The housing market has been a talking point for a long time. Yes, there might have been a cooling off period for a brief moment. However, mortgage financing rule changes, lower foreign investment demand combined with a large supply of new condos, and the potential for higher interest rates, have all made home buyers question the timing of their purchase.
The fact is, however, that property prices are higher than ever, and a number of people are active in the housing market. Given the current economic climate, these individuals might be considering the merits of renting versus buying. A natural approach to this decision is to evaluate the opportunity costs of renting versus buying. Considering whether you should rent or buy your home? Here are some major factors or key risks that might be applicable to a given individual and that should be considered when determining the opportunity cost.
It might be an interesting exercise to consider a hypothetical situation with a typical young urban professional; “Jamie” is currently single and looking for a place to buy or rent. Jamie has been working for four years, has no student loans and earns a salary of $80,000. He also enjoys running, skiing, and fine dining.
Jamie would like to maintain a certain lifestyle for the next five years, and is looking for a two-bedroom condo in downtown / midtown Toronto, close to work. He wants to be near popular restaurants and bars and at the centre of the action. His budget is around $300,000 (depends on the exact size, location and developers). After working for a few years, Jamie has saved $30,000. To avoid paying mortgage loan insurance, a down payment of 20% ($60,000 in this case) would be needed. Jamie's parents offer to help with a payment of $30,000 (which is more than welcome) and they charge interest on that amount at 3%.
The next step would be to determine the cost of buying the condo.
Mortgage Payment: Assuming a five-year fixed mortgage term with a rate of 3% and an amortization period of 25 years results in a $552 bi-weekly payment or $1,104 per month, plus $75 for Mom and Dad.
Maintenance Fee: This depends on many factors and will range from $350 to $500 a month. Jamie likes nice amenities; therefore, the maintenance fee is likely to be around $450 including the utilities.
Property Taxes: Sigh - one can’t forget their property taxes! In this case, let’s say it’s 0.8% of property price (this would vary based on locations). This is an additional monthly payment of $200 for property tax.
Assuming the maintenance fees covers all utility bills, Jamie needs to pay $1,829 just to keep the condo and that sounds a lot of money every month. Roughly $560 of this is capital repayment, which results in the growth of Jamie’s equity in the condo.
Instead of buying, Jamie can rent the same condo for $1,350 per month including utilities. Jamie can invest the $30,000 he has saved in the stock market or mutual funds. Instead of paying a 2.95% annual interest for the mortgage, Jamie can earn 5% from a balanced mutual fund or index products that are relatively safe. This results in almost an 8% difference in interest with renting a property versus buying. This results in a net cost per month for Jamie to rent of $1,228, namely the rent less the investment income from saving.
So the opportunity cost would be $601 ($1,829 less $1,228) versus roughly $560 of equity build-up per month if Jamie chooses to buy instead of renting for the next five years assuming no capital gain from the condo unit itself.
Should Jaime rent, or is he better off buying? According to our financial analysis, the decision is fairly neutral. Jamie would lean towards buying if property values are expected to increase above the associated cost of a resale (agent and legal fees).Any concerns with unexpected events such as loss of income, major home repairs or significant change in property tax could steer Jamie away from purchasing. Thinking beyond the five-year horizon, Jamie would also need to consider whether mortgage rates will be higher at the end of the initial fixed-rate period.
At the end of the day, buying or renting a property is a very personal choice with many emotional factors in addition to purely economic terms.
The simple financial analysis above is meant to offer food for thought for those faced with this decision. But the numbers only tell one side of the story. How one evaluates the key risks from future uncertain events and their impact will swing the decision one way or the other.
Authors: Jason Alleyne, FSA, FCIA, FIA, FRM and Fei Xie, Senior Manager, Scotiabank