One of the financial questions almost everyone will ask themselves at some point is “should we buy a home or should we rent”. In Denmark, we have a very big societal pressure to buy. If you dare to question the general notion that everyone should buy their own home the answer I hear most often is: “I want to pay off on my house instead of pouring money into the pocket of some landlord”. This is an emotional response rather than a rational so I will try to dig into the math’s instead.
Now I will say, there are some reasons to buy a house. In general, if you look to buy you have a large selection of villas with garden while the rental market predominantly consists of apartments in some shape or form. I own a house with my girlfriend and some of the reasons we did it was:
- We wanted a garden when starting a family
- We wanted more space than was feasible in the apartments offered in our desired location
- We didn’t want our hands tied when it came to remodeling and gardening
Was it a smart financial decision for us to buy a house? Absolutely not! Just the interest on our loan+the property taxes almost cover our previous rent. Then add in maintenance and utilities and we are spending a lot more than necessary. Had I been alone in taking the decision we would have probably stayed in our apartment until we had a few kids, but we are happy where we are. It is one of the sacrifices my girlfriend was not willing to make to FIRE earlier and that is fine by me. So, if you want a house then I won’t stop you, I just want to try enlightening you on the numbers so you can make an informed decision.
A house is a cost, not an investment
Many people think of buying a house as an investment. In some ways, it can be argued that it is an investment – it is an asset that you own (at least partially) and that fluctuates in value. In general though it makes a lot more sense to think of it as a cost. You will always need a place to stay and so some portion of your wealth will go to housing expenses. You can then choose to spend that money on a lease or you can choose to spend it on buying a property and both models have their pros and cons, but either way you are spending money to cover a need. Even with a paid off house you will have expenses (property taxes, maintenance, insurance to mention some).
The reason that some people view housing as an investment is probably that most people get a lot of money in hand when they sell the house. But did they really earn a lot? A lot of it is surely. From what I can find the Danish real estate market seem to trend at increases very close to the general increases in salary. Without knowing much, I think it makes sense that in an open market, when peoples salaries rise they have more money to spend on houses and the prices will reflect that. Since real income (after inflation) tends to rise a bit properties appreciate a little in value over time compared to inflation – but on a countrywide basis we’re probably talking about 0.5%-1% per year which is less than property taxes. In areas like Copenhagen or Aarhus the salaries are generally rising much faster than the nationwide average and that means that the local real estate rises at about the same pace. If that trend continues then buying in one of these places might earn you more appreciation while buying in the countryside will in a lot of cases lose your property value over time.
What most people forget when they look at property value increases is that if you own just your own house you are generally not benefitting from appreciation. As I said in the beginning of this paragraph you will always need a place to stay. So, if your entire city experiences a 30% appreciation over several years your house may be worth 30% more but if you sell it to buy another house then that price will generally also have risen by thesame amount. Of course, if you downsize your house or move to another area you might benefit since your needs changed. If you do however own more than one house, then you could benefit from appreciation and this is what some people bet on for investments.
A reverse approach
I’d like to just take a short moment to look at this from the point of view of the landlord. Those that buy properties to rent out for profit are the professionals in this world and they (at least those that are successful) know more than you and I. The rule of thumb that I hear here in Denmark is that the gross yearly rent should be at least 1/10th of the price of the property or more precisely that the net rent after expenses should be at least 1/20th. That seems reasonable since that would give you an expected return of 5% pretax which you can then leverage with a mortgage if you dare. So, say you are currently living in an apartment in Copenhagen and paying 6,000 kr rent and that that apartment would cost you 1.8 million to buy. A real estate investor would look at that and say 6,000*12*10=720,000 kr so buying the apartment to earn that 6,000 kr a month would be a bad investment. If you buy that apartment, then you’re in essence making that investment. To consider buying the apartment your actual rent should be around 15,000 kr! Of course, you are a bit better off due to tax implications – your 6,000 kr saved is tax free while the profit part of his 6,000 kr is taxed. Still I think this perspective gives some insight into just how often buying is a financially bad decision.
Generally, in Denmark it’s not that easy finding properties that you can rent out at 1/(12*10) value monthly and I think that is an indicator that renting is by and large a good option in Denmark. Between laws that regulate rent (mostly in properties built before 1992) and a general desire to own that drives prices above sensible levels (in an investment sense) I think Denmark is a pretty good country to be a renter. But of course, if you just spend all your paycheck every month and lack the discipline to save then having forced savings in the form of house payments can be pretty good for you.
In a second I’ll give you a spreadsheet you can use to try to estimate the financial impact of renting vs buying with your own numbers and estimates. But let’s start out by looking at what type of expenses you have when you own a house. The categories of housing expenses on a high level:
- Closing costs
- Mortgage payments
- Bank payments
- Extra utilities
- Property taxes
- Selling costs
- Opportunity costs
The last two are a bit more speculative than the first ones, but the opportunity costs are a very large part of the total expenses you face when buying a house. Say you buy a house at 2.5 million kr. Then a typical down payment on that would be 500,000 kr and with closing costs and a bit of moving costs and initial repairs we might approach 600,000 kr out of pocket to get started. Of course, the 500,000 kr is not gone but it is tied to the house so we must think of the time value of it. Had you taken those 600,000 and invested them at 6% pre-tax then you’d earn around 26,000 kr a year after taxes, more if in a retirement account. Adding the mortgage interest of say 2,000,000*2.5%*0.664=33,200 kr after tax credits, property taxes of around 34,000 kr and extra insurance at say 6,000 kr and maintenance at 24,000 kr the yearly cost of owning is around 125,000 kr or close to 10,000 a month. This was just a quick example so I tried creating a spreadsheet you can use to do the calculation for yourself with your own inputs:
There are a bunch of approximations in there and it got pretty complex over time so if you find an error please let me know so I can fix it.
In general, I think owning a house is more expensive than people think. If you just look up loan rates you will only see the payments and not the total price of owning. If you play a bit with the timeline you will probably see that buying a home to live there for less than 5-10 years will be very expensive since the buying and selling costs will be a major contributing factor to the total costs. If you plan to stay for longer than 10 years then most likely the biggest factor will be the opportunity costs of all the cash you tie up into the house (if you, like me, believe that stock markets will perform far better than real estate appreciation long term). I think the calculator is a good way to check up on the costs for you so I will just provide some vague guidelines that I think you should follow when buying a house:
- View the purchase as a cost – not an investment. You can buy additional properties to rent out as investment, but you’ll do yourself a favor by only buying your home as a means to meet your need for shelter.
- Only buy if you plan to stay for 10 years. As a rule of thumb the transaction costs are too big otherwise. Also, getting locked in place can have a big opportunity cost career wise – I know I could certainly earn a LOT more if I could uproot and move across the country.
- Don’t go asking the bank “How much can I afford?”. They will want business so they will stretch your finances as much as they can while still minimizing risk of foreclosure. Instead ask yourself “How much do I really need?”.
- Don’t underestimate the risk. I’d advise going for a house that you can still pay if shit hits the fan. For me and my girlfriend that meant that we limited our search to homes where we could still make the payments if one of us had ZERO income. Sure, we both have unemployment insurance, but being conservative means we can sleep well at night even through a crisis. The same concept applies to variable rate mortgages. Feel free to use those as they often perform very well, but don’t take one that you can just about pay now and then watch your house get foreclosed if rates rise to 5%.
I hope to hear your input on this – I think the rent vs. buy discussion is very interesting and the more I read the more I keep finding great insights so I’m sure some of you can enlighten me as well. I’ll just link the spreadsheet again and invite you to go run the numbers for yourself and let me know what I can improve: Rent or buy?