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Whether to buy or rent a home is a difficult decision.
Existing home sales of 6.12 million in 2021 reached the highest level since 2006. They are expected to approximate 7 million in 2022. Median home prices are expected to increase approximately 6% in 2022 after increasing 16.9% in 2021, the largest percentage price increase on record. These increases in both the number of homes sold and the median sales price are due in part to the pandemic, low interest rates and a low supply of available homes.
Overall there was an 11% increase in median asking rent across the country for 2021. Single family home rentals were up 26% for the year. Rent growth is expected to reach 7.1% in 2022.
The increase in sales price and sales activity over the last couple of years, as well as the increase in rental rates, has not made it any easier to make the buy or rent decision.
Is it Better to Buy or Rent a Home?
The buy or rent decision is a complex one and you should consider your personal and financial goals. As you assess your personal goals, you might ponder certain lifestyle considerations such as: the size of your living space, whether you work from home, the school district you want to live in, the neighborhood amenities you value or the features of your living space.
Financial considerations include both tradeoffs and opportunity costs. By renting you limit your maintenance costs and reduce the upfront costs necessary to buy a home which might allow you to make other investment decisions with the available capital. As you contemplate the buy versus rent decision, you will find many of the lifestyle decisions cannot be quantified whereas the financial decisions are more black and white.
Lifestyle Considerations to Buy or Rent a Home
Unlike the financial considerations, which we will discuss shortly, as we compare the lifestyle considerations, it may not be obvious if a better choice for you is buying or renting a home.
If you buy a single family home you need to comply with local zoning laws, but you should have few restrictions placed upon you. That might not be the case if you buy a condominium or your neighborhood has a homeowners association. You can buy a home that gives you as much privacy as you choose.
Every home has maintenance expenses no matter how new or old it is, or if it is in good condition or not. However, it is the owner’s responsibility to decide how much or how little to spend. When you buy a home, and make a considerable investment, it could be costly to leave. If you make a decision to move to another area, you might incur additional costs to sell the home and you may be forced to take a lower price than you would like because of market conditions. However, in the meantime, you have the satisfaction of owning your own place.
If you rent a home your landlord could place significant restrictions on the lifestyle you would like. For example, there may be no pets allowed or you may not be able to decorate as you would like. The level of privacy you like may be different than what other tenants or the landlord would like. When renting a home typically the landlord is responsible for maintenance; however, if you have an irresponsible landlord they may not fix something right away or not at all. When your lease is over you can leave without any strings attached.
Financial Considerations to Buy or Rent a Home
The upfront costs associated with buying a home is often far more than the buyer realizes. Those costs include the down payment, closing costs, loan application and origination fees, appraisal fees and the cost of a title search and title insurance, among others. Recurring costs include the monthly mortgage payment (principal and interest), property taxes and insurance.
What Can You Afford?
A rule of thumb is your principal, interest, taxes and insurance (PITI) (Housing Cost Ratio) should not exceed 28% of your pre-tax monthly income. In addition, another ratio mortgage lenders look at is the Total Cost Ratio. This ratio compares your PITI and other debts like credit cards, student loans, auto loans and any other debt to your pre-tax monthly income. This ratio should not exceed 36%.
The Housing Cost Ratio and the Total Cost Ratio are tools used by mortgage lenders to determine if you can pay them back. However, you, the home buyer, should not buy a home based upon these two ratios alone. You also need to consider your own spending habits and how you use and manage money.
There are two schools of thought. Some will say you should buy the most expensive house you can afford as an investment with the hope that your income will grow to pay for it. Others will say you don’t want to be “house poor”. Being house poor can be stressful and you have very little extra money to do other things. Evaluate your situation fully since it is a choice you may have to live with for many years.
Repairs and Maintenance
In addition, home purchasers sometimes push to the limit the size house they can afford without considering the cost to maintain the house.
There are many metrics you should consider. For example, some financial planners suggest setting aside 1% of the value of your home annually for repairs and maintenance. Other financial gurus suggest that metric should be 4%, while others suggest you save approximately 10% of your PITI annually to maintain your house. Another metric used to budget maintenance costs are $1 per square foot of living space. Unfortunately there is no easy answer; it depends in part on the age, condition, location and how you take care of your home.
Cost of Rentals
As a renter your costs only include the monthly rent, utilities and insurance. However, you are subject to annual increases in your costs.
