Should I Rent or Buy?
In the long run, homeownership tends to be more favorable financially. This is because while mortgage and rental costs per month may look similar, buying allows one to accumulate equity in a home which builds their net worth over time.
Sooner or later, we are all confronted with the need to make a really big purchase.
As far as big purchases go, most of us will never make a bigger one than our homes.
Home buying is a complex process. In addition to the sheer volume of dollars involved in a home purchase, buyers must navigate a series of administrative tasks like mortgage approval, purchase contracts, appraisals, inspections, title insurance, and closing.
All of this, of course, after many people spend months searching for just the right house in the part of town they want, with all the features that have previously been missing from their lives.
It’s a lot to take on.
Not only that but considering most mortgages are issued with 30-year terms, buyers are agreeing to assume a debt that may be around for decades to come.
With this in mind, we want to provide some thought-stirring best practices and guardrails to aid homebuyers as they navigate the homeownership process.
Rent or Buy: What Do Americans Buy?
Before we look into rent or buy, we thought it would be useful to take a look at how our friend, Average J, approaches the purchase of a home.
For those of you who have not been introduced, Average J’s full name is Average Jane or Average Joe (you get to pick which).
We created Average J to represent the most average American possible. Average J’s purpose in life is to provide a basis from which you can measure your own financial choices.
In summary, Average J’s identity is completely tied to the American average for any given thing.
When it comes to the mortgage, Average J holds a conventional 30-year mortgage loan and has a monthly mortgage payment of $1,967 as of April 2022.
Average J also enjoys a household (not individual) income of $77,881 annually which translates to $6,490.08 per month.
Average J also takes home 78.258% of his or her monthly income after taxes and other benefit deductions. As a result, we can deduce that Average J spends 38.7% of his or her income on the monthly mortgage payment.
I was curious, so I ran the same calculation with pre-pandemic, 2019 data. Back in 2019, Average J’s mortgage was 32.78% of take-home pay. That’s an 18.1% increase in 3 years.
I’m highlighting this dramatic increase because this is being written in September of 2022. For two years, real estate has been on an absolute tear in the United States.
Low-interest rates, combined with a dramatic shift in remote work philosophies and a woeful shortage of physical housing units, have fed one of the quickest and most competitive real estate runs in history.
A few months ago, the federal reserve began to raise interest rates which is starting to slow things down a bit, but it’s still a crazy environment right now.
In summary, it is a very challenging time to buy a home and it’s even more difficult if you’re a first-time buyer.
In times like these, it can be very challenging to make the optimal choice for a variety of reasons. We hope to provide some insight and direction to help you navigate the process today.
Rent or Buy: The Case for Renting Instead of Owning:
While the benefits of homeownership are numerous, in some circumstances it may be wiser to rent. Let’s look at a few of those here.
1) You need the flexibility to leave
While monthly mortgage payments may be similar to or less than a rent payment for a similar-sized space, there are costs that come with the process of purchasing and closing on a home.
On average, closing costs are over $3,300 for the average home and that’s before any applicable taxes.
If you pay those costs and sell again just a few years later, meaning you’ll likely also be paying a hefty real estate agent’s commission of 6%, you don’t have time for the difference between renting and buying to pay off.
If you suspect that a change of location may come in the next 4 to 6 years for work, downsizing, or upsizing, consider renting until you are more confident about your long-term needs.
2) You can’t afford a down payment
If you haven’t been able to save enough for a down payment, making a commitment to a mortgage is probably not the best idea.
Besides, you aren’t likely to get approved for a loan if you aren’t able to purchase any equity in the home. That’s because lenders want their borrowers to 1) have some skin in the game, and 2) have equity to provide margin in the case of a foreclosure.
We’ll talk more about how much you should try and have available for a down payment later in the post.
3) Decreasing real estate values
Perhaps you’ve heard you should never try to catch a falling knife.
Real estate prices do fall from time to time. If you buy before a significant dip, you could find yourself with more debt in your house than its market value.
As a result, if you have to sell the home you will lose money on the deal.
In a scenario like this, it may pay off to be patient while the market finds a little stability so you don’t get burned.
