One of the idiosyncrasies of the ERN family early retirement plan is that it involves a relocation. It’s not that we don’t like our current location. But even with our nest egg solidly in the seven figures we likely couldn’t afford to retire here comfortably because of the insanely high housing costs. The state income tax rates are also unpleasantly high. So, if everything goes well we will relocate to another state with low or no income tax and lower housing costs.
The options we consider:
- Own a house, mortgage-free
- Own a house, plus mortgage. But what term: 30-years or 15-years?
- Rent a house or apartment, long-term
- Nomadic lifestyle: have no fixed residence, move from place to place with light luggage
Ok, I have to admit, I threw in that last option just for fun. Some people can pull it off (GoCurryCracker), but I doubt that the nomadic lifestyle is for us. I like to have a home base! The way I can tell is that as much as we love to travel, it’s always nice to come back home to sleep in our own bed. Even if I know I have to head back to the office the next day. Seriously!
Quantifying the tradeoffs
We can write as much as we want about the pros and cons of renting vs. owning, but in the end, it all boils down to the numerical assumptions, especially the rental yield (annual rent divided by purchase price):
- If we can rent a house for only 5% p.a. of the purchase price or less it’s likely a no-brainer to rent. The opportunity cost of our money tied up in a house plus the depreciation and taxes would be too large. Unless, of course, we factor in huge property appreciation. But our baseline assumption is that property values appreciate with the rate of inflation. The last time folks were budgeting outsized returns in housing it didn’t end so well, remember 2008/9? So, renting can be much smarter than owning, see some examples at 10!Rocks and Millenial Revolution.
- If the annual rent is 10% or more of the purchase price, it’s almost a slam dunk to buy.
Somewhere in between has to be the sweet spot. Let’s check where’s that crossover point in the rental yield!
Here are the assumptions:
- Purchase price: $300,000, which buys us a 3 to 4 bedroom, 2 bathroom house in a nice middle-class neighborhood. We stay away from the big McMansions when practicing Stealth Wealth!
- Rent per month: We look at six different rental yields: 5, 6, 7, 8, 9, and 10% of the purchase price in annual rent. Per month this implies a rent of between $1,250 and $2,500 in steps of $250.
- Mortgage rates: 15-year: 3%, 30-year: 3.75% (did anybody else notice the recent rise in mortgage rates? Oh my!!!)
- The cost of owning: Some of the cost assumptions and estimates are borrowed from the excellent posts on Slowly Sipping Coffe and MoneySmartsBlog to account for repairs, taxes, and insurance.
- Repairs and maintenance: $7,500 p.a. (2.5% of the value)
- Taxes: $3,000 p.a. (1.0% of the value)
- Insurance: $1,500 p.a. (0.5% of the value). This value might be a bit high because the renter would also need renter’s insurance and general liability and the $1,500 figure would be in addition to the few hundred dollars a year in renters insurance.
- Inflation: 2% p.a. (=0.165% compounded monthly). The following variables grow at this monthly inflation rate: home value, rent, repairs, taxes, insurance
- Transaction costs for home purchase: 1% of the purchase price upfront, 7% of the home value on the backend.
- No impact on taxes from either mortgage interest or capital income.
- We assume we use the standard deduction in retirement. There is no tax reduction from the mortgage interest paid!
- All dividends are qualified and capital gains are long-term taxed at a zero rate in the first two federal income tax brackets.
- Equity investment expected return assumptions:
- The mean expected return (nominal): a conservative 7% p.a. (=0.565% compounded per month). This is the nominal return, so we target a real equity return of around 5% p.a.
- The standard deviation of equity returns (for Monte Carlo simulations): 16% p.a. (=4.34% monthly)
- Notice that all of our numbers are scalable. If you wonder how this exercise would look like for a $240,000 house, then the crossover rental yields are the same and all the $ values would be scaled by a factor of 240/300=0.80.
Let’s look at how the cash flows compare across the different housing choices. The 7% rental return translates into a monthly rent of $1,750 (adjusted for inflation every month, just for simplicity). After 10 years the final rent is well in excess of $2,000. Buying a house with cash sets us back $303,000 (purchase price plus 1% fees). The monthly costs are only around $1,000 (maintenance, taxes, insurance). The value of the house, net of 7% transaction cost and the final month’s maintenance cost amounts to only slightly under $339,000. With an 80% mortgage, the upfront cost is $240,000 lower but the monthly costs are much higher, too, because of the mortgage payments. Paying off the remaining mortgage balance after 10 years when selling the house yields net proceeds of around $245,000 (15-year mortgage) and $150,000 (30-year mortgage), respectively.
