Rent vs Buy Decisions and Payday Lending, ECON 107b Project 1 Activity – Study Notes
Difficulty: Beginner to Intermediate | Prerequisites: Understanding of interest rates and credit (see companion notes on Choosing the Right Credit Card).
The rent-vs-buy decision is one of the largest financial choices most people face. This section of the project applies the concepts of interest rates, loan terms, creditworthiness, and personal budgeting to realistic housing scenarios. It connects directly to the credit card material: both ask you to evaluate the cost of borrowing against your income and financial position. The payday loans discussion adds a layer of consumer protection and market fairness, asking whether certain lending products exploit vulnerable borrowers. Together, these topics form the personal finance core of introductory microeconomics.
Whether to rent or buy depends on your income, savings, credit history, life stability, and the loan terms available to you. A low interest rate on a fixed mortgage with affordable monthly payments can make buying worthwhile, but a high-interest subprime loan on an unaffordable home is a recipe for financial trouble. Payday loans are a separate form of short-term, high-cost borrowing that critics argue traps low-income borrowers in cycles of debt.
Mortgage
A loan used to purchase real estate, where the property itself serves as collateral. If the borrower stops making payments, the lender can seize the property through foreclosure.
Think of it as a decades-long instalment plan for a house, with the house as the lender's security.
Fixed-rate mortgage
A mortgage where the interest rate stays the same for the entire life of the loan. Your monthly payment is predictable from the first month to the last.
In simple terms, this means the rate you sign up for is the rate you pay for 15, 20, or 30 years.
Subprime loan
A loan offered to borrowers with poor or limited credit history, at a higher interest rate than a conventional loan. The higher rate compensates the lender for the increased risk of default.
Think of it as the expensive option for people who cannot qualify for a standard mortgage.
Down payment
The upfront cash a buyer puts toward the purchase price of a home. The mortgage covers the rest. A larger down payment means a smaller loan and lower monthly payments.
In simple terms, this means the chunk of money you pay out of your own savings before the bank lends you the remainder.
Debt-to-income ratio (DTI)
The percentage of your gross monthly income that goes toward paying debts (mortgage, car loan, credit cards, student loans). Lenders use DTI to assess whether you can handle additional borrowing.
Think of it as the share of each pay cheque already spoken for by existing debts.
Payday loan
A small, short-term, unsecured loan (typically due on the borrower's next payday) that carries extremely high interest rates and fees relative to the amount borrowed.
In simple terms, this means a cash advance against your next pay cheque, but the fees can push the effective annual interest rate into the hundreds of percent.
Compounding interest
Interest calculated on both the original principal and any previously accumulated interest. Over long periods, compounding causes the total amount owed to grow faster than simple interest would.
Think of it as interest on your interest, which is why mortgage balances and credit card debts can grow so large over time.
Housing market crisis (subprime mortgage crisis)
The financial crisis of 2007 to 2009, triggered in large part by widespread lending of subprime mortgages to borrowers who could not afford them. When housing prices fell and borrowers defaulted, it caused cascading failures across the financial system.
In simple terms, this means banks gave home loans to people who could not repay them, and when those loans went bad, it nearly collapsed the global economy.
Before analysing specific scenarios, the factors that determine whether someone should rent or buy are:
Income and job stability (can they reliably make payments for years?)
Savings and down payment (do they have enough upfront cash?)
Credit history (does their score qualify them for a reasonable interest rate?)
Life stage and flexibility (are they settled, or might they need to move soon?)
Loan terms available (what interest rate and duration is the bank offering?)
Debt-to-income ratio (will the mortgage payment leave enough room in the budget?)
A general guideline: housing costs (rent or mortgage payment) should not exceed roughly 28% to 30% of gross monthly income.
Profile: 22 years old, single, no plans to start a family, fair credit, no savings, $30,000 annual income.
Loan offered: Subprime mortgage for a $200,000 home at 13% interest.
Analysis:
Monthly gross income: $2,500. A 13% mortgage on $200,000 over 30 years produces a monthly payment of roughly $2,214, which is nearly 89% of his gross income.
He has no savings for a down payment, closing costs, or emergency repairs.
Fair credit means he cannot qualify for a conventional low-interest loan.
He is young, single, and may need to relocate for career opportunities.
A 13% interest rate is extremely high for a mortgage and reflects subprime territory.
Verdict: Continue renting. The subprime loan is unaffordable, and buying would leave him financially exposed with no savings cushion.
