Illustration by Erick M. Ramos
Hello,
Welcome back! You’ve made it to the fourth session of the MoneySmart Bootcamp. Today’s financial workout focuses on that age-old housing question: Should you rent or buy?
People have opinions on the matter. On the one hand, generations of Canadians grew up hearing at the dinner table that renting is a waste of money. Also, many people in this country have come to see homeownership as a great way to build wealth – and after years of enormous home price gains, how can you blame them?
On the other hand, some people decry what they call Canada’s “homeownership cult.” From their perspective, you can save a lot of money by renting and use that spare cash to grow your wealth by investing in the stock market.
In practice, whether you should rent or buy depends on a number of variables specific to your situation. So instead of giving you an answer, here’s a process to help you think through the issue.
Step one: How long will you live there?
If you’re likely to move in the next five years, there’s usually an easy answer to your dilemma: Rent. Why? Because buying and selling a home is really expensive (not to mention, a lot of work).
- When you’re buying. Be prepared to spend the equivalent of 3 per cent of the home purchase price in various fees and taxes. On a $600,000 home, you’re looking at $18,000. And that doesn’t include your down payment or any mortgage insurance. The good news is there are federal, provincial and municipal tax breaks for first-time homebuyers that help defray some of costs.
- When you’re selling. One of the biggest costs will be your real estate agent’s fee, which is typically 3 to 7 per cent of the home price. Let’s say your $600,000 home is now worth $700,000. A 5 per cent fee would set you back $35,000. There are also legal fees and a host of other possible expenses, including the costs of fixing up and staging the property to maximize buyer appeal. You do not have to worry about capital gains tax if you’re selling the home you’ve been living in.
- Bottom line. Transaction costs can easily erase any gains from an increase in the value of your home if you sell less than five years after moving in.
Step two: The 5 per cent rule
If you expect to stay put for five years or longer, it’s time to do some math. To see how renting stacks up against owning a home, you can use a back-of-the-napkin formula known as “the 5 per cent rule.” Here’s how it works:
- Homeowners also waste money. When you pay rent, you give money to the landlord. When you buy a home, you’ll own an asset that usually goes up in value over time. Is that a slam dunk argument for owning? Not so fast. When you own a home, you’ll also spend money every year on things that do not increase your ownership stake in it (like paying off your mortgage principal) or drive up your home value (as is often the case with renovations).
Transaction costs, as we’ve seen, are an example of unrecoverable costs for homeowners. The interest you’d pay on your mortgage as a homeowner, as well as property taxes, wouldn’t build home equity either. And guess what? If a pipe clogs, it’s on you to pay for a plumber, a cost you would have been able to pass to the landlord as a renter.
There is also a more subtle cost of homeownership that you should consider: The cost of tying up your money in a home when you could earn better returns in the financial market. While home prices can certainly rise faster than stocks in any given year, over the long term, stocks have historically yielded better returns than real estate.
- The math. The 5-per-cent rule is a simple way to compare the unrecoverable costs of renting and owning to gauge whether you’d be better off pouring a bunch of money into a real estate asset or renting while investing your extra cash in the financial market. The rule goes like this: If a year’s worth of rent adds up to less than 5 per cent of the value of a home similar to what you’re renting, being a tenant is financially attractive. If you’re paying more than 5 per cent, you might want to consider owning.
- An example. Let’s say you’re renting a two-bedroom apartment for $2,000 a month. A year worth of rent would add up to $24,000, which is 5 per cent of $480,000 (divide the annual rent amount by 0.05 to calculate 5 per cent). If a two-bedroom condo or similar home in your area costs more than that, you may want to keep renting.
Step three: Housing costs vs. your income
Whatever the 5 per cent rule shows, the next step is to compare your expected housing costs with your income. Whether you’re paying rent or carrying a mortgage, spending too much on housing will suck the air out of your budget. You won’t have breathing room to save for important things like retirement – or fun things like vacations.
- If you’re buying, a good starting point is this online mortgage qualifier tool provided by the federal government. It simulates how most lenders will vet your finances when you apply for a mortgage. But the banks won’t take into account many big monthly expenses you may have, such as daycare fees. For a more complete picture of whether your mortgage would leave you house poor, you can use The Globe and Mail’s Real-Life Ratio Calculator.
- If you’re renting, a commonly used general rule holds that rent plus utilities should amount to less than 30 per cent of your income before tax. But in many high-rent cities, few tenants would be able to meet that bar. A less stringent gauge of affordability that also takes into account different spending needs is this: Make sure that your fixed expenses – including but not limited to rent and utilities – are no more than 55 per cent of your income after tax.
Step four: The quality-of-life variable
Regardless of what the math says, many Canadians find they simply can’t make long-term renting work. Sure, in countries like Germany, where less than half of households own a home, you’ll find plenty of happy forever renters. But the realities of Canada’s rental market are different.
When being a tenant means living in fear of a rent increase or eviction, many people understandably opt for owning, if they can. And if you have or are planning to have kids, finding a rental big enough for a family can be a challenge.
That said, sometimes life nudges you toward renting instead of owning. For example, I’ve spoken to people who decided to rent in retirement and never looked back. That pipe clog, being someone else’s problem? There can be a psychological relief factor in it that the math just doesn’t capture.
Step five: What if you can’t buy or rent?
This is where the going can get really tough. Sometimes the math will show that you can’t afford to either rent or buy in the city where you live. Or maybe your only option is to rent – usually cheaper than owning – but you can’t find a place that fits your needs.
There is no way around it: You’ll have to either find a way to increase your income or reduce your housing costs (by moving to a lower-cost city or taking on roommates, for example). These can be hard choices, especially if you’re pondering them when you’re well past your 20s, as is the case for a growing number of Canadians. Still, keeping your housing costs in check will spare much financial pain and heartache in the future.
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Try this at home
- Try out the 5 per cent rule for yourself. If you’re a tenant, compare 12 months of rent with the value of similar homes in your area. If you own, use an online calculator to estimate your current home value, then look for a similar property that’s up for rent nearby. What does the math show?
- If you’re pondering a home purchase, it’s a good idea to get some practice with the FCAC’s online mortgage calculator. If you’re comparing homes in different municipalities, don’t forget to input an accurate estimate of property taxes. You’d be surprised how much they can vary and how high they can be in some smaller towns.
- Curious how your mortgage payments might change based on payment frequency, amortization or term? Use our mortgage calculator.
NEXT UP: Why you may need flood insurance and other commonly overlooked aspects of disaster-proofing your finances.
If you like this newsletter course, you might also like Stress Test, The Globe’s award-winning personal finance podcast for Gen Z and millennials. Listen for free wherever you get your podcasts.