How do we compare which option is best? Renting costs less upfront but yields no payoff at the end of the 10 year period. So, what if we were to invest the incremental cash flow of owning over renting in our go-to investment vehicle, i.e., an equity index fund? Let’s look at the numerical results below!
Numerical results Part 1: Assume a deterministic 7% p.a. equity return
As a function of the house holding period and the initial monthly rent, here’s the incremental return over renting. We do this for the 10-year horizon, as well as shorter holding periods of 3 and 5 years. The first result that jumps at me is that paying for a house with cash seems quite unattractive. But it’s not too surprising: You tie up $300k in a house that’s a depreciating asset (4% carry cost, only 2% gains p.a.) and incurs a total of 8% transaction cost. The renter, on the other hand, can generate around $21k in annual capital gains and dividend income, in a very liquid investment.
Buying a house with 20% down and financing the rest with a 30-year mortgage looks more attractive than buying and paying with cash. Over short horizons, the real estate transaction costs of around 8% are going to hurt the homeowner. But over a 10-year horizon, the rent crossover point is somewhere between $1,750 and $2,000 monthly rent. So probably around 7.5% yield is the cutoff.
Numerical results Part 2: Assume a random equity return (Monte Carlo Simulations)
Nobody can guarantee exactly 7% on their investments. How much uncertainty is there in the estimates and how much of an advantage or disadvantage over renting can we expect for different returns over the 10 year period? Let’s get the computer warmed up and run 1,000 Monte Carlo simulations with 120 random draws of monthly returns with 7% p.. expected returns and 16% annualized risk.
Let’s look at the table below for the distribution of incremental performance over the rental, both for owning+pay cash (top portion) and owning with a 30-year mortgage (bottom portion). The median incremental return is roughly the same as under the fixed 7% return assumption above. Paying cash already becomes attractive at a 9.5% rental yield. But at $2,000 (8% rental yield) you still have a 38.6% chance of coming out ahead of the rental and even at $1,750 rent you beat the rental with a probability of almost 30%. With a mortgage, you beat the rental of $1,750 with a probability of over 36%.
Let’s look in more detail at the $1,750 rent assumption and see what’s the origin of the large range of possible incremental returns. Several $100k in both cases!
In the scatterplot below, I plot the incremental return of owning+pay cash as a function of the average equity return over the 10 years. Large shortfalls occur when the equity market is doing really well. That makes perfect sense: The renter can invest a cool $303,000 more into the stock market upfront. The homeowner without a mortgage has slightly lower cash flow needs than the renter throughout the 10 years but has no chance of ever catching up with the renter if the equity market is on a roll and returns 10%+. Likewise, it doesn’t take much of an equity return disappointment to beat the renter. Average returns of about 4 maybe 4.5% and lower and we’ll likely beat the rental. One could interpret the home purchase as an insurance against a bear market. It will cost us around $118,000 over ten years but pays off handsomely if the equity market return assumptions don’t cooperate.
Same for the 30-year mortgage scenario, see chart below. True, you’re most likely to fall behind the rental but the house plus mortgage is a hedge against poor equity market performance. When the renter beats us by six-figures or more (equity return of 10%+), we wouldn’t be too distraught, knowing that our seven-figure equity portfolio also went through the roof.
Numerical results Part 3: 15-year vs. 30-year mortgage
Despite using a significantly lower equity expected return (5% real vs. 8.4% in FL’s case), we get the same result. The 15-year mortgage comes in a bit behind the 30-year mortgage. But we don’t want to dwell on that and rather point out the fact that going with the 15-year mortgage over the 30-year mortgage has that same equity hedge feature we saw before. With more noise, that’s for sure, but there is definitely a negative correlation with the equity return. As crazy as it sounds but we may entertain a 15-year mortgage despite giving up a little bit of expected return. Or at the very least, use the mortgage choice as an equity market timing mechanism: If equities seem expensive (CAPE-ratio) then go for the 15-year mortgage. If equities seem cheap we’d go for the 30-year mortgage.
