Of all the thousands of ways you are scrutinized for wasting your hard-earned cash, none of them gets a bad rap quite like renting. Stop me if you’ve heard this.
“Why are you wasting money when you could be building equity?”
“Why are you paying someone else’s mortgage?”
“My home is the best investment I’ve ever made!”
“Renting is just throwing your money away!”
Buying a house can be a huge boost to your quality of life…in the right circumstances…when you’ve done all the math…and you are financially stable…in a place, you want to live for a long time. Purchasing a home without thinking it through because you just want to start adulting, or because you think renting is only for people who can’t afford buying is a big mistake. Like cashing out your 401(k) to go on vacation type of mistake. One day’s bad decision could haunt you for years to come.
Rules of thumb
There are several times where it just doesn’t make sense to buy a home. First, you are job hunting or thinking about changing careers. Anytime you KNOW that your future income, and possible location, is very uncertain don’t buy a home. Second, you are looking to start a family and the school district or neighborhood won’t be a fit. Having kids changes everything. That house near the hip bar scene downtown might be a lot of fun today, but would you want the aftermath of someone’s 21st birthday party waking up your three-month-old that you just spent an hour getting to sleep? Finally, don’t ever buy a home because it is a great price. You should like where you live. Don’t ruin that on a speculative purchase.
Buying vs Renting: Doing the math
If you’ve passed the aforementioned rules of thumb and are serious about buying a home, let’s break out excel and get started. First, the easy part. What does it cost to rent? Add up the base cost to rent, the cost of renter’s insurance, and upcharges for pets or other reoccurring charges like a covered garage. Any one-time application fees are usually small enough that they don’t affect the outcome and you get your deposit back. If you want to include these as a sunk cost, it is easiest to subtract them from the home closing costs to balance out the equation.
Now comes the hard part, what owning a home actually costs. First, we add up PITI. That stands for principle, interest, taxes, and insurance. This is where the first mistake comes in as most people just compare the 30-year mortgage payment to the rent and say, “I could own a home for what I’m paying in rent”. Next, we add in other known fixed costs like PMI (Private Mortgage Insurance) and homeowner’s association fees. Unless you are putting 20% or more down PMI is a big additional cost you need to factor in. It can vary significantly but the cost is typically like adding 0.3% to 1.5% onto your interest rate per year. Finally, add in the squishy costs of annual home improvements, maintenance, and repairs. Expect to add between 20% and 30% of your annual principal and interest cost. Seriously.
If you’ve never owned a home this last expense sounds crazy. Start with a $12,000 a year mortgage and expect to pay $2,400 – $3,600 a year in additional expenses and upkeep. That is easy to do just between lawn care and spreading out major repair costs like roofs, air conditioning units, furnaces, and appliances that are provided for renters.
Is a house a good investment: Finding your break-even point
Once you add all the numbers together you are almost ready to find your break–even point. The last major factor is accounting for your down payment on the house, which we believe in today’s environment should probably be in the 5% – 20% range.
We ran a break–even scenario with the following information. Rental Assumption costs all in at $1,500 a month. Home purchase assumptions used: $200,000 mortgage, 10% down payment, $2,000 annual property tax, $800 insurance premium, $1,000 PMI, 25% of the annual mortgage payment for maintenance and repair costs, and $250 for homeowner’s association fees.
There are endless scenarios, but in the one, we described the cost to rent is $544 cheaper than owning. To be fair you are building equity, so we added back 2% a year to account for this. So, owning is now a net positive of $3,055 a year. Yeah! But wait…what about the money you forked over for the down payment? The reality is you realize little of that between closing costs to buy and selling costs on the other end (like the standard 6% commission for a realtor’s services). You also lose out on an interest that could have been earned had you rented and invested the down payment instead. Roughly this nets out.
The last step is to factor in how much you put down to see how long you need to own the home before the equity built up overcomes the additional expense of owning. In our example, the magic number is 7. In our opinion, if you plan to stay in the house for 7 years or more you should come out ahead.
A related word of advice. Please don’t use the sale price minus your purchase price to determine if your home was a good investment. That’s not how it works. According to the Freddie Mac House Price Index home prices in the US have gone up by about 3% a year since 1975. Great if you were part of the 50% that was above average, but not so great if you ended up in the bottom half. Again, lots of variables, but going through this exercise can be enlightening.
Exception to the rule
There are always exceptions. One would be for real estate professionals, who use an entirely different set of metrics to gauge the result of purchasing a house. They may be renting it out or using an interest-only loan to finance the purchase. All these dramatically change the timeline and expense.
The other major exception is because you just love it. The floorplan is perfect for entertaining, it’s really close to work, and is in a great school district. YOUR HOUSE DOESN’T NEED TO BE AN INVESTMENT. It’s benefit just needs to exceed the cost in your mind.
If all of this seems a bit daunting to you, start simple. Just figure up the costs to own vs borrow and see how much more it may cost to own. Then think about the intangible benefits you would receive and if they are worth that amount per month to you. If so, you can stop before all the fancy math of home appreciation or equity building. This step alone means you know more than most home buyers, and knowing is half the battle.