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## Finance and capital markets

### Course: Finance and capital markets > Unit 2

Lesson 2: Renting vs. buying a home# Is buying a home always better?

The math of renting vs. buying a home. Challenging the notion that it is always better to buy. Created by Sal Khan.

## Want to join the conversation?

- why did he end up paying 26,000 in rent(19 votes)
- He paid $36,000 in rent, but then added his $10,000 in interest per year to calculate his total cost per year at $26,000.(40 votes)

- There are considerations other than money, though. If you're renting, in many situations, you can lose your home suddenly if the landlord decides he wants to move in, move in a relative, or increase the rent so high you can't afford it anymore. The cost of moving and potential adjustments to jobs and schools can be very high, monetarily and emotionally.(25 votes)
- True, or like in the area I live in, there are absolutely zero places available for rent within 50 miles. So to move out and into our own place, my husband and I had to get a mortgage, but we’re paying $950/month now, instead of $250/month on family property and no ability to do what we want.(3 votes)

- for the renting scenario, don't you have to pay taxes on the 10K interest earnings?(14 votes)
- Yes, but it's only 15%, or at least on the federal level, so I guess that brings the cost of rent up 1.5k in this example.(6 votes)

- I felt as if this video was trying to talk people out of buying a home, but statistically speaking people who own a house are 26 percent wealthier. If you buy a house with a 6 percent interest rate you probably should not have bought it in the first place. Also, if two identical houses are next to each other it would cost more to rent and cheaper to buy, because nobody would buy a house and rent it out to lose money on their return on investment. Something does not add up in this video.(8 votes)
- There are a load of variables going on here that vary year by year and city by city. There's no right or wrong answer. Right now, in the specific city in Southern California where I live, if you put 20% down on a $1M home your monthly payment is cheaper than renting that same place. I know because I put 20% down on exactly a $1M purchase price at a 3.625% 30 year fixed rate and the monthly payment is $3650. Literally next door is an almost identical place and it rents for $4200/month. And that's true all over where I'm at.

But that's not true everywhere, and may not be true where I'm at in 2-3 years when rates are higher. The point is it's not black and white.

But what I do know is the example in this video isn't a good snapshot of reality (that is, the video assumes mortgage rates of 6% which are way higher than the average rate today of around 4%, and it assumes the home buyer is on an interest only loan which is not a smart loan to get in general, let alone when you are putting 25% down). And the video is assuming for now that the home is not going to increase in value (which again, over the long run, isn't true),

If you are doing a 1 year comparison, you could demonstrate renting is better than buying. If you're doing a 5 year comparison, not so much. And if you're renting at $800/month more than the mortgage, the home owner is saving thousands of dollars more per year than the renter plus paying off principal that he'll get back on the eventual sale.(11 votes)

- Isn't this scenario unrealistic? How can someone earning $100K per annum buy a home for 1 Million? I know, maybe the $250K was a gift or inheritance, but the wages of 100K could never sustain something like this. Maybe put the $250K towards a home affordable with that kind of income and your scenario would change. Most people who have money DO NOT SAVE it, but putting it towards a home forces them to pay something off and after 15-20-25 years, at least they have something they own outright.(10 votes)
- All I can say is that I can get money... on a 10 yr term here in Ontario Canada for 3.7%... I can get 4 year money at under 3%. The math is fundamentally true, I think the tax implication vary depending on where you are.(3 votes)
- I live in Texas. His example is correct, but it is not typical of the historical relationship between cost of house and rent charged. A million dollar house should have a mortage payment of about 10,000 per month (princial, interest, taxes) and a million dollar house should rent for about 10,000 per month. Then renting is better for short term, buying is better if you are going to live in the house for 4 plus years. The numbers he is using are the numbers that have been generated by the housing bubble and the real estate colapse.(10 votes)

- is it possible, if you take out a slightly larger loan and hold on to some of your cash that would be earning interest that would reduce your out of pocket per year costs?(4 votes)
- It's probably not possible in the example you've given. The bank is loaning you the money because they can always take the house away if you fail to pay them back. If they've given you more money than the house is worth, and you fail to pay, the bank has now lost more money and can't even get that back by selling the house again. However, if you want to take out a larger loan and use the extra money to make improvements on the house, the bank will probably allow that because you're increasing the value of the house and if you fail to payback the loan, the bank now has a house that matches the value of money they gave you.