4) You’re not able to maintain a property
If you find yourself on the road for extended periods of time or you’re just not physically able to care for and maintain a home, renting may also be better for you.
Homes deteriorate with time. Maintenance is just part of the deal. If you’re not around to prevent small issues from turning into expensive repairs you may regret taking on that responsibility in the long run.
For many who are aging and growing less and less able to take care of a home, there may be some sentimental resistance to selling a home they’ve had for years.
This is a tough spot to be in emotionally, but it won’t prevent the elements from taking their toll on the house. It’s usually wiser to sell and find an arrangement that doesn’t require ongoing maintenance responsibilities for the property.
5) Your rent is fixed or just very affordable
Maybe you just know better than to look a gift horse in the mouth.
If you have a great deal on a living situation, not moving might be the right move.
You can evaluate the value of your current situation by comparing your rent to other similar rentals or homes in the area. If you’re paying below-market rent and you like where you are, you shouldn’t feel compelled to run out and buy a home.
Instead, use the money you’re saving on housing to take your next steps on the Next Dollar Roadmap.
Rent or Buy: The Case for Owning Instead of Renting:
1) Owning vs Renting: A Case Study
In our opinion, there is no better case to make for home ownership than simply conducting a financial analysis of the decision.
To make the mathematical case for home ownership, we thought we’d pull back the curtain and run through the numbers we evaluated when we bought our first house in 2005.
Much of it will be from memory, so I can’t guarantee the numbers are exactly right but the principles have been preserved. The prices are 16 years old now anyway.
What we hope this provides is an illustration of how you might approach your own housing purchase decision.
In October of 2005, we bought a 2600-square-foot house in Hoover, AL for $211,000. Closing costs were about $2,700 and we were able to put 20% down on the house leaving us with a balance of $168,800 we needed to borrow.
We were both working and had no kids so we decided to opt for a 15-year mortgage with an interest rate of 5.625%.
Our monthly mortgage payment (not including taxes and insurance) was $1,390. Rent for a comparable house in our area would have been about $1,500 at the time.
For this scenario, we’ll leave out utilities since one would pay those whether renting or buying. I’ve included relevant insurance and maintenance costs (for the buy option) since that should be a consideration as well.
Curt & Lisa’s 2006 Home Buying Analysis | Buy 15yr (5.625%) | Buy 30yr (6.25%) | Rent |
Monthly Cost of Housing Only | $1,390.00 | $1,039.00 | $1,500.00 |
Annual Cost of Housing Only | $16,680.00 | $12,468.00 | $18,000.00 |
Annual Taxes | $1,500.00 | $1,500.00 | $0.00 |
Annual Insurance | $744.00 | $744.00 | $150.00 |
Closing Costs | $2,700.00 | $2,700.00 | |
Annual Maintenance (1% of home value) | $2,110.00 | $2,110.00 | $0.00 |
Total 1st Year Cost | $25,124.00 | $20,561.00 | $19,650.00 |
1st Year Interest Deduction | $9,298.35 | $10,493.98 | N/A |
1st Year Real Estate Tax Deduction | $1,500.00 | $1,500.00 | N/A |
Tax Bracket | 25% | 25% | 25% |
Total 1st Year Deduction Value | $2,699.59 | $2,998.50 | $0.00 |
Annual Equity | $7,381.76 | $1,977.99 | $0.00 |
Total 1st Year Impact to Net Worth | ($15,042.65) | ($15,584.52) | ($19,650.00) |
A few things I’d like to point out:
- The renter’s insurance cost is a guess, but it’s really low.
- We itemized taxes. If you take the standard deduction annually, then that would equalize the benefit for all three columns and you can leave it out of your analysis.
- In 2005, we were in the 25% bracket. You’d need to adjust this number for whatever bracket you’re currently in IF you are itemizing.
The primary takeaway is the out-of-pocket cost of buying is higher in the first year.
This is due to several factors like taxes, maintenance costs, and insurance, but mostly because of closing costs that won’t be paid in future years.