The Buy or Rent a Home Decision
Suppose your household income is $100,000. Using the Housing Cost Ratio above, 28% of your pre-tax monthly income is $2,333 [($100,000/12) x 28%]. Since the Housing Cost Ratio includes principal, interest, taxes and insurance, part of your pre-tax monthly income of $2,333 covers taxes and insurance. Since we are determining the amount of mortgage you can afford, we are only considering principal and interest. Let’s assume 80% of your Housing Cost Ratio amount is for principal and interest, say $1,866.
So how large a mortgage can you afford assuming the interest rate on a 30 year mortgage is 4% or 5%? At 4% and 5% the mortgage amount would approximate $390,850 and $347,600 , respectively. The difference of 1% in the interest rate has a significant impact on the amount of the mortgage which might be approved by a lender. There are many free online calculators which will calculate how much your monthly payments would be depending on the interest rate and length of the mortgage.
The following tables illustrate the cost of renting a home or the cost of buying a home over 1 and 5 year periods. This illustration assumes it is the same single family home and not an apartment in a building compared to a single family home. The numbers used are all for illustration purposes only and may bear no resemblance to real costs where you live.
We are evaluating the costs for a $200,000 house, requiring a 20% down payment upon purchase, $6,000 of closing costs and a 30 year, 5% mortgage. We are assuming inflation on the value of the home increases by 3% per year, and upon sale we would have to pay the realtor a 5% commission. In Year 1, this results in a decrease in value since the 3% increase in value is less than the 5% realtor commission. In addition, the $46,000 for the down payment and closing costs are included as an opportunity cost, assuming a 5% return on investment.
We have not considered inflation and other time value of money concepts other than the increase in value of the home. In addition, we have not considered income taxes, including the potential tax benefits you might receive from mortgage interest and property tax deductions, if you itemize deductions when filing your taxes. Since the Tax Cuts and Jobs Act (TCJA) was signed into law in late 2017 and significantly raised the standard deduction, it was estimated in 2019 that only 13.7% of tax payors itemize deductions. However, please look at your own individual situation and determine if it is more beneficial to itemize your deductions and if so, include that information in your Buy or Rent analysis.
The Cost of Renting
| Year 1 | Year 5 | |
|---|---|---|
| Monthly Rent is $1,600 | $19,200 | $96,000 |
| Renters' Insurance is $250 per year | 250 | 1,250 |
| Utilities are $300 per month | 3,600 | 18,000 |
| Total | $23,050 | $115,250 |
The Cost of Buying a Home
| Year 1 | Year 5 | |
|---|---|---|
| Mortgage Payments ($160,000 Mortgage) | $10,307 | $51,535 |
| Property Taxes | 3,000 | 15,000 |
| Closing Costs | 6,000 | 6,000 |
| Homeowners' Insurance | 2,000 | 10,000 |
| Utilities are $300 per month | 3,600 | 18,000 |
| Maintenance Cost (1% of the value of the house per year) | 2,000 | 10,000 |
| Opportunity Cost for Down Payment and Closing Costs | 2,300 | 11,500 |
| Appreciation of home, less sales commission, net | 4,300 | (20,262) |
| Mortgage Payment - Reducing Principal | (2,361) | (13,074) |
| Total | $31,146 | $88,699 |
| COST OF BUYING A HOME IN EXCESS OF COST OF RENTING | $8,096 | |
| Cost of Renting a Home in Excess of Cost of Buying | $26,551 |
The analysis above includes assumptions about all the costs, so when performing your own Buy or Rent a Home Analysis, be sure you are using data that is appropriate for your market and your situation.
The result of this analysis tells you on a quantitative basis you would be better off financially in Year 1 if you rented and in Year 5 if you purchased your home.
The result in Year 1 is significantly impacted by one time items, including closing costs and the cost of the assumed sale of the house offset by mortgage principal payments. The result reinforces the fact that if you move and expect to move again in less than 3-5 years you typically should not purchase a home.
The result in Year 5 is significantly impacted by the assumed increase in value of the home and 5 years of principal payments. Keep in mind, you have to sell the house to realize those benefits.
Everyone is different. Some people will base their decision to Buy or Rent a Home totally on financial considerations; others will be totally on lifestyle considerations. However, most of us will base our decision on a little of both.
How will you make your decision to Buy or Rent a Home?
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