One of the most common misconceptions out there is the notion that buying a home is always a better financial decision than renting one. This is nonsense.
“Always” is rarely a good answer in the world of personal finance. There are too many factors at play for one alternative to always trump the other ones.
A common argument in favor of buying that clearly overlooks many important factors goes something like this: “my mortgage payment would be roughly the same as my rent payment. Therefore, I should buy because I’m building equity!“.
Not unreasonable, but awfully incomplete.
With that in mind, let’s take a look at some of the most important, yet overlooked factors of the buy vs. rent decision:
- Opportunity cost
- Most common costs of home ownership
- Transaction costs
- Repairs and maintenance
- HOA fees
- Taxes and insurance
- Other possible costs
- Putting it all together
After we go through all of these, I will show you how to use this information to run the numbers so that you can make a good financial decision.
Let’s dive in!
1. Opportunity Cost
When you buy a home you are putting into it a large amount of cash. Think of this as your down payment or your purchase price if you are paying it all in cash.
Let’s use an example to illustrate the opportunity cost of having your money tied up on your home. To keep the example simple let’s assume we have an all cash prospective buyer, Sara, who is currently renting. Here are the assumptions:
|Should include closing costs and any repairs the house may need.
|Return if $ goes to home
|The amount she doesn’t have to pay in rent every year. Assuming monthly rent of $1,167.
|Return if $ invested elsewhere
|Annual gains assuming a 7% return. Could be stocks, bonds, etc.
As you can see in the example, Sara would be in the same place financially regardless of whether she buys or rents.
Now, if you account for insurance, taxes, maintenance, and repairs then she would be better off renting. If she could find a less expensive house, she could be better off buying. Just like if she could rent a place for less, she would be better off by renting, and so on. As you can see, the most clever financial decision for Sara, and for anyone in a similar position, DEPENDS on the factors at play.
2. Most Common Costs of Home Ownership
Mortgage payments are hardly the only cost of owning a home. To make the best decision between renting and buying you should account for ALL costs that come with home ownership. Some of the most common are:
- Transaction costs
- As a buyer: loan origination fees, credit report fees, title insurance, settlement fees, appraisal fees, home inspection, recording fees, wire fees, etc. As you can see, it is a long list. For our recent home purchase all of these fees totaled $3,419. As we negotiated, the seller paid $1,500 of these fees. Making our total transaction costs $1,919
- As a seller: the biggest transaction cost for sellers are often real estate commissions, which usually range between 4% to 6%. Additional seller costs may include deed transfer fees, seller settlement fees, home warranties for buyer, seller paid closing costs, wire fees, etc. For our sellers, these costs totaled $9,561. These come out to about 5.5% of the total price of the house.
As you can see, transaction costs associated with buying and selling a home can be significant. Don’t forget to consider these when deciding if you want to own a home, doing so can result in a bad decision. Transaction costs also bring up the concept of holding period. How long do you plan on living and owning your home? The shorter the time frame, the more likely you will be better of renting. For example, if I were to sell my home 1 year after buying it, I would be spreading the transaction costs $12,980 (1,919 + 9,561 ) over 12 months. This means it would cost me, in transaction costs alone, $1,082 per month to own my house! I can rent a really nice place in my area for that much and I haven’t taken into account many other costs of home ownership.
Takeaway, buying a house rarely makes sense financially if you plan to own it only for a short period of time.
- Repairs and maintenance
These are pretty self-explanatory and include things such as repairing/replacing appliances, plumbing issues, roof leaks, electrical problems, lawn mowing, etc. These costs can vary widely depending on the age and condition of the home. For purposes of running your own numbers, a common rule of thumb says that on average you should set aside 1% of the home’s value every year to cover repairs and maintenance. This means a $200,000 home costs about $2,000 per year to maintain. It will likely not cost you $2,000 every year, for many years it can be less than that, then you can have a year in which you need to repair the roof and get a $10,000 bill. The 1% rule of thumb is a good conservative projection of the AVERAGE annual costs for repairs and maintenance.
- Home Owners Association (HOA) Fees
Depending on the home you buy, you may have HOA fees. These usually cover maintenance for common areas in townhomes and apartments. They are supposed to offset some of the repairs and maintenance costs you would incur yourself if you didn’t have an HOA. For example, my neighborhood’s HOA repaired a damaged piece of siding on my house a couple of months ago “free” of charge (we pay HOA fees so it isn’t really free). The takeaway here is, don’t forget to include them in your analysis if the home you are considering has them. Our HOA fees are $137 per month.