Profile: 35 years old, single mother of two, good credit, $75,000 annual income, $15,000 in savings.
Loan offered: 30-year fixed-rate mortgage at 3% for a $200,000 home.
Analysis:
Monthly gross income: $6,250. A 3% fixed mortgage on $200,000 over 30 years produces a monthly payment of roughly $843, which is about 13.5% of her gross income, well within the 28% guideline.
She has $15,000 in savings, enough for a modest down payment or closing costs.
Good credit qualifies her for the low fixed rate.
She has children and a dog, meaning she needs stable, long-term housing.
A 3% fixed rate is historically low and locks in predictable payments.
Verdict: Buy the home. The monthly payment is affordable, the rate is low and fixed, she has savings for upfront costs, and her family situation calls for stability.
Profile: Recent graduate, starting career, renting an apartment, can afford a home worth a given dollar amount.
Loan offered: 30-year fixed-rate mortgage at 3% compounding interest, monthly payment of $1,429.39 for a $212,000 home.
Analysis:
The monthly payment of $1,429 must be weighed against your actual starting salary. For a recent graduate earning, say, $50,000 (roughly $4,167/month gross), that payment represents about 34% of gross income, above the 28% guideline.
A recent graduate may have student loan debt, limited savings, and uncertain career trajectory.
The 3% rate is favourable, but the total commitment (30 years) is long for someone just starting out.
Potential further education costs add another financial obligation.
Verdict: This one depends on your specific numbers, but the activity's framing (recent graduate, further education planned) leans toward continuing to rent until income stabilises and debts are under control.
Payday loans are small, short-term loans (typically $100 to $1,000) secured against the borrower's upcoming pay cheque. They carry fees that, when expressed as an APR, often exceed 300% to 400%.
Why they exist:
They serve borrowers who cannot access traditional credit (poor credit scores, no bank relationship, urgent cash needs).
They fill a gap that mainstream banks and credit cards leave open.
What critics say:
The interest rates are predatory. A $15 fee on a $100 two-week loan translates to an APR of roughly 390%.
Borrowers frequently roll over the loan (take out a new payday loan to pay off the previous one), creating a debt cycle where fees compound and the principal never shrinks.
Payday lenders disproportionately operate in low-income communities, raising concerns about targeting vulnerable populations.
The loans do not help build credit, because most payday lenders do not report to credit bureaus.
What supporters say:
For someone facing an emergency (car repair, medical bill) with no other options, a payday loan provides immediate cash.
Restricting payday lending removes a financial tool from people who have few alternatives.
The key takeaway for the exam: payday loan interest rates are extremely high, and the debt-cycle risk is the central criticism.
The activity asks you to add a monthly credit card payment to your personal budget. The principles to remember are:
Your total monthly debt payments (credit cards, car loan, student loans, mortgage) should not exceed your monthly income.
Credit card balances should ideally be paid in full each month to avoid interest charges.
If you chose to buy a home in Scenario 3, your budget must accommodate the $1,429 monthly mortgage payment in addition to all other debts and living expenses.
A realistic budget accounts for fixed costs (rent/mortgage, insurance, loan payments), variable costs (food, transport, utilities), and savings.
Monthly mortgage payment (fixed-rate):
M = P x [r(1 + r)^n] / [(1 + r)^n - 1]
Where:
M = monthly payment
P = principal (loan amount)
r = monthly interest rate (annual rate / 12)
n = total number of monthly payments (years x 12)
Example for Susan: P = $200,000, annual rate = 3%, so r = 0.03/12 = 0.0025, n = 360.
M = 200,000 x [0.0025(1.0025)^360] / [(1.0025)^360 - 1] = approximately $843 per month.
Example for Charlie: P = $200,000, annual rate = 13%, so r = 0.13/12 = 0.01083, n = 360.
M = 200,000 x [0.01083(1.01083)^360] / [(1.01083)^360 - 1] = approximately $2,214 per month.
Debt-to-income ratio:
DTI = (Total monthly debt payments / Gross monthly income) x 100
Charlie's DTI if he took the mortgage: ($2,214 / $2,500) x 100 = 88.6%. Lenders typically want this below 36% to 43%.
Susan's DTI for the mortgage alone: ($843 / $6,250) x 100 = 13.5%. Comfortable.
Payday loan APR equivalent:
APR = (Fee / Loan amount) x (365 / Loan term in days) x 100
A $15 fee on a $100 loan for 14 days: (15/100) x (365/14) x 100 = 390.2% APR.
