Often the first decision a person ponders when considering owning a home is whether it’s best to rent or buy a place to live. While it’s impossible to give a blanket statement on which is better, it is possible to give an outline of circumstances that may make one or the other more favorable for your situation.
Renting vs. Buying – An Emotional & Financial Decision
“The American Dream” often includes the notion of homeownership. For many, the prospect of owning a home has been a dream since an early age. For this reason, it’s not simply a financial decision when debating renting versus buying a house, condominium, or another type of property, but an emotional one as well.
Financial Considerations
If you were to look at a home as strictly a financial decision, then the math rarely points to purchasing as a better option in the short term. The stock market regularly outperforms returns on homes, and the fees involved usually make owning a more expensive option than renting.
Real Estate Fees
The main problem with purchasing a home is the combination of cash required for the down payment; real estate transaction, lending, and other fees incurred; as well as the mechanism by which a mortgage amortizes over time. For the most part, homebuyers have sizable closing costs and other expenses to consider. One-time transaction fees and ongoing service fee requirements that do not exist in a typical rental.
Many of these costs, if spread across a lifetime, could make the financial decision sway in favor of ownership. However, many Americans will own their home for just a few years. For this reason, these expenses are not spread across the typical 30-year timeframe and make the cost of owning the home, and later selling the home, much higher.
Building Equity in Your Home
The argument commonly forged relating to gaining equity in a property usually only happens after paying on a mortgage loan for several years. The way mortgages amortize, or are paid over time, is structured so that in the beginning much of the payment only goes toward the interest on the loan, as opposed to paying down the principal.
This creates a situation whereby the principal balance of the loan is very close to what it was to begin with even after five or six years of making regular mortgage payments.
Combined with the selling and moving costs, the buyer, who is now the seller, is often left in a situation where they will lose a considerable amount of money from the transactions because they have very little equity stake to make up the difference.
With all that said, property values are currently on the rise due to short supply in many major cities, along with other factors, so this is a period where the opposite is true for many who bought just a few years ago. However, buying now while prices are high could put you in a situation where you have to short sale the property if prices fall again like they cyclically do.
Here are several advantages and disadvantages to consider with owning a home.
Pros of Buying a Home
- Build equity in land, structure, or both, by paying down the loan
- Profit from increased home prices
- Receive tax deductions for the interest portion of the mortgage payments, real estate taxes, and insurance
- Only minor fluctuations in payment amount (if fixed-rate mortgage)
- It feels good to own
- More control over the property and land
Cons of Buying a Home
- High upfront costs
- Total responsibility for repairs
- Home could lose considerable value
- Meant to be a long-term investment – buyer likely to lose money if sells too soon
How Much Can You Afford?
When lenders look at the credentials of a potential borrower, one of the main factors they look at is capacity – the borrower’s ability to repay the loan. A key metric used to determine this is their debt-to-income ratio.
Debt-to-Income Ratio
In this ratio, the lender determines how much of the borrower’s pretax monthly income would go toward the mortgage payment. Usually, banks like to cap the total percentage of income spent on all housing related expenses (mortgage payment, insurance, real estate taxes) to 28%, and all debt to 36%. Often referred to as the 28/36 rule.
For instance, if your monthly income was $5,000, the bank would be most comfortable with housing expenses up to $1,400 (5,000 * 0.28), and total debt expenses up to $1,800 (5,000 * 0.36) per month.
Final Thoughts on Renting Versus Buying
Overall, the decision to buy or rent a home cannot be answered simply one way or another. Each person’s situation is unique. One of the most important pieces to keep in mind is the length of time you plan to stay at your new residence.