- Taxes and Insurance
These are pretty self-explanatory as well. You can easily find out how much you will pay in taxes for a property you are looking at. The MLS listing, or even places like Zillow and Trulia should have records of property taxes. For our house, property taxes were $1,648 in 2016. The insurance cost may be a little harder to estimate. Ours turned out to be $413 per year after shopping around a lot. We got some other quotes for closer to $1,000. If you want to have a pretty good estimate for insurance the best thing to do is to get a few quotes from actual insurers. Otherwise, as a conservative rule of thumb, use 1% of the value of the property and move on.
3. Other possible costs
“You can get more house for your money if you buy far away from the city!”. Ever heard a phrase like that? I have, many times, sigh…
It is true you can get a larger home for the same price as you expand your search into further away places. But at what cost?
Is more space, which is likely going to be empty 99% of the time, worth thousands of dollars in additional gas, car maintenance, repairs, and depreciation? And more importantly, is it worth all the time you will spend commuting? I could go on a long rant about commuting, but instead I will leave you with an excellent post from Mr. Money Mustache on that very subject: The True Cost of Commuting. With this in mind, we chose a location that is within biking distance from both of our jobs.
The bottom line here is, when buying a home consider how far it is from the places you frequent the most (home, school, etc.). If buying will mean a longer daily commute, don’t forget to take that cost into consideration.
Purchasing a home may come with larger utility bills compared to renting one. We used to rent an apartment in which the water bill was about half of what it is now. This is mainly because at the apartment some of water fees were shared with the other units in the same building. On the flip side, our energy bill is lower now. All in all, our average utility bills combined (water, electricity, etc.) are $30 higher per month at the new house. This is roughly in line with what we estimated prior to making the big move.
Generally, moving from renting an apartment to buying a house will come with higher utility bills. Don’t forget to consider this when running your analysis.
Financing is a complex subject, which could take a while to cover thoroughly. Luckily for us, online rent vs buy calculators can do most of the heavy lifting. The most important thing for you is to understand the inputs to the calculators and make sure you are using conservative and realistic figures. I have tried several online calculators and this one was my favorite.
Before we go on through all of the numbers of our recent home purchase. I’d like to give you a few words of caution about financing:
- Banks will lend you more money than they should: remember the 2008 financial crisis? Lax lending standards by financial institutions, and lack of financial knowledge and responsibility by Americans were the main driving forces of the financial meltdown. You would think we would have learned from our mistakes and that lending practices are much better today. They may be to some extent, but not enough in my opinion. We could have borrowed as much as $350,000! Even though when we were applying I had not started working yet so it was all based on just one income. I could go on a long ugly rant from here but I won’t :).
- A lower monthly payment does not necessarily mean a better deal for you: if you have made it this far you probably know this already, but just in case you don’t, you need to look at the complete picture. You will want to know the ins and outs of your mortgage terms. Don’t sign anything without understanding how much interest you will pay over the life of the loan, what your APR is, what loan origination costs you will pay, ask if there are any prepayment penalties, is your interest rate fixed or variable, etc.
5. Putting It All Together
Finally, here are the all the numbers behind our recent home purchase. This is a screenshot of our inputs into the calculator:
As you can see, most of the inputs into the calculator are self-explanatory. There are only a few things I would like to go through. The fields with the locks inside the red circles will populate automatically based on the price of the home. I have overridden some of these since I have actual information. Unless you have actual quotes or data from your research, you should leave those alone as the calculator provides good conservative estimates.
Another thing to point out is the appreciation rate of the property (number 1 above). Historically, home prices have roughly kept up pace with inflation so I would suggest using a conservative figure. For my calculation, I used 2% as this is the lowest value the calculator allows. In other words, I’m not counting on any significant appreciation. I rather be conservative and be pleasantly surprised than the other way around.
Finally, as you can see in the “Results Summary” section, buying becomes profitable for us in year 4, or in other words, after August of 2019. When we went through this analysis last year, we thought there was a high likelihood we would live in Raleigh beyond 2019. Therefore, buying was the better financial decision in our situation.
As you can hopefully appreciate from the analysis above, the decision between buying or renting a home involves many factors. We had considered buying a home a couple of years ago. We chose to keep renting because at the time we didn’t know if we would move to another city or country. Also, if our home would have cost more than $230,000, the holding period for buying to be the better option would have been 6 years. We didn’t feel comfortable with this either so we chose our price point accordingly.
Buying a home is a big decision. Run the numbers, decide for yourself. Don’t let society or anyone else make this big decision for you.