Even so, a 30-year mortgage is almost cheaper than renting. In the 2nd year, it will definitely be less and will grow more advantageous as time goes on since rents generally increase with market pricing.
I assume if the closing costs were folded into the mortgage, the 30-year would have been “cheaper” from the get-go.
The next thing I want to point out is the impact on net worth. This is really where home buying shines over renting.
Even with all of the higher costs for buying, its impact on net worth was $4,000+ more advantageous in this scenario.
That’s because your monthly payments were buying part of your house from the lender. This partial ownership is known as your equity in the home and it grows every time you make a mortgage payment.
There is no equity growth for renting. We’ll further discuss the importance of this in a bit.
I’ve inserted a 2nd year summary of costs and net worth impact below so you can see what a difference a year makes.
Curt & Lisa’s 2nd Year Home Buying Analysis | Buy 15yr (5.625%) | Buy 30yr (6.25%) | Rent |
Monthly Cost of Housing Only | $1,390.00 | $1,039.00 | $1,500.00 |
Annual Cost of Housing Only | $16,680.00 | $12,468.00 | $18,000.00 |
Annual Taxes | $1,500.00 | $1,500.00 | $0.00 |
Annual Insurance | $744.00 | $744.00 | $150.00 |
Annual Maintenance (1% of home value) | $2,110.00 | $2,110.00 | $0.00 |
Total 2nd Year Cost | $22,424.00 | $17,861.00 | $19,650.00 |
2nd Year Interest Deduction | $8,872.65 | $10,366.76 | N/A |
2nd Year Real Estate Tax Deduction | $1,500.00 | $1,500.00 | N/A |
Tax Bracket | 25% | 25% | 25% |
Total 2nd Year Deduction Value | $2,593.16 | $2,966.69 | $0.00 |
Annual Equity | $7,807.46 | $2,105.23 | $0.00 |
Total 2nd Year Impact to Net Worth | ($12,023.38) | ($12,789.08) | ($19,650.00) |
In year two we no longer have closing costs to hassle with, so the out-of-pocket gap between rent or buy is reduced or eclipsed depending on which mortgage you choose.
Also, the impact on net worth has grown even more in favor of buying. The advantage of $4,000+ from year one is now closer to $7,000 or more depending on the mortgage terms.
2) Major source of wealth for most Americans
The second pro of homeownership is its wealth-building potential.
It’s important to evaluate a home purchase’s impact on your overall net worth because that’s where all the value is in home-buying over renting.
In fact, on average the American household has 70% of their net worth tied to their primary residence. That’s a bit high in my opinion, but that’s for another post.
What is clear is that home ownership is the primary driver of net worth for most Americans.
You have to live somewhere, so logically you can see the advantage of building equity while you pay for a place to stay. Meanwhile, renting from someone else only makes the landlord wealthier.
3) Credit builder
Another side effect of buying a home is the credit-building power of making timely monthly payments.
Among other factors, the amount of credit you carry, your success rate at paying on time, and the number of years you’ve been paying the debt all play a role in developing your credit score.
Your credit score may not be anything to write home about when you buy your first home, but it sure is handy to have down the road if you need it.
Lisa and I sold the Hoover house in 2016. Buying our second home was somewhat smoother given the fact we enjoyed a credit score near 800.
Buying a home is an excellent way to build your borrowing reputation.
4) Way of life: Security, Schools, Comfort
The primary motives for wanting to buy a home are not typically quantifiable. Goals like a quality-of-life improvement, shorter commutes, school districts, privacy, and even security tend to underlie and drive most home-buying decisions.
We don’t have any exceptional insights into how you score these against other factors, but they are certainly an advantage over renting in our experience.
We chose to live in the area we live in because our oldest child was beginning kindergarten in 2016. We moved about 2.5 miles away from our first house simply because we wanted him to go to a certain school.
By owning our home, we don’t have any concerns about increases in our rent or a landlord declining to renew our lease. As long as we submit our mortgage payments, we know we can stay right where we are.
Rent or Buy Calculator:
If you want a little mathematical help deciding to rent or buy, try Nerdwallet’s Rent or Buy Calculator.