Students often think renting is "throwing money away." Renting is paying for housing you use. Buying ties up capital, carries maintenance costs, and only builds wealth if the property appreciates, which is never guaranteed.
Students often assume a low interest rate automatically makes buying the right choice. A low rate helps, but it means nothing if the borrower's income cannot support the monthly payment alongside other expenses.
Students sometimes believe payday loans are illegal. In most U.S. states they are legal, though some states cap the fees or ban them outright. The controversy is about whether they should be more tightly regulated, not whether they currently exist.
Students often confuse a payday loan's flat fee with its true cost. A $15 fee on $100 sounds small, but annualised it exceeds 390% APR, which is the figure examiners expect you to calculate.
Expect a scenario-based question where you must advise someone to rent or buy, using their income, credit, savings, and loan terms. Justify your answer with specific numbers (DTI ratio, monthly payment as a percentage of income).
Know how to calculate a basic monthly mortgage payment using the formula, or at least estimate whether a payment is affordable given a stated income.
Be prepared to explain why subprime loans contributed to the housing market crisis.
Payday loan questions will likely ask you to identify the criticism (high interest rates, debt cycles) and calculate the effective APR from a fee and loan term.
True or false: A debt-to-income ratio of 88% is acceptable to most lenders. (False. Most lenders want DTI below 36% to 43%.)
Fill in the blank: A subprime loan carries a ________ interest rate than a conventional loan because the borrower is considered ________ risk. (higher; higher)
True or false: Payday loans typically have an effective APR below 50%. (False. Effective APRs commonly exceed 300%.)
Fill in the blank: In the housing market crisis, widespread defaults on ________ mortgages triggered a financial collapse. (subprime)
True or false: Susan's mortgage payment of $843/month on a $75,000 annual income falls within the 28% housing cost guideline. (True. It is about 13.5% of gross income.)
Q: A 25-year-old earns $40,000 per year and is offered a 30-year fixed mortgage at 5% for a $180,000 home. The monthly payment would be approximately $966. Should they buy? Explain using DTI.
A: Monthly gross income is $3,333. DTI for the mortgage alone would be ($966 / $3,333) x 100 = 29%. This is just above the 28% guideline but below the 36% threshold many lenders use. If the person has minimal other debt and some savings for a down payment and emergencies, buying could be reasonable. If they carry significant student loans or credit card debt, the total DTI would push too high and renting would be wiser.
Q: Explain the "debt cycle" criticism of payday loans.
A: When a borrower cannot repay a payday loan by their next pay cheque, they take out a new payday loan to cover the old one, paying another round of fees. Each rollover adds fees without reducing the original principal. Over several cycles, a borrower can end up paying far more in fees than they originally borrowed, making the loan increasingly difficult to escape.
Q: Why did the availability of subprime mortgages contribute to the 2007 to 2009 housing crisis?
A: Subprime mortgages allowed borrowers with poor credit and insufficient income to buy homes they could not afford. When housing prices stopped rising and many of these borrowers defaulted, the loans (which had been packaged into securities and sold to investors) lost value rapidly. The cascading losses across the financial system triggered a broader economic crisis.
Q: Charlie has fair credit and earns $30,000 per year. He is offered a $200,000 home at 13% interest. Calculate his approximate monthly payment and DTI, and explain your recommendation.
A: Monthly payment at 13% on $200,000 for 30 years is approximately $2,214. Monthly gross income is $2,500. DTI = (2,214 / 2,500) x 100 = 88.6%. This is catastrophically high. The recommendation is to continue renting. Charlie would have almost nothing left for food, transport, utilities, insurance, or any other expense.
The rent-vs-buy decision connects to the credit card material in the companion notes, because both involve evaluating borrowing costs against personal income. The same logic (APR, total cost, affordability) applies whether you are choosing a credit card or a mortgage.
Payday lending connects to broader microeconomics topics such as market failure, information asymmetry (borrowers may not understand the true cost), and government regulation of markets. If your course covers consumer protection law or the role of the Consumer Financial Protection Bureau (CFPB), this is where it ties in.
Rent vs buy, renting versus buying a home, mortgage, fixed-rate mortgage, subprime mortgage, subprime loan, housing crisis, 2008 financial crisis, subprime mortgage crisis, down payment, debt-to-income ratio, DTI, monthly mortgage payment, 30-year mortgage, compounding interest, payday loan, payday lending, predatory lending, debt cycle, rollover loan, consumer credit, consumer protection, CFPB, personal finance, budgeting, housing affordability, ECON 107b