Whether to Rent or Own a House. How to Decide?

Intorduction

In personal financial planning, one of the most important decisions to make is whether to rent or own a house. If you decide to own a house, the second question is when or at what stage of your life or financial journey? Since constructing or buying a house, in a majority of cases, is going to be the biggest expense to be incurred, it merits a lot of deliberation and forethought. This single decision holds the potential to substantially alter the course of your financial life, for better or for worse.

The purpose of writing this blog post is to suggest a way of thinking to be followed while taking this important decision. No decision is good or bad in absolute terms. What makes it good or bad is the way you take it, relative to your situation and priorities in life.

Is it Must to Own a House?

There is a broad consensus on the issue that owning a house, at some stage in life, is a must and sooner is better. There are many reasons for this strongly held opinion. These reasons can be social, psychological, cultural, or financial. Some are listed here briefly:

Any asset that has linkage with land is considered very safe. (psychological)
In financial terms, physical assets are believed to be safer and more reliable as compared to digital or virtual assets. (financial)
It is perceived that the only reason someone is not owning a house is that he can’t afford it. It can’t be out of choice. (social, cultural)
Owning a house is a substantial part of our social stature. (social, cultural)
Living in a rented accommodation is restrictive with regard to some of our choices. Although, in some other ways, owning a house is also restrictive. (social, psychological)
While deciding to own a house, financial considerations tend to take a backseat and social reasons are likely to override. We are easily given to believe that paying a financial cost of our social choices is easier than paying a social price of our financial choices. (social, financial)

Important Factors to be Considered

Let us first list down the important factors which should be considered while making this decision. These factors are as under:

Your financial net worth.
Your priorites in life.
The market situation.

Now we can discuss these factors in detail.

Calculate Your Net Worth

The starting point of the decision-making process could be to know your net worth.

Make a list of all the assets you own. This should include the entire cash, jewelry, expensive items, automobiles, bonds, shares, property, and any other asset. Write down the approximate market value of each asset and calculate the total value. This is your financial net worth. You should keep updating it periodically. This can be useful in many ways.

One way of using it is to compare the sum of approximate cost of the house you want to own, your automobile(s), and the jewelry in your possession to your net worth. Notwithstanding how much is your net worth, this is a litmus test of your financial health. If all this put together is less than 20-25% of your net worth, you are in a comfortable financial position and can plan to retire soon. On the contrary, if all the elements mentioned above are more than 70-75% of the net worth, your financial health is not good and your retirement is going to be delayed indefinitely.

This way of thinking can help you take a pragmatic decision with regard to owning or renting a house.

Owning a House, Now or Later

A question may arise here that if one has to construct or buy a house, why not do it earlier because, with the passage of time the prices of land, construction material, and labor charges are going to rise or the money allocated for this expense is going to be less worthy due to inflation.

A safe assumption to make here is that, historically, property (especially housing) prices appreciate in tandem with or slightly more than inflation. There might be some sharp spikes but they tend to even out in due course. Good businesses, of which real estate is only a raw material, can potentially grow faster than property prices. Therefore, if you postpone your decision to own a house for a considerable length of time, at least 10 years, and invest your money in some good businesses, not only that you can beat inflation but you can earn substantial profit as well.

Smart capital allocation on a long-term basis can be extremely powerful. Big decisions in your financial journey should be viewed from a capital allocation perspective.

Priorities in Life

If you are the kind of person who accords a very high priority to owning a house as early as possible, due to some or all of the reasons mentioned above or some other reasons, you must own a house immediately. Of course, you will have to manage to pay all the associated financial costs.

If your priority is financial stability first and then owning a house, you will look at this issue differently. You will have to juggle with your priorities and see at what stage you can own a house.

If you are comfortable both ways i.e. renting as well as owning, you will take a decision purely on its financial merit. In this case, the market dynamics are central to the decision-making. In some countries owning a house makes more financial sense while in others renting is preferable.

