The ‘great Australian dream’ has always been to own your own home, debt free. It gives you financial security, and over the past three to four decades, homeowners have enjoyed rising prices which has helped them build wealth.
But is it always a good idea to own your home, or is renting better? Put differently, how financially important is it to own your home?
The pros and cons of renting your home
There are several important pros and cons for people to consider if they plan to rent a home, rather than buy. This is often referred to as rentinvesting i.e., rent where you desire to live so that you can invest in pure investment-grade locations. I discuss the common considerations that I have helped clients navigate when contemplating whether to buy a home.
Tax free capital growth
Let’s begin with the biggest negative of not owning your home. There aren’t many things in life that are tax-free. So, if there’s an opportunity to build wealth and avoid paying capital gain tax, then we should probably take advantage of it. Whilst we typically buy a home for reasons other than wealth accumulation, it can be a great plan B. That is, if you buy well but everything else goes wrong, at least you will have heaps of equity in your home to fall back on i.e., if you sell it. It can also be a great way to trade up so that you can eventually afford your dream home, as I’ve discussed here.
It is possible to rentinvest and still enjoy the benefits of a main residence (CGT) exemption by using the 6-year rule. For example, if you buy a home and genuinely occupy it as your main residence (and have sufficient evidence of that) but subsequently move out and rent another property, you can continue to claim the main residence (CGT) exemption for up to 6 years, as long as you do not claim another property you own as a main residence. If your reoccupy the property again as your main residence before the 6 years has elapsed, you can reset the 6-year term again if you subsequently rent out the property. This is called the 6-year rule – see here.
Most states will levy land tax on any properties that you do not occupy (main residence land tax laws are different than federal tax laws), so land tax might still be payable.
Therefore, if you want to rent a home, it would be worthwhile considering whether you can take advantage of the main residence exemption using the 6-year rule.
It’s a forced savings plan
Owning a home is a good forced savings plan because people tend to be very focused on repaying their home loan as fast as possible, especially in higher interest rate environments. In the absence of this “commitment”, it is tempting to spend more and invest less.
Where you want to live won’t make a good investment
Often it is possible for people to buy an investment-grade property and use it as their main residence. That is, the location and type of property they want to live in makes an otherwise great investment. In this situation, they are killing two birds with one stone i.e., meeting lifestyle goals and building equity in their home.
However, if you want to live in a type of property and/or location that wouldn’t make a good investment (i.e., doesn’t have good prospects for capital growth), then perhaps you are better off renting. For example, often new-build, high-rises located in CBD’s don’t make good investments but can be attractive to live in. In this situation, someone might be better off renting a CBD apartment and investing in an investment-grade property.
Can’t afford to buy where you want to live?
One advantage of renting is that it might be more affordable for you to rent in the location (or type of property) that you want to live. This can be the case for two reasons. Firstly, cash flow wise renting may be cheaper, especially now as interest rates are much higher than they were a few years ago. Secondly, you might not have enough equity/deposit or borrowing capacity to be able to buy a property in the location you want to live.
Therefore, you might be better off buying a downsizer property now, in an investment-grade location, which you can occupy in the future when your kids have left home and/or you are retired. Meanwhile, you can rent a larger home that better accommodates your family’s needs.
However, be careful to avoid living beyond your means. Sometimes it is not always possible to live in our first-choice location i.e., be it either renting or owning. We must always be realistic about what is affordable and sustainable. Spending beyond your means is never a good idea and will cost you dearly in the long run. The longer you do it, and postpone the consequences (i.e., kick the can down the road), the more severe the ultimate consequences will be.
Trading down might be the solution to living where you want
If you can afford to buy a home in your first-choice location (i.e., your borrowing capacity is sufficient and you can service loan repayments), but it will give rise to a very large amount of debt, one solution could be to commit to downsizing in the future to repay/reduce debt.
For example, you may buy a large family home in a blue-chip suburb for $4 million and that gives rise to a home loan of $2.5 million, which is huge (yet still affordable), of course. Let’s assume that all you do for the next 15 years is just service the interest on the loan i.e., repay interest-only. In 15 years, when your kids have finished school, you may be able to sell the home for over $10 million (assuming an average growth rate of 6.5% p.a.), repay the loan, and walk away with over $7.5 million of cash in the bank.
This scenario may help you achieve your lifestyle goals (e.g., living in a good public-school zone, large family home, etc.) whilst building (tax-free) wealth at the same time. Of course, this only works if you buy well, so don’t be afraid to pay for advice (i.e., use a good buyers’ agent).
Lock in a school if you have kids
If you have kids, a big disadvantage to renting is that the landlord might cease renting the property to you. If that happens, you need to find replacement accommodation at a similar cost, that is hopefully near the school your children attend. That might be challenging, depending on the type and size of property you need. This ‘uncertainty’ can be worrying for some people and encourage them to own rather than rent.
The true cost of home ownership…
It is very easy to underestimate the true cost of home ownership.
Firstly, because your home loan is not tax deductible, it is very costly to repay this debt as you need to do so from after-tax dollars. Secondly, the money spent on incidental and even more substantial maintenance/improvements over the years can add up to a substantial sum of money.
Whereas, if you rent, the property is maintained by the landlord and it’s easier to resist the temptation to make improvements i.e., fewer trips to Bunnings.
When reviewing a property’s capital growth over time, you must consider how much has been spent on maintaining and improving the property over the ownership period – not all the value appreciation has been due to capital growth.
You’ll almost certainly want a home eventually
In my experience, everyone wants to own their own home eventually. Over the years, clients have told me that they are happy renting indefinitely. However, on every occasion, their preference changed eventually. Having the security of a home, a place that you have full control over, is important to us at some point in our life.
Therefore, if we know that it’s likely that we’ll want a home at some stage, then we should make sure our investment strategy accommodates that likelihood. And if you want to live in a blue-chip location, it’s likely that a home will cost you a lot more in the future (compared to what it costs today). That is, the longer we delay buying a home in a good quality location, the more we will have to pay (using after-tax dollars) in the future. As such, most people are better off buying that future home as soon as possible.
The most compelling considerations
In my experience, the most important factors to consider are:
- Taking advantage of the main residence (CGT) exemption, whether that be by occupying a property of your own or using the 6-year rule; and
- Given its likely you will want a home at some point, it is best to consider whether you are better off buying it sooner rather than later. Of course, this is only possible if you can confidently predict where you will want to live in the future.
Owning your own home isn’t critical to build wealth successfully. However, depending on its location, our home can be one of the best “investments” we make, on an after-tax basis.
