Growing up, I didn’t think too much of rent vs. buy a home debate. I always thought that buying a home was the epitome of reaching financial freedom. No more paying rent the rest of your life, no more random landlord rules, and total freedom to do whatever you want with your house. That’s what my parents did, so that must be the right financial move to make right?
It turns out, it’s not that simple. Renting vs. buying a home is a complicated decision that involves a bunch of different factors. How long are you going to stay? How much do houses appreciate in your area? What does the property tax situation look like?
While there is no one right answer to making this decision (unless you literally can’t afford to buy a house), there are some important pieces of information you should consider. This post will help you understand all the factors that go into making the decision to rent or buy a house with 10 questions you must ask yourself.
1. How Much Will It Cost?
Cost is probably the most important factor to consider when choosing to rent vs. buy (unless you’re so rich that it doesn’t matter). The cost of renting is pretty straightforward, but the total costs of buying a house are not so simple.
Buying a home involves mainly two types of costs:
One-Time Costs
Closing costs: the amount required to “finalize” a home purchase. Closing costs usually include things like an appraisal fee, credit report fee, origination fee, application fee, and title search. Some of them might be negotiable, some of them might not be. You will have to ask about each one individually when making the deal. Typically all this adds up to somewhere between 1-5% of the loan amount
Down payment: the initial amount you pay on the total price of the house. Most people pay 5-20% of the house value in their down payment. The most optimal down payment is 20%. 20% lets you avoid paying PMI (explained below) and you will probably get a lower interest rate on your mortgage loan.
Ongoing Costs:
Property taxes: taxes collected by the local government, usually in the ballpark of 1-2% of your home value.
Homeowners association (HOA) fees: if your property is part of an HOA, this fee is used to maintain and improve properties in the association. Note: this isn’t used to cover maintenance fees of your home, just the communal property within the HOA. It’s roughly a few hundred dollars a month. Usually the more fancy communal stuff that needs maintaining, the higher this is going to cost you.
Home insurance: homeowners insurance helps pay for unexpected property damaged or legal/medical bills if someone gets hurt on your property. This is required by most mortgage companies before they will lend to you. This is usually $500-$1500 per year depending on your area.
Private mortgage insurance (PMI): insurance you need to pay if your down payment is less than 20% on a conventional mortgage. It’s roughly 1% of your loan amount per year. Avoiding this cost is why it’s recommended to put 20% down when buying a house.
Future home renovations/maintenance: Things always break down when you least expect it. As a homeowner, you are the one responsible for paying to fix it. Typically people budget about 1% of their home value per year for these types of repairs.
Utilities: You might be paying for utilities as a renter, so nothing new here. However, homeowners typically pay more for their utilities than renters.
Owning a home does have one advantage when it comes to taxes. Many of the costs of owning a home like property taxes are tax deductible. If you’re paying off a mortgage, you can count your mortgage interest as a deduction when you file your tax return.
You also have the option to rent out some rooms. That could offset some of the ongoing costs if you can handle dealing with the struggles of being a landlord.
With renting, on the other hand, the money just “goes away”. There are no financial incentives like tax deductions, equity or rising property value. However, one major benefit of renting is predictable expenses. Owning a house involves more unpredictable expenses coming from unexpected repairs and maintenance.
The easiest way to do a comparison of the costs is to google “rent or buy home calculator”. There are a bunch of online calculators that tell you which option saves you the most money.
While the cost of owning a home might not be favorable, there are still other considerations that might make you lean towards home ownership.