Rent vs. Buy: Seven Factors to Consider Before Buying a Home

June 25, 2014

Owning your own home has long been considered part of the American dream but as the housing market starts to heat up in certain areas of the country, home ownership may not be the most economical solution to housing.  A recent article in The New York Times draws attention to several factors that must be considered when evaluating the financial benefits of home ownership and provides a link to a Rent v. Buy Calculator* that potential homeowners can use to quantify the tradeoff. Here are some guidelines you can use when considering each factor:

Home Price

It is sometimes said that you should buy the most expensive house you can afford but while a more expensive home may offer higher potential capital appreciation, it may also cost more in maintenance, utilities, and property taxes.  As a rule of thumb, the monthly cost of your home—all things included—should not exceed 25% of your take-home pay.

Length of ownership

Because of acquisition and disposition costs, the less time you plan to keep a home, the less advantageous it is to buy one.  As a rule of thumb, you should plan on keeping a home for at least seven years before you consider buying one.

Cost to borrow

As you would expect, the higher the interest rate you pay on your mortgage, the more expensive it is to own a home and the more favorable it is to rent.  Since interest rates are dictated by market forces, there is no rule of thumb that I am aware of when it comes to your interest rate (other than the 25% of take-home pay mentioned earlier) but in general, most lenders offer their best rates to borrowers that put down at least 20% (and usually more when it is investment property) so you should consider that when considering a home purchase.

Taxes

The tax benefits of owning a home are sometimes touted as the best reason for owning a home but as my colleague Erik Carter likes to say, you should never let the tax tail wag the dog.  While it is true that mortgage interest and property taxes can be taken as an itemized expense, the value of this benefit is only marginal and should not be the sole reason for buying a larger home—or buying a home at all.  As a rule of thumb, you should pay off your mortgage as soon as your mortgage interest is too low to allow you to benefit from itemized deductions.

Closing Costs

Closing costs can vary anywhere from 2% to 5% of the market value of the home depending on where the property is located and is yet another expense that adds to the cost of home ownership.  This cost can be even greater if you ever refinance the property, although refinancing may be worth it if the new terms are substantially better.  Some lenders will offer to roll your closing costs into the loan but as a rule of thumb, you should not do this.  Instead, save up for these costs and pay for them out of pocket.

Other Factors

Other factors that you must consider when choosing to rent or buy include expected increases in rental rates, expected performance on funds not used for homeownership expenses, and future growth in the housing market.  It may be best to speak with a financial and/or real estate professional in your area to get a better sense of what these factors are like for your specific location.

On a side note, investors that own real estate as rental property may be getting the best of both worlds.  As a rental property owner, you allow somebody else to pay some, if not all, of the expenses of home ownership while enjoying certain tax benefits and potential capital appreciation.  Obviously, the tradeoff is finding renters and dealing with maintenance issues—the normal stuff a landlord deals with.

Whether you rent or buy is as much a matter of preference as it is a matter of dollars and cents.  For me and my family, owning a home makes a lot of sense because we plan on staying in the same place for a long time, we like the certainty of a fixed monthly housing expense, I like doing yard work and home improvement projects, and homeownership simply makes us feel more secure.  For my colleague Erik, he prefers to rent right now for a variety of other reasons. The bottom line is that like many financial decisions, this one has a lot of shades of grey.

*Find the New York Times Rent v. Buy Calculator a bit much?  Here is a simpler one from Trulia: http://www.trulia.com/trends/vis/rentvsbuy-summer-2013/