then it makes sense to buy your home.
You might notice that I have left out the ‘buy-to-let’ option – where people might buy a home initially, and then move out and rent it when they’re ready to move on.
While it’s something to consider, I’m not sure that it’s something to count on. Some people do it, and some people make it work. But just anecdotally, that particular option seems to require a lot of work for not very much upside. And all it takes is one or two months of vacancy before you’re back to square one, and eating into your savings.
What if you keep upgrading?
There is also the option of constantly upgrading your home as you need to, using the home equity from the first as a deposit for the second, and so on. Now this is dangerous – mainly because South Africa has very high costs associated with buying a home.
To illustrate this, some basic numbers:
- Assume transfer costs (all-in) are around 10% of the home value.
- Equivalent rentals are around 5% of the home cost.
- You upgrade twice over the next 20 years. So you buy a new home at the start, then in year 7 and again in year 14.
- Each time, you upgrade to a place that’s worth 20% more than the current home.
Unfortunately, this is where it’s very easy for people to make mistakes.
The ‘earn the capital appreciation on the entire value of your home’ sweetener is very attractive – but you also have to pay the transfer costs on the full value of the home upfront. Those transfer costs make all the difference – because the renter just moves house, while the home-owner gets whacked with a massive moving cost penalty (10% of the value of the new home, in this example). Hence the dips at year 7 and 14 in the chart above.
So move house a couple of times as a buyer, and you’ll rapidly be eating into your savings.
Especially here in South Africa, where home ownership carries really high costs of transfer.
This financial argument only makes sense if you’re also able to diligently save the difference between mortgages and rentals. But if we’re honest with ourselves, most of us are much better at making our home mortgage payments work than we are at putting away savings.
So if you’re a bit of a spendthrift, it’s possible that the best way for you to get your house in order is simply to buy it.
But if you’re fairly self-disciplined, then…
Commit when you’re actually going to commit
The main point is: settle down when you’re ready to settle down.
And then stay settled down.
That’ll really make your home purchase a good financial decision – and it’s one that is (mostly) within your control.