How to Think from Market Perspective

When you decide to own a house, whether through buying or constructing it, financially speaking, you are making an investment. Although this is your own house and you are going to live there, it is very useful to think how much return you would be getting every year if you had rented it out. This is equal to the average rental market value of the house which you can find out easily. By comparing it with the total cost of your house you can get a ratio or a financial number i.e. annual return on investment or ROI (annual rent that you can potentially earn from your house, divided by the total cost incurred on the house, expressed in percentage terms). By inverting this ratio, you can get another number which is called price to earnings ratio or P/E ratio. This ratio is not expressed in percentage terms.

You are now in a position to know how much your house is earning vis-a-vis other options available in the market. This simple process will exactly let you know whether renting or owning a house makes more financial sense.

Let’s now relate it to some numbers:

You bought a house for 20 million units of currency and started living there. An identical house in the same neighborhood is available on rent for 45,000/- units of the same currency per month.

The ROI comes to 2.7% (45,000*12/20,000,000*100).

The P/E ratio is 37x (20,000,000/45,000/12). This means the price of the house is 37 times its annual earning or simply put, it will take 37 years to recover the cost of the house from rental income (disregarding the annual increase in rent and long-term capital gain).

You can now look around in the market to compare the ROI of the house with those of other investment options available and see for yourself:

How economical or expensive your living is.
How prudent or otherwise your capital allocation is.

The P/E ratio also tells you the same thing. It is a measure of how expensive or cheap a certain investment option is, relative to its regular earning. Obviously, 37x is way more expensive than something that is available at 10x.

A point regarding long-term capital appreciation the house is going to give you may come up here. Firstly, in this particular scenario, the annual rental yield of the house may be much below the average market yield of other investment options which should be roughly around 12-14%. Secondly, long-term capital gain in housing is only 2-3% more than the average rate of inflation. Therefore, purely from a financial standpoint, owning a house is way more expensive than renting it.

The assumed numbers depict a particular market scenario. Obviously, these numbers point to a bubble-like situation in the housing prices, relative to rental yields. This lopsidedness is likely to persist as long as people prefer to own properties over other financial assets. The situation can be altered, to a significant extent, through spreading financial awareness and some regulatory measures in the housing sector, the most important of which is the establishment of a mortgage authority.

Admittedly, every market is different. You should take the above numbers i.e. the prices of houses, the rental yields, inflation numbers, P/E ratios, and average earnings of other investment options from your market, and carry out an objective analysis to see what suits you the best. However, the broad framework suggested above is relevant and makes a lot of sense.

So, What Should be Preffered?

Before concluding, let me consolidate the findings of this discussion:

When Renting is Preferable

When your net worth is so less that more than 50% of it will have to be allocated to the house.
When the housing market is in a state of bubble i.e. the prices of houses are high and the rents are low. Arguably, it is a renter’s market.
When you want to improve your financial situation first and think about the house later.

When Owning is Preferable

When the cost of your house would be less that 20% of your net worth.
The housing market supports the owners i.e. the house prices are quite low compared to the earning yields. A quick measure to find it out is the P/E ratio. Less than 15x P/E implies that it is the owner’s market.
You and your family are willing to pay financial cost of your social choices.

Conclusion

The decision to own a house is an important one. It must be thoroughly deliberated along with all its pros and cons. Various factors like your net worth, the market situation, and your financial cum social orientation should come under detailed consideration. Both are valid options. You have to see what is in your best interest.

How did you find this content? Please comment and give suggestions, if you have any.

My other articles you may find useful are:

How to Make a Personal Financial Plan – Basic Considerations

Personal Finance – A Suggested Checklist

Investment vs Speculation

A Brief History of Money

Why I Started a Blog on Personal Finance

Anatomy of Financial Risk

Debt, Equity, and Real Estate: An Overview

Retirement Planning

How to Compare Equity and Real Estate as Investment Options

How Stock Market Works and How to Work in Stock Market?