Renting versus Buying a home | Housing | Finance & Capital Markets | Khan Academy

Narrator: What I want to do in this video is give ourselves a
framework for thinking about the rent versus buy decision for a home. The key takeaway I hope
you have after this video is there's not just a simple right answer, that it's always better to rent or that it's always better to buy. For full disclosure, I own a house and I bought it for a
whole series of reasons, some of them emotional, some
of them potentially economic. It depends on your personal context, where you are in your life, and what part of the world you live in, and what the economy is
doing at that moment, and what rents are versus
what housing prices are. Hopefully this video
will give you a framework for at least how to think about them.

Let's say this house in on the market, and it's on the market for
rental at 1,500 a month. 1,500 per month, which is the
same thing as 18,000 a year. 18,000 a year; so, that's
one option that you have. Let's say there's an identical neighboring house that's on the market for sale, and you are in a position to buy it. Let's say that house is $400,000, is the price that you can get it at. You don't have $400,000, you're going to have to borrow some money. You saved 100,000 for your down payment. 100,000 down payment. Down payment. You're going to have to take
the remainder out as a loan.

You're going to take out a 300,000 loan. Now, a traditional mortgage,
one that has a fixed term; maybe it's a 15 year fixed mortgage,
or a 30 year fixed mortgage. Every month you pay your mortgage bill, and some of it goes to,
in a traditional mortgage, some of it goes it towards
the loan and some of it goes to pay down the
interest, and the rest of it will go down to pay down the loan. For example, let's say that
your mortgage payment is 1,800. 1,800 per month. Early on it might be
disproportionately interest. It might be, say, 1,500
a month in interest and $300 to actually pay down your loan, to actually pay down this $300,000 loan, and then as that loan is paid down near the end of the term of your mortgage it might have gone the other way where each month you're paying much
more to pay down your loan. Maybe by that time it's
1,500, and the interest, since it's interest on a
lower amount by that much because you've paid down the loan so much, your interest might be lower. This would be a traditional
process of a traditional mortgage.

To simplify our analysis, I'll assume that you're taking an interest-only loan; a loan where you're only required to pay the interest portion of it, and you could pay down your loan as you want to. Let's say that this is interest-only. This is going to help
just simplify things, and obviously if we want
to get really detailed we'd probably have to
get a spread sheet out to really analyze things and see how the interest payment changes as we go through the life of the loan.

Let's assume it's interest-only
at 6%, 6% interest. Interest-only at 6% interest. That means on an annual basis, you're going to pay 18,000 in interest. 18,000 in interest; 6% of
300,000. 18,000 in interest. Now, depending where you live and what your income level is, in a lot of places, you can
deduct mortgage interest from your income, so this
doesn't mean that you get all of the 18,000 back, this
is saying if you're making 100,000 a year, instead
of paying, say, 30% on 100,000, you're now
going to pay your taxes on 100,000 – 18,000. Your taxable income
would go down to 82,000.

You'll save, roughly, your tax
rate as a percentage of this. Let's say you save,
roughly, a third of this on reduced taxes; so,
that's reduced taxes. So, your effective
interest that you're paying after the tax break,
let's say it's $12,000. $12,000 is out-of-pocket,
or the effective. Effective cost of
interest. Cost of interest. We're not done; we know that
there are costs of home ownership. You'll have to pay, usually,
some type of property tax. Let's say it's 1% property
tax. 1% of 400,000 would be 4,000 in property
tax. Property tax. You, of course, have to upkeep the house. Maybe you have a gardener. maybe you have to repair things, you get things painted;
who knows what it might be. These are things that
you usually would not have to pay if you are renting; so, let's say, although
it might be different, once again, depending on the situation. Let's say there's 2,000 a year. 2,000 per year in upkeep. In upkeep. Now, the reason why I
listed all of these things, and obviously we can go into more depth and more detail and
think about other things that are more particular
to different circumstances, but this is a list in
either of these cases, are the things that are essentially are going out the door.

