The Road to Financial Freedom Starts Here!

Friday, April 30, 2010

Is it Better to Buy or Rent?

I found myself asking this question often ever since I started earning my own money. For many of us, the holy grail of independence is to own our own home (which is also one of the most important reasons why most Chinese save a significant portion of their income); if you’re on the wrong side of thirty and you’re still renting your apartment, you’re not yet “made.”

We all know that buying your own place provides several important intangible benefits like a sense of accomplishment and security that renting cannot provide, but is it really the best economic option? In making a financial decision as important and expensive as buying real estate, you’ll have to consider all relevant factors and perform due diligence analysis, which can easily overwhelm you with details and data. It’s a good thing the New York Times recently released an online, interactive tool that helps you decide which is the better option for you.


Basic Inputs

The graphic comes pre-loaded with default values that you’ll have to change to reflect your own specific circumstances. The first thing you have to realize is that while some of the input boxes are labeled with the US dollar sign ($), you can actually use any currency unit (like our beloved Philippine peso) as long as you’re thoroughly consistent.

On the left-hand side of the main page, you’ll have to enter basic information about the property and your finances:

1. Monthly rent – of the property you’re thinking of buying, or another property that’s comparable to it; the typical monthly rent for a 40-square meter condominium unit along Katipunan Avenue is around 20,000 pesos

2. Home price – current market value of the property if paid up front; note that this is not the same as the sum of your monthly payments if you get a mortgage (housing loan) to pay for the house; the market value of the condominium unit I’m using in this example is around 2.5 million pesos

3. Mortgage rate – the annual interest rate of the housing loan that’s available to you; for most banks, this is at around 10%; for Pag-Ibig, interest rates for lower loan amounts are substantially lower; a 2.5 million peso loan from Pag-Ibig goes at an annual interest rate of 10.5%

4. Annual property taxes – there’s no one percentage rate applied for property tax in the Philippines, and the computation is really quite convoluted, so I think leaving the default value as is should suffice.

On the top portion of the graph, you’ll find two slider bars for the following inputs:

5. Annual home price change – this should be the long-term annual percent change of the price of the property; for the sake of conservatism, I set this one to zero

6. Annual rent increase or decrease – in my experience, apartment rents increase at an average of 5% per year

Advanced Inputs


If you want a more customized analysis, click the “advanced settings” button at the upper right corner of the graph. The more relevant advanced settings include,

1. Condo fee/common charge (buying) – condo fees are around 40 pesos per square meter per month, so that’s 1,600 for my property

2. Rent deposit (renting) – rent deposit is anywhere from 2 to 3 times the monthly rent

3. Rate of return on investments (other) – this is your opportunity cost of capital, the answer to the question “how much annual interest would you earn from an available investment with similar risk?”; a good figure would be 8%, which is the typical yield of medium-term retail corporate bonds nowadays (more on that in a future post)

4. Marginal tax rate (other) – or income tax rate, anywhere from 20% to 35%, depending on your gross monthly income

5. Inflation rate (other) – the average annual percent increase in the price of basic goods and services; 5% should be a good enough estimate

I decided to leave other details as is.

The Output

After entering all the required information, the tool coughs up its recommendation. Based on the details I’ve entered, “Buying is better than renting after 11 years.” Well, that’s pretty clear, straightforward and useful. That means if I plan to stay and live in the Katipunan area for less than 11 years (an eternity in my book), I would be better off if I rented a condo for 20,000 pesos per month that if I buy the same property now for 2.5 million pesos (and sell it when I’m ready to move).


The tool also presents an organized summary of the annual and total costs of both alternatives, and a year-by-year analysis of the better decision based on how long you plan to live in your chosen place of residence (for example, renting the condo for ten years will save me a total of 60,617 pesos compared to buying).

GIGO

I always ask my classes what they think this acronym means; the most common answer is “Go In, Go Out,” which up to now does not make sense to me. I guess IT professionals would be more familiar to the phrase “Garbage In, Garbage Out,” which just means the reliability of the any process’ output depends on the soundness of the inputs. So in using the NY Times’ Buy or Rent tool, you should remember that the usefulness of its recommendation is only as good as your input estimates and assumptions. Finally, while making important purchasing and financial decisions is best done objectively and quantitatively, sometimes intangible, intuitive factors are equally important.