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Does renting make sense?

The truth is, it does for many people.

By Karen Datko Feb 1, 2010 8:46AM

This post comes from J.D. Roth at partner blog Get Rich Slowly.

 

Writing “Your Money: The Missing Manual” has been intense. I’ve spent a ton of time researching personal-finance topics ranging from buying a car to funding a 401k to the relationship between money and happiness. My research has reinforced some of my convictions (index funds are the best investment for 99% of personal investors, for instance) but has toppled others.

One of my beliefs that’s been set on its head is that Americans are better off buying their own homes. I don’t believe that’s necessarily the case anymore.

 

Advantages to renting
In 2007, Tim Ellis shared a guest post with GRS readers about the realities of home ownership. “It’s a real shame when people are driven to get into the housing market because of misplaced notions of imagined financial benefits,” Ellis wrote at the time. I didn’t pay much attention (because I was in London!), but I now believe he’s right. Yes, homeownership makes sense for some people. But there’s no shame in renting; in fact, for many folks, that’s the way to go.

 

The housing industry is huge, and it spends a lot of time propagating certain myths about homeownership, myths like:

  • If you rent, you’re throwing your money away.
  • Owning your home is a forced savings plan.
  • Home ownership is a path to wealth.

My own research shows that over the long term, housing prices (and gold prices) barely outpace inflation. In fact, since 1926, home prices (and gold prices) have returned about 1% above the inflation rate. That’s hardly a good investment. (Stocks have averaged about 6.8% above inflation.)

 

There’s no question that buying a house makes sense for some folks, but mainly for nonfinancial reasons. Owning a home gives you stability (you’re not at the mercy of a landlord) and freedom (you can do what you want with the place). But financially, it’s not usually the best bet. (It’s true that you build equity, but you do so at a very high cost.)

In an editorial in the June 2007 issue of Kiplinger’s Personal Finance, Knight Kiplinger wrote, “It often costs less to rent. The annual cost of owning a property, be it a house or a condo, is usually greater than the cost of renting, after taxes.” And there are other advantages to renting.

 

For one, you have flexibility; you can move at a moment’s notice. For another, you’re not responsible when things go wrong. If the shower starts leaking before you leave for your vacation in Duluth, you don’t have to worry about it -- you call in the landlord.

 

Still, this is a personal-finance blog, so let’s look at some ways to examine the decision to rent or buy in a financial light.

 

Renting by the numbers
One way to tell whether it’s better to rent or buy is by checking out the price-to-rent ratio (or P/R ratio). This number gives you a rough idea whether homes in your area are fairly priced. Figuring a P/R ratio isn’t too tough. All you need to do is:

  1. Find two similar houses (or condos or apartments), one for sale and one for rent.
  2. Divide the sale price of the one place by the annual rent for the other. The resulting number is the P/R ratio.

For example, say you find a $200,000 house for sale in a nice neighborhood. You find a similar house on the next block for rent for $1,000 per month (which works out to $12,000 per year). Dividing $200,000 by $12,000, you get a P/R ratio of 16.7.

 

But what does this number mean? Writing in The New York Times, David Leonhardt says, “A rent ratio above 20 means that the monthly costs of ownership will exceed the cost of renting.” That’s a little opaque, but what Leonhardt means is that the higher the P/R ratio, the more it makes sense to rent -- and the less it makes sense to buy.

During the housing bubble, the national P/R ratio came close to 20 (and went far above that in some cities). In other words, you could rent a $200,000 house for $10,000 a year (or just over $800 per month), which is a pretty good deal.

 

The normal range nationwide is between 10 and 14 (meaning it would cost between $1,200 and $1,600 to rent a $200,000 house). During the 1990s, just before the housing bubble, the national P/R ratio was usually between 14 and 15 (about $1,100 to $1,200 to rent a $200,000 house).

 

Note: I couldn’t find any info on current price-to-rent ratios, but CNN has a table of P/R ratios for 54 American cities from the summer of 2007. These are out-of-date, of course, but still interesting to look at. Plus, the table has long-term averages.

 

Another way to gauge the cost of housing is to compare it with your family’s income. From 1984 to 2000, median home prices were about 2.8 times the median yearly family income. (In other words, the typical house cost about three times what a family earned in a year.) During the early 1970s, home prices were about 2.3 times median family income. During the housing bubble, that ratio jumped to 4.2.

 

These numbers may not mean a whole lot on their own, but they can give you some sort of idea whether housing is overpriced in your area. Plus, it seems safe to assume based on past figures that most families can comfortably afford a home that costs about 2.5 times their annual income. (So, if your family makes $80,000 a year, you can afford our theoretical $200,000 house.)

Note: I’ve shared it before, and I’ll share it again: The New York Times has a great rent vs. buy calculator that can help you decide which is best for you. Just plug in the numbers for your situation, and the calculator tells you how long it would take you to break even if you bought a house.

 

Home sweet home
Despite the results of my research, I’m not about to sell our house. The thing is, there’s more to this decision than just the numbers. As I always say, money is more about mind than it is about math. Our financial decisions have more to do with our psychology than with the numbers.

 

Kris and I are happy in our drafty old house. We love the vast yard that gives us space to grow a vegetable garden, blackberry canes, and fruit trees. We love the uneven floors, the outdated kitchen (everything’s from 1950), and the zillions of windows. It may not make the most financial sense, but there’s more to happiness than just money.

 

We’re not about to move, but you know what? If I had it to do again, I’d never buy this house. If we had stayed where we were, we’d now have just four years left on our mortgage. But knowing what I know now, I might even be inclined to rent. For most folks, renting isn’t a bad option.

 

Related reading at Get Rich Slowly:

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