Other factors to consider
- We’ll be stuck in the new location for 10 years to make homeownership work. A lot of things can go wrong during that time. Renters have the option to just pack up and leave without incurring a 7% loss when selling the property. That’s worth a lot!
- Rental inflation could be higher than overall inflation! Two recessions and a housing crash haven’t prevented rental inflation from running hot since 2000. Specifically, since 2000, rental inflation was 3% p.a., compared to only about 2% for overall inflation, see chart below. Higher mortgage rates will only fuel more rental inflation going forward!
- In retirement, we will have no more regular employment income. Unless we finalize the mortgage application before I hand in my resignation letter we will have a tough time securing a mortgage with a competitive interest rate.
- Tax bracket mayhem: the extra cash flow needed for either the mortgage or rent, may push us into the 15% tax bracket for ordinary income and/or the 15% bracket for capital gains. Suddenly an 8% rental yield becomes 0.08/0.85=9.4%. Buying a house with cash could look attractive again.
Conclusions
- The financial aspect of the rent vs. buy decision in early retirement (or any other time, for that matter) boils down to how long we want to stay in one location and what’s the prevailing rental yield.
- With a conservative equity market expected return of 7%, 4% carrying cost for the house and just under 4% mortgage interest for the 30-Year, it looks like the crossover point is somewhere at 7.5% rental yield. Buying a house with cash seems unattractive for rental yields under 9.5%.
- Use caution when looking exclusively at point forecasts and crossover points! Having a house, whether paid for with cash or with a mortgage offers a hedge against bad equity returns. Homeownership beats renting exactly when the stock market performs poorly. Likewise, if the stock market were to go up by more than 7%, true, we’d fall back behind the rental but with our 7-figure equity portfolio going through the roof, we’d still be happy
campers,uhm, homeowners. We may probably shave off another 0.5% or 1.0% from the rental yield to account for this hedging feature, so 6.5-7.0% minimum rental yield when buying with a mortgage and 8.5-9.0% minimum rental yield when buying with cash. - It would be foolish to tie such a profound decision to just monetary factors. We’ll have to weigh some purely emotional factors, like the pride of homeownership vs. being stuck in one location.
Nice analysis, and thanks for the link! When we looked at it, we realized that if we went from the Gulf Coast to Southern Canada (respectively) we could be in for some climate shock and maybe a couple of years would be enough. By renting during those first 2-3 years, then we would know if we want to stay and start shopping for a house, or start house shopping in another state/climate. This way we’d protect ourselves from the massive loss associated with sellng our home.
In the end, we’ll ultimately be homeowners somewhere, but maybe just not initially on our FIRE journey. It is an interesting take on paying for cash or getting a mortgage, but like you mentioned it may be hard to get a mortgage if there is no income beyond our investments. We haven’t looked at that aspect yet, so thanks for the details on how that pans out.
Thanks for sharing! Yes, during that transition, the first 2-3 years, trying to find out if we actually like the new location we might also rent. We’ll see…
Cheers!
Hello BigERN. First time blogging your site. I am really enjoying all of your work. Your writings and analyzes have given me great confidence since I retired early this year at age 59. Is this Monte Carlo analysis comparing renting vs. mortgage available for downloading in Excel like your SWR Tool Box? My wife and I are contemplating selling our mortgage free home and renting instead while investing the rest. Candidly, I am tired of all the maintenance and recurring costs of ownership, and thus, want to consider downsizing and renting downtown Tampa which is an up and coming mid size city instead of owning in the suburbs. Thank you.
Thanks! The analysis was done in Matlab (or GNU Octave = free version of it). I don’t have anything to share or a Google Sheet for this. Maybe in the future…
I like owning a home mortgage-free in retirement because it helps with Sequence Risk. Ask yourself, would you want to put that entire pile of cash from the home home sale into equities right now…
You’d also potentially owe taxes on the capital income.
But I really like the idea of downsizing!
Great number analysis completed with some other thoughts.
My Belgian:
As we own a house now, I assume we still own it at FIRE. I would keep it as I like the neighbourhood, the people here. In Belgium, there is little tax advantage when moving, unless moving to some cities that have low tax. Houses there are in general expensive, so, not sure we could get an edge here.
