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March 10, 2022

🏑 When Renting is Smarter Than Buying

🏑 When Renting is Smarter Than Buying

Earlier this week I had a conversation with someone who was sick of “throwing away money on rent” and felt like it was time to buy a home. It’s a common invisible script that you need to own a home – after all, isn’t it the American dream? Well I don’t think it has to be… and there are actually some great reasons that renting can be a better option. However, instead of writing this from scratch, I thought I’d share a post I wrote on the topic for the Wealthfront Blog (which has so much good content from my colleagues, including three great guides on Financial Health, Home Planning and Equity & IPOs). 


🏑 Why Renting Is Sometimes Smarter Than Buying

This post originally appeared on the Wealthfront Blog (here)

Home-buying has made a lot of headlines lately. Many people are buying earlier than anticipated, in part because mortgage interest rates are relatively low and because a year of remote work has made it tempting to get a little more space. Maybe you even know a few people who have taken the plunge and bought a home recently.

There’s no denying that owning a home can be pretty great. You get to lock in your cost of living (which serves as protection against potential rent increases), you can personalize your space any way you’d like, you get significant tax benefits, and you can enjoy the psychological benefits that come with knowing your home is yours. As a result, many people look forward to buying a home and consider it a major life milestone.

If you’re still renting and are experiencing some FOMO, we’re here to help you think things through before you jump on the buying bandwagon. Renting can be a good choice too. It might seem like “throwing money away” in the sense that you aren’t getting equity in a home, but buying also forces you to “throw money away” on costs like property taxes, mortgage interest, HOA fees, and maintenance. Here are four advantages to renting you might not have considered:

1. Renting gives you more flexibility

Renting comes with a lot more flexibility than buying does. If you need more space, you can rent something bigger. If you want to downsize, you can rent something smaller. You can move to take a new job and you can switch school districts. It’s much easier to move when you rent. Ending (or even breaking!) a lease is much simpler than selling a home and buying a new one.

2. Renting means fewer responsibilities

Renting comes with fewer responsibilities than owning. If you’re renting an apartment and your washing machine breaks, your landlord should coordinate and pay for the repairs. But if you own your home and your washing machine breaks, it’s your problem. In some places (like San Francisco), homeowners are even responsible for repairs to the sidewalk in front of their home. These responsibilities can end up costing you a lot of time and money. If you rent, upkeep is generally the responsibility of your landlord.

3. Renting comes with smaller transaction costs

When you rent an apartment, you’ll sometimes have to pay an application fee or, in some cities, a one-time broker fee. These costs don’t usually add up to much in the grand scheme of things. 

When you buy a house, the transaction costs are bigger. In addition to your down payment, you’ll also need to pay fees known as closing costs, which generally add up to 2-5% of your home’s purchase price. These costs could include fees for an appraisal of the home, attorney fees, title search fees, transfer taxes, and any other fees your lender charges.

When you’re ready to sell your home, there’s another set of costs. It’s usually the seller’s responsibility to cover the commissions of both the buyer’s and seller’s real estate agents, which costs around 6% of the sale price on average. You often pay taxes and fees on the sale, too, which can total 2-4% of the sale price, which brings the total closing costs for sellers to 8-10%. 

Between buying and selling, you could be paying as much as 15% of the value of the home in transaction costs and fees (although that percentage is likely to be lower in areas with higher home prices). If you’re going to stay in your home for a long time, this isn’t a huge deal. A good rule of thumb is that you need at least five years for your house to have the chance to appreciate enough to make up for the money you’ll spend on transaction costs.

4. Renting leaves you with more cash to invest

Large purchases like buying a home come with large opportunity costs. When you rent, you can invest the money you otherwise would have spent on a down payment and transaction costs.

For example, let’s say you’re able to save $150,000 this year by renting a home instead of making a down payment on the purchase of one. We’ll imagine you invest that $150,000 in a Wealthfront Investment Account with a risk score of 8, which has had an average annual pre-tax return of 8.9% since late 2011 (net of our annual 0.25% advisory fee). If you waited five years to buy a home and didn’t touch your $150,000 investment until then, it would grow to $229,736.85 based on that rate of return. That said, if you invest money you’ll need for a down payment – particularly over the short term – you should be prepared for the possibility that it could decrease in value. Markets behave unpredictably in the short term, which is why we recommend investing for the long term.

The takeaway

Many people look forward to buying a home, but you don’t need to rush into it just because it seems like everyone else is doing it. Buying a home is a big decision, and it’s important to think through the details and feel confident before you do it. In the meantime, don’t feel bad about renting – it has plenty of advantages.

When you’re ready to buy, Wealthfront has your back. Check out our home planning guide for everything you need to know about purchasing a home. 


πŸ“Ί Video: Rent vs. Buy

While we’re on the topic, I thought I’d also share a video I made in 2019 on the topic of renting vs. buying when I was running my last startup Grove. I made a few different points here, like how buying a home often forces you to pre-buy space that you wouldn’t have needed to rent yet (since you’re planning for a longer time in the home).


πŸ’° Deducting Mortgage Interest on $1m+ Homes

The IRS allows you deduct home mortgage interest on the first $750,000 of a mortgage ($375,000 if not married, filing jointly)1 which is an amazing benefit for homeowners. However in places like San Francisco or New York, it’s almost impossible to find a home where your mortgage isn’t going to exceed that limit, so you’re not able to deduct all the mortgage interest you pay. Well if you fall into that scenario, there’s a tax hack that when executed correctly, will greatly increase the amount of interest you can deduct (note: this is NOT tax advice). Also, I know this won’t be relevant for everyone, but it’s such a great hack for some of you that I wanted to share.

So how it works is that the interest on any money you borrow and then use to invest can be categorized as investment interest expense and deducted from investment gains (e.g., interest, dividends, cap gains) and thus reducing the taxes you’d owe. Two practical ways this could work:

  1. If you already have a mortgage over $750,000, you would use your cash to pay that mortgage down to $750,000 and then later do a cash-out refinance to bring the balance of the mortgage back up to however much you want. Then use all the money you cash out to invest.

  2. You want to buy a home and can pay for it in cash. Then within 90 days you do a Cash Recoup Mortgage and use all but $750,000 of the cash you get back from the mortgage to invest.

I don’t expect most people to have this much cash just sitting around, but if you recently had a windfall that you’re planning to invest, this could make sense before you make the investment. Or the tax savings could be enough for it to make sense to sell your investments to execute this strategy and then reinvest the money after.

If any of this is interesting, I’d recommend reading this great blog post from SVB and ABSOLUTELY talking to an accountant beforehand. Also, part of the complexity here is around a concept called “interest tracing” which requires you trace the funds to show that they were used for the correct purpose. If you’re interested in learning more about it, Deloitte has a great Interest Tracing Guide.


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1

https://www.irs.gov/publications/p936


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