If you're renting, that $18,000 a year, that's just going out the door; that's what you have
to pay for the benefit of living in this house. If you buy, things that
are just going out the door are your effective cost of interest,
your property tax, your upkeep. This will all add up to, let's see, 4,000 + 2,000 is 6,000 +
12,000 is 18,000. 18,000. Just like that, it looks
like our annual costs that are just going out the door, given the assumptions, in every different circumstance you're
going to have different assumptions, so this is just a framework. Your what's going out the door
is $18,000 a year in either case. But, we are not done yet. In this case, we didn't even talk about what we're doing with our $100,000. Over here we had to use
it for our down payment. Over here we still have $100,000 invested. 100,000 invested, so we're
going to get some income from this 100,000 that we
wouldn't have gotten here, and it depends what we're doing with it, if we have it in a
really safe bank account, maybe we're getting 1% or 2%, but maybe we're investing
it in a portfolio of things and getting 4%, or who
knows what we're doing here, but we need to think about what we could have gotten from that down payment; from investing this incremental money.

Let's just say, for the sake of
argument, that you get a 2% return. At 2% annual return; so you're getting $2,000
in investment income. Investment income, from that $100,000. Your actual out-of-pocket,
if you were to net your income benefit
that you didn't have to, or the investment return
that you didn't have to use up on the down payment, that netted against your
rent and now you're 16,000. Now you're 16,000 out-of-pocket. 16,000 cost per year. Now, the way that I rigged
the numbers for this video, it turns out that for this individual, purely on the economics,
purely for this year, as we'll talk about in a few seconds, things might change in the ensuing years, but purely for this year, if we can assume these numbers, it actually might
make sense to rent a house.

Of course, this analysis
completely changes depending on how these numbers change; if this house were cheaper,
if you got lower interest, whatever it might be, and all of a sudden, this number might look better. If the rent was a lot higher, this number would look, similarly,
would not look as good. If your return on investing
weren't that good, this number would be higher
and it would not look as good. The key thing to realize
is just try to analyze what your actual out-of-pocket costs are.

Well, look, just psychologically, when I'm doing this mortgage, at least it's forcing me to save; and that's true, it is a forced
saving that's happening here. But, in theory, you could do it here. The equivalent amount
that you would have paid for interest, or the interest
portion of your loan, that's your rent, and
above and beyond that you could just save that $300 a month, and put it into your investment pool, and after 30 years, you might very well have a good amount of money there collecting a lot, or
generating a lot of income. There's no very clear-cut
answer that renting is always better than
buying, or that buying is always better than renting. It really depends on the circumstances.

This is a back-of-the-envelope version; in future videos we'll do
a more in-depth version. But, other things that
we should think about beyond just the numbers
are the intangibles. Let's just think about those in a second. Let's think about the
intangibles that favor renting, and the intangibles that favor buying. The biggest reason, and this is why we bought a house a few years ago, is for buying their stability. There is stability. You might get a great deal on a rental, and the owner takes care of it, and it's in a great neighborhood, but maybe they want to
rent it out to someone else or maybe they want
to move into the house themselves and then you've got to move. If you buy a house, as long
as you pay the mortgage, or you pay off the house eventually, you're pretty much, and you can pay the property taxes and things, you're pretty much guaranteed
that you can stay there.

Another reason that you might want to buy is rents are unpredictable;
rents could go up. Rents could go up. If you're in a really rapidly
rental appreciating market, say, some place like
Manhattan or San Francisco, it's nice to be able to
say, "Oh, look, I got "a fixed mortgage payment;
this is what I got to pay. Once I pay this thing
down, I don't have to worry about the craziness of
what rents might do because the economy is, because so many people want to live wherever
your house might be." Then, another thing, and once again, this isn't an exhaustive list, is that you can customize, and you
can make improvements.

Back when my family was renting, I can't tell you how many places we saw that looked really nice if they had just changed this
bathroom a little bit, or if they just changed
that kitchen a little bit, or if they did not paint
that one wall yellow. When you buy a house you can
make those same improvements. All the intangibles aren't
just on the buying side. They could also be on the rental side. If you're just settling down in an area and you want to figure
out the lay of the land, you might not want to
commit to one neighborhood or one house without
understanding things better, so you might want to have the flexibility. Flexibility of renting. To keep buying and selling houses, there's a lot of costs
involved, especially when the cost of the
brokerage fees and whatnot; so, you might like the flexibility, you get into a 6 month
lease, 1 year lease. Once you understand things, then you might want to buy a house or then you might want to rent in another neighborhood, and as we saw earlier in
the 2003 to 2008 period, sometimes you have housing bubbles, and sometimes these
economics go way out of wack and housing is just over-priced.

Housing over-priced relative to Housing is over-priced relative to rent. Once again, big takeaway, it all depends on the context. Hopefully this gives you a
little bit of a framework for thinking about the
rent versus buy decision..

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