I also like to have a home base.
In FIRE, my kids are normally going to college. As we live nearby a big college town, that could mean we save on student housing.
When reading your points, It seems to come down on how long you want to live somewhere: Minimum 10 years to make the numbers good. Predicting now how long you might live somewhere is nearly impossible. In that case, renting might be a better option, as the flexibility is greater.
Thanks! If you can/want to stay where you are in FIRE, great for you!
If we could stay here we would, but it’s way too expensive. There is a blessing and a curse to move. Lower taxes vs. the uncertainty of the new location. At least in terms of the numbers we created some certainty, but there are other factors to consider too.
Cheers!
I love the depth of the analyses you do for us here, ERN. We could consider pros and cons ’til the cows come home, but numbers speak to me, too.
The annual rent : cost to buy ratio should be an easy one to figure out for any market you’re considering. It’s nice to have an over / under (7.5%) to help in making such a decision.
For a few years, we’ll probably have a semi-nomadic lifestyle, but with our second home (which will essentially become our primary home), a 2 bedroom, 1 bath cabin, as a home base. When our boys are ready for high school, we’ll probably settle down in a place we want to call home for a minimum of five years.
Cheers!
-PoF
We checked the rent/cost ratio on Zillow and it comes in right around that crossover point. But then again, who knows what will change between now and 2018. Mortgage rates and inflation rates??? I have the feeling I have to rerun everything again later. 🙂
Cheers!
Spiffing summary real estate magnate. You have a future career in politics……😉
Here’s our status/plan.
We bought a home already in the mountains of NH 3 years ago so that decision was made then!! We have had three fantastic years getting used to the home, area and it’s where we will relocate to in 2 years time. If we run into issues with catastrophic rising healthcare costs, I could see us dusting off the U.K. passports but that would be a VERY last resort. If the kids don’t adapt to school in the new area (very unlikely), we’ll look at alternatives in the NE region. We like NH for tax favorability. Although NH can have high property taxes in certain areas, our town does not and we don’t appear to suffer from any amenities issues. Winner, winner low tax dinner.
The mountain region suits our activities interests (hiking, skiing) and yet we are close enough to places like Portland, Manchester and Boston for international travel needs or more cosmopolitan endeavors on occasion. Also a drive to fantastic places like Montreal or Quebec or to Acadia national park is very doable for an extended weekend or longer.
Haha, with some orange spray tan in my face, maybe I can start my second career in politics. 🙂
Very nice setup you have there. Buying a place already and using it as a vacation spot would solve our issue with the mortgage application down the road. Hmmm, have to think about that…
Thanks for stopping by!
Cheers,
ERN
A characteristically awesome analysis, ERN! Thank you for the shouts re mortgage stuff!
The notion of using the mortgage as a lever for maintaining investment levels in equities is muy powerful as you illustrate. And the point you make about “market timing” with the duration of mortgage loan is a great one that, I suspect, is often overlooked. I like how you frame it here.
Yes, I did notice the mortgage rate creep this week. Interesting implications for y’all maybe. On the one hand, those creeping rates aren’t awesome for borrowing. On the other, it’s possible the higher rates will help your ~$300k budget go further because of softening demand for home purchase in the face of those higher rates.
Great graphs, by the way…beautiful analysis, but even prettier graphs! Great stuff, ERN – thanks!
Thanks FL. I love creating charts in Excel and Matlab/Octave. 🙂
Great work on your mortgage posts, which was the inspiration for this post. Cheers!
ERN
Yes, definitely lots to think about. I love the detailed analysis as always…even pulling out the monte carlo simulations! We are still a ways off from having to make this decision, but that hasn’t stopped us from giving it a lot of thought. My general conclusion at this point in time is to own our home (no mortgage) with easy access to a good airport as we hope to do a lot of traveling. Our current location, Charlotte, wouldn’t be bad for this. Although I do like the idea of being able to pack up and move to a new area occasionally without taking a 7% hit on a home sale, just for the life experience of learning and adapting to a new spot.
Yes, Charlotte is nice. Not too big, not too small and both beach and mountains not too far away. NC is on our radar screen, too.
Thanks for sharing!!!
