Sunday, October 16, 2005

Rent vs Mortgage: Comparisons of Dead Money

The standard advice is that rent is dead money. But is it?
In this article we'll be delve into this standard financial advice. We will compare the differences between paying rent and paying a mortgage, and investing the difference.
If one is better than the other, is there an optimal point for either.

Any bank website will provide information about the loan repayments and also the schedule of the loan (year by year). This information provides a good start to determine the optimal strategy for renting vs mortgage.
If you are not disciplined enough to save the difference between rent and mortgage repayment then having mortgage is a good form of forced investment.
Also as the loan amount may not change for the life of the loan (if no equity is withdrawn), the amount owed remains static. This means that whilst you might have a $300,000 loan, the property should appreciate over the period of the loan to have a value much higher than the original purchase price.
This capital gain/appreciation was used as a sample return on property and used to determine the value and hence the rent over the life of a loan.

The calculations were made with the following numbers:
1) Mortgage interest rate: 7.32%
2) Rental Yield: 4%
3) Property Return: 5% (Total 9%)
4) Fixed Interest: 5%
5) Stocks Return: 12%
6) loan amount: $270,000.00 ($300,000 with 10% deposit)

Assumptions:
1) Landlord is able to increase rent each 12 months to maintain rental yields in line with property value. ** This has not been the case in Sydney over the last 5 years
2) Straight line increases in investments (ala no cycles)
3) No changes in mortgage interest rates for the life of the loan.

Basically rent and interest are dead money in terms that neither provide a return. The amount of money available to invest (the difference between mortgage and rent) enables to renter try and out-perform the property investor (mortgage repayments).

Here are the results:
1) If the money difference between rent and mortgage is invested in stocks, the long term gain means the total investment after 30 years is higher for the renter, with a $750,000 difference.
2) The optimal point were rent begins to exceed interest repayment is around 10 years. This result would indicate that if you must buy property, moving into the house after 10 years is a effective way to minimize the cost of housing.
3) Around year 13-14 the rent begins to exceed the total repayment per week. (Remember assumption 1 though). This point is found by using the percentage the principal makes up of the mortgage repayment vs the difference between rent and mortgage.

What these results indicate is that if you are a good tenant paying a reasonable rent,
1) Sign a longer lease as this demostrates you are a good tenant to the landlord.
2) Setup an automatic saving account which deducts at paytime.
3) Invest the proceeds in a stock market or buy the property and rent elsewhere and put the difference towards repaying the loan faster.

I didn't check whether using leverage ala investment property or stock margin loan increased the overall return to the renter. Without checking, it probably will and will also be tax effective.
Result one demostrates that renting can be an lifestyle choice which with discipline to invest can result in having more wealth at the end of the loan term.

Have Fun

Disclaimer: You will need to check these calculations for yourself and seek financial advice.