Also, generally the loan you get for a house is going to be cost more than the interest you earn for a CD. As of right now a 1 year CD will get you about 2.5% and you will pay 3.7% on a house loan. You'd be losing 1.2% of your money doing this.(5 votes)

- Mr. Khan uses a 6% interest rate for a 30 year fixed rate mortgage, but mortgage rates are actually in the neighborhood of 3.5%, and haven't been as high as 6% since 2008. Making such an unrealistic assumption drastically skews the results in favor of renting. Viewers who are trying to learn this subject should be aware of this.(4 votes)
- Well, the video was uploaded to youtube in 2008...

He could redo the whole video with 3.5% and in four years it would be out of date again. But in my opinion that wasn't the point of the video. The point of the video is to show that it is possible that renting is cheaper than buying and shows you the basics of how to figure it out. I think that's important because it is still a very common misconception among young people that renting is throwing money away.(7 votes)

- When I take an interest-only loan and I pay back every month the interest only when do I acually pay the principal ?(5 votes)
- It's not all about the math. It's about pride of ownership, neighbors, stability.(3 votes)
- You are correct. You should seldom think of your main residence as an investment. Usually the math is just a way to determine if you can reasonably afford something.(7 votes)

## Video transcript

Welcome back. I'm now going to take a slight
tangent and cover a topic that, I think, this is probably
the single most important video that really
anyone can watch. I go to all of these parties
where I go see family. And my wife and I right now,
we live in Northern California. And we're renting. And I like to point
out, by choice. And I have family members,
why don't you buy? You're at that stage in
life, that's a major milestone, all of this. There's a lot of pressure
to buy. And when I tell friends,
I tell them I'm not going to buy. Because I think I'm pretty
convinced, almost 100% convinced, that housing prices
are going to revert back. And I'm going to do a bunch
of presentations to justify why they will. But then my friends, they'll
just throw out the statement that I hear from them, that
you hear from real estate agents, because obviously
they want you to buy. Well, isn't buying always
better than renting? And I think that kind of common
wisdom comes out of the notion of, when you have a
mortgage or when you borrow money to live in a house, every
month that money that you give to the bank is kind
of going into savings. That's the perception. While when you rent,
that money's just disappearing into a vacuum. In this video I'm going to work
through that assumption, and see if that actually
is the case. So let's say I have a choice. Let's say there are
two houses. This is house number one. And this is house number two. And let's say that they're
identical houses. These are three bedroom, two
bath, townhouses some place in Silicon Valley, which
is where I live. And I want to live in
one of these houses. I'm indifferent as to which
house I live in, because they are identical. So living in them is the
identical experience. I can rent this house
for $3,000 a month. Or I could buy this house
for $1 million. And let's say that in my bank
account right now, let's say I have $250,000 cash. So let's see what happens
in either scenario. Let's see how much money
is being burned. So in this scenario
what happens? I'm renting. So in a given year, let's just
see how much money comes out of my pocket. So in a given year
I pay $3,000. $3,000 times 12 months,
so I lose $36,000. So I'll put a negative
there, because that's what I spend in rent. $36,000 per year in rent. And then of course I
have that $250,000. I'm going to put that into the
bank, because I have nothing else to do with it. I didn't buy a house with it. And let's say that I can,
in the bank, let's say I put it in a CD. And I get 4% on that. So let's see, 250, that's
what? $10,000, I think. That's 0.04. Right, I get $10,000 in interest
a year on that. So I get $10,000. So plus $10,000 a year
in interest. So out of my pocket, for the
privilege of living in this house, in Silicon Valley, with
beautiful weather, out of my pocket every year
goes $26,000. So that's scenario one. So what happens if I give in
to the peer pressure of family, and realtors, and the
mortgage industry, and I buy this house for $1 million? Well I only have $250,000, which
is more, frankly, than most people who buy $1 million
houses have. But I have $250,000 cash. So I need to borrow $750,000. So I take out a mortgage
for $750,000. And I'm going to do a slight
simplification. And maybe in a future
presentation, I'll do kind of a more complicated one. In a lot of mortgages, when you
pay your monthly payment, most of your monthly payment,
at least initially, is the interest on the amount that
you're borrowing. And you pay a little bit
extra on that, to bring this value down. That's called paying
off the principal. You can also take an
interest-only loan, but the component of the interest
is the same. Essentially, when you take a
traditional mortgage, kind of a 30-year fixed, every month
you're paying a little bit more than the interest, just
to take down the balance. But for the simplicity of this
argument, I'm just going to say that we're doing an
interest-only mortgage. And then maybe with any
extra savings, I can pay down the principal. And that's the same notion. And right now, if I do 25%
down, and I'm buying a $1 million house, I'll have to
take a $750,000 mortgage. I don't know what a
good rate is, 6%? So let's say at 6% interest. So
to live in this house, how much am I paying just
in interest? Well I'm paying $750,000
times 6% a year. So $750,000 times 0.06 is equal
to $45,000 in interest. That's coming out
of my pocket. And of course, on a monthly
basis, that means in interest per month, I'm paying,
just to get an idea. I'm paying about $3,700, $3,800
in interest a month. My mortgage actually might be
something like $4,000 a month. So I pay the interest. And then
I pay a little bit to chip away at the whole
value of the loan. It takes 30 years to chip
away at the whole thing. And over time, the interest
component becomes less, and the principal becomes more. But for simplicity, this is the
interest that I'm paying. $45,000 a year. And then of course at a party,
when I start to explain this, it's like, ah-ha. But interest on a mortgage
is tax deductible. And what tax deductible means,
is that this amount of money that I spend on interest
on my mortgage, I can deduct from my taxes. I can tell the IRS that
I make $45,000 less than I actually did. So if I'm getting taxed at,
let's say 30%, what is the actual cash savings? Well I'll save 30% of this. I'll have to pay $15,000
less in taxes. How does that work? Well, think about it. Let's say I earned $100,000
in a year. And I normally have
to pay 30%. So I normally pay $30,000
in taxes. Right? This is, if I didn't
have this great tax shelter with this house. Now I have this interest
deduction. So now I tell the IRS
that I'm actually making $55,000 a year. And let's say my tax
rate is still 30%. it actually will probably go
down since I'm -- but let's, just for simplicity, assume my
tax rate is still $30,000. So now I'm going to pay $16,500
in taxes to the IRS. So how much did I
save in taxes? So I saved $13,500 from taxes,
from being able to deduct this $45,000 from my income. So let's say tax savings,
plus $13,500. Now what else goes into
this equation? Do I get any interest
on my $250,000? Well, no. I had to use that as part of the
down payment on my house. So I'm not getting
interest there. But what I do have to
do is, I have to pay taxes on my property. In California, out here we have
to pay 1.25% in taxes, of the value of the house. So what's 1.25%? So, taxes, this is
property tax. And that's actually tax
deductible too, so it actually becomes more like 0.75% or 1%. So let's just say 1% just
for simplicity. Property taxes. So 1% times $1 million. That equals what? 1% of $1 million is
another $10,000 a year in property taxes. And notice, I'm not talking
about what percent of my mortgage goes to
pay principal. I'm just talking about money
that's being burned by owning this house. So what is the net effect? I have a $13,500 tax savings. I have to pay $10,000 --
actually I have to pay a little bit more than that, but
we're getting a little bit of income tax savings on
the deduction on the property taxes. And then I actually have to pay
the $45,000 of interest that just goes out the door. So I'm paying $41,500. Notice, none of this $41,500
is building equity. None of it is getting saved. This is money that is
just being burned. So this is a completely
comparable value to this $26,000. So in this example -- this
example is not that far off from real values. Out here in the Bay area, I can
rent a $1 million house for about $3,000. But in this situation I am
burning, every year $41,500, where I could just rent the same
house for $26,000 out of my pocket, when I adjust
for everything. And then people a couple of
years ago said, oh, but houses appreciate. And that's what would
make it up. But now you know, very recently
-- we know that that's not the case. And in the next video, I'll
delve into this, and a little bit more. I'll see you soon.