Cheers,
ERN
Fantastic analysis! With so many factors and variables, it still ends up being a judgment call, but many people would be wise to consider all the variables you’ve laid out here. Some of my non-ER friends would be wise to choose 15-year mortgages, for example, just because it’s forced equity-building — the assumption that the lower mortgage payment results in higher portfolio investments certainly wouldn’t be true for them 🙂
Back in our home towns in the Pacific Northwest, the cost of renting has typically been below the 5% “no brainer” level, but we’ve also seen annual rent increases pushing 10-15% year-over-year for the past few years. That kind of price growth made buying a wise choice, though it’s challenging to predict what will happen in the future.
Thanks!
Yes, that’s the curse of living in the expensive cities along the coast. We faced the same challenge and luckily bought a condo that appreciated quite substantially over time. But after the relocation to a cheaper area I doubt we can repeat those double digit % increases in property value. Hence, the conservative assumption.
Anyway, thanks for stopping by!!!
Cheers!
Good analysis. Can you remind me where you live?
Having a primary residence that’s paid off in a place you love is worth it IMO.
You can leave your asset to your kids as well. I love being able to own a home in the places I truly enjoy: SF, Honolulu, Lake Tahoe. There’s something much more special than coming back home, than renting someone else’s home.
Sam
Hey Sam, thanks for coming over! I’ll keep my current and future planned location a secret for now. Stay tuned!!!
True, living in a place we love and owning a home there is worth a lot. The peace of mind and the feeling to be invested in the community (literally and figuratively) is something that will probably tip the scale in favor of home-ownership and no mortgage.
Cheers,
ERN
Good post as usual ERN and thanks for the shoutout. Retirement is actually the best time to own a home, if the financials bear out as you say, as most of career and family uncertainty are resolved by that time. Otherwise, 10 years is a long time in a typical career of say 35 years. If this 10 years of homeownership comes at the cost of career compromise due to lack of mobility, that cost would often be bigger than others consideered. That this opportunity cost is difficult to estimate does not make it any less real for most working people as I explain here: http://tenfactorialrocks.com/buy-or-rent-consider-career-cost/
That’s a great point. At least in retirement the location is set by me, not by my employer or the business cycle! Thanks for stopping by! Cheers!
Surf and turf
What about owning a home and renting out the basement you could have 25-50%. Of your mortgage paid for.??
Hmmm, that’s a nice idea too. I will make sure to search for duplexes and houses with in-law units and basement apartments, too!
Cheers!
ERN
Great post, backed up with strong analysis. Whether you rent or own, your biggest win is moving away from a high cost of living and high tax state. Way too many drags on wealth in states like that.
Thanks a lot! That’s a good point: There’s already so much money we can save from moving to a cheaper location, the rent vs. own decision is small potatoes. I’ll have a nice single malt scotch when I send in that last tax return to the highwaymen in my current state. Cheers!
Wow, such a wonderful article and exactly the kind of analysis I’ve been working through for the last year. Jenny and I are looking at what our housing situation will be right after retirement and we’re sharply leaning towards downsizing into an apartment. All my numbers say the short-term (2-5 years) housing we’re think of doesn’t work financially for an outright purchase or mortgaged property. That pride of ownership can’t be ignored, but I think if you know you want that freedom of pulling up the tent stakes and going elsewhere, it can be overcome. BUT, it is a very personal decision. Thanks so much for all the great analysis AND posting it for us to consider. GREAT work! Good luck!
Awesome! Glad you liked the post. Yes, there is that priceless feeling of homeownership. Well, it’s not completely priceless. I wouldn’t want to buy a place at any cost. Which is why I calculated some of the tradeoffs here. Cheers!
ERN
(This is meant to be a general comment – not a reply – but I don’t see the usual Comment field at the end)
Just wanted to say great stuff as usual! And to suggest that you consider updating this post with a three year retrospective and updated analysis now that you have the benefit of some hindsight.
One more general suggestion for all your articles. I (and presumably most if not all your readers) would find immensely helpful if you would include the date of publication of each article at the TOP! The first thing folks want to know is how fresh or stale an article is – particularly those like here that are so time context sensitive (market conditions, interest rates, etc.), and while it won’t necessarily change a decision to read or not to read it, it is crucial to a reader’s mindset and temporal context for analytical purposes at the outset. Thus, having to scroll down to the bottom and then back up – especially on my rather slow, aging iPad – is actually more of a hassle and time drain than you might assume.
Just food for thought to make your already superb publishing even more stellar 🙂
Very interesting article, and comments. Thanks…
I live in the UK. Our housing market is way different. Renting usually costs more than the mortgage. We are already retired, one son lives at the other end of the country so we don’t see him too often, the other son lives on the other side of the world, we see him even less. I am now pondering whether to sell our home and rent for a few years in different places. The investment of the lump sum from the house would pay the rent, all being well, wherever we were…. Food for thought.
Thanks for sharing, Erith. Yes, fundamentals and tax laws are different in different countries. Over a short horizon, an investment in equities can also be much higher or lower than the rental yield. So, that equity return risk another issue to consider. Cheers,
ERN
BIG ERN! So, the current blog post discussing current CAPE (~30) and potential muted near term (10Y) equity returns (Bogle commentary) brought me back over here on the early-retirement housing choice topic … particularly as we approach the home stretch of our FIRE journey.
Rental yields are currently ~7% in our FIRE location. We will likely purchase (w/mortgage) to maintain our overall target NW portfolio AA%.
1) I’m curious – in the 7 (wildly bullish) months that have transpired since publishing this article – have current CAPE levels given you reason to revisit your buy/mortgage/rent decision tree?
2) Similar to your wonderful “SWR Toolbox” Google Doc, would it be possible to request you share a “Housing Choice Toolbox” Google Doc to evaluate individual parameters & test local sensitivities?
Have a great day!
Thanks for stopping by!
Great idea! That’s now on my to-do list to create a Google worksheet for the rent vs. buy and mortgage vs.cash decision.
The high CAPE and the lower expected equity return have definitely made me think about the tradeoffs in a new light. I don’t consider 7% equity return all that realisitc anymore. So, buying with cash is essentially a high-yield, low-risk bond. Looks quite attractive!
Thanks for the feedback!!!
Thank you for adding that to your list!
Along with reducing my near term equity return expectations, we have also become quite intrigued with the value proposition of paying cash for our LCOL home.
This is the absolute best and non-biased analysis on this topic so far! Thanks so much. Others I’ve read usually end with “Yup, it’s cheaper to rent an 800 sq ft apartment than buy 1500 sq ft house. Problem solved.”
A big pivotal point on this is having a mortgage or not. It’s a much bigger -emotional- issue than people think. I always assumed I’d keep my low interest mortgage and invest the potential early principle, but as I’ll be faced with that actual decision (paying off my mortgage early) very soon in my personal life, it’s not that easy after all! I know financially big picture I’ll likely end up with more money by investing vs early payoff, but owning an asset outright and having an extra $1k/month cash flow is emotionally very, very appealing!
Ha, thanks for the great comment! That made my day!
For me, the mortgage pay down was never an emotional issue while working. I was OK with stretching out the mortgage payments for the entire 30 years and setting the investments on auto pilot.
Retirement might be different. Having no more regular income and having to fund the mortgage payments from a risky portfolio might just entice me to go mortgage-free in retirement,
I know you have since published other updates on this topic, but I wanted to ask two questions about your analyses…
1. Why simulate random equity returns but not random returns on the home? https://www.unisonim.com/2017/01/20/the-devil-is-in-the-details-risk-and-return-in-residential-real-estate/ seems to imply that there’s a lot of uncompensated risk for an individual house. Indeed, more than for the equity position. Do you assume that most of this is down to selecting the right opportunity/property?
2. In some locales [like your former SF], most of the value is in the land. Not only that, but it seems the land portion can appreciate quite a bit faster than the building part (which is falling apart but after that should roughly track inflation). See https://howmuch.net/articles/this-animated-map-shows-the-rising-cost-of-land-past-forty-years-gif4 but I know the Lincoln Institiute has published a more definitive paper on this.
Yeah, that’s a good point. Especially for leveraged real estate you’ll quickly get return volatility close to those in equities. It’s a shortcoming of this analysis!
To do this analysis the right way one would have to have an estimate of the joint distribution of equities and RE. Including the correlation!
If I have some time I might tackle this in the future! Thanks for the great links!