Full Disclosure Finance

By Justin

I’ve heard varying opinions on the Rent vs. Buy topic. These opinions come from people with all types of education (financial and otherwise) and all levels of income. One will say “We bought because a house is the best investment you can make”, while others will back it up with “We bought because we were throwing money away by renting”.

The rent crowd looks to maintenance, utilities, and taxes (those other fees that come with owning!) when they say that “You’re throwing away money paying operating costs which can be almost as much as my rent”. One friend who is financially savvy rents because it gives him more cash (from reduced expenses and use of savings) to use in the markets. He figures he can beat whatever return a house/condo would provide. Whether he actually does I am not privy to.

There are valid points on both sides, but the argument still hasn’t been settled once and for all.

Firstly, I’m going to be like every other person that has touched this subject and say that the answer (Rent or Buy) will be different for everyone because there are too many variables to issue a blanket answer. However, I don’t intend to cop out and leave it at that. There are some clear principles one can use to make a decision.

Key Variables affecting the Rent vs. Buy decision:
• Level of Financial Education
• Plan for Savings
• % Down Payment
• Property Market
• Stock Market
• Nature of Income
• Location

Let’s take a look at the parameters and discuss how they could impact your decision.

I will use a scorecard approach to each variable, assigning points based on your status. Add them up and compare your score to the chart in the final post in this series. It should give you an idea about what option would be better for your situation.

1. Level of Financial Education:
I think this one is obvious, but it is definitely worth explaining. The Rent vs Buy decision hinges on your ability to do something with your savings to earn a decent return. If you consider dumping it into a GIC to be a “good move”, this is a signal that buying is probably right for you. Here’s why:

GIC: Assume a GIC will be paying 5%, I’m feeling generous. So you rent and take your down payment money (assuming 20% of purchase price if you were to buy) of $50,000 and put it into the GIC. After year 1 your GIC is worth $52,500, for a gain of $2500 (5% return).
Condo or House: You use your $50,000 to purchase a house worth $250,000, leaving you a $200,000 mortgage. Assume your house appreciates at 5% (make this most accurate by researching property price increases in your area for the previous quarter) After year 1 your house is now worth $262,500 for a gain of $12,500 on your investment of $50,000 (25% return).

Comparison: The return on your money is 5 times higher by buying the house. Now, the gain on your place of residence is tax free, so your return is even higher relative to the GIC gain which is fully taxable as interest income.
But you’re not done yet. This is where the homework comes in. You need to subtract all of your related expenses from these gains.

GIC: Subtract your rent, tenant insurance, and any other expenses not common to buying a house. For example, don’t subtract internet if you will be paying the same for it whether you rent or buy.

Condo or House: Subtract your mortgage, taxes, insurance, estimated maintenance cost, and utilities.

Now compare the GIC and Condo or House numbers, which now don’t look nearly as good!

For fun, project the numbers out for 5-10 years to get an idea of their behaviour over time. Does this change the scenario?

Some people with a high level of financial education will look at a housing purchase as tying up a large portion of their savings. Putting $50,000 -$100,000 in their home (although you could likely convince your bank to let you take out some equity in your house if you really wanted to get into an investment) eliminates their ability to participate in other investments.

If you’re likely to use the money to buy some deep in the money calls, a great dividend stock, or want to put money into a company with a great long term story (see Sandvine, SVC:TSX) you may be able to generate a great return.

Let’s say that Johnny or Jane expert averages 25% a year for a 3-5 year period. Are they better off renting? Well if we take the $50,000 and it generates 25% in year 1 we would have $62,500 for a gain of $12,500. This would be a capital gain, so therefore taxed at half of your personal income tax rate.

If you bought a house for $250,000 as in the above scenario and it appreciates at 5%, you end up with a gain of $12,500 also.

Therefore, you would need a gain greater than 25% a year on your non-house investment, but accounting for the capital gains tax you will pay upon sale (30% bracket) 15% of the $12,500 in tax. This is equal to $1937.50 and decreases the return from 25% to 21%.

It would seem that you need to be realistic with your investment performance.
In order to match the gain on a property by using an investment, here’s a quick guideline:

E.g. Property Appreciation Rate (P) = 5%, Income Tax Rate (I) = 30%, Down Payment Amount (D) = 20% Required Rate of Return on Other Investment (IRR)=?

So to calculate the rate of return required to keep up with a house we do:
IRR = P / (D/100) / (1-(I/2))

For the example, you would need a return of 29% to equal the return on your house purchase. This would take a high level of financial education.

Scoring: 1-5 Give yourself a 1 if you think a high interest savings account is a great place to put your money. Give yourself a 5 if you can read a financial statement effectively and have successful experience with a variety of investment products.

Stay tuned for Part 2 where I’ll get into Plans for Savings and % Down Payment and how they will impact the Rent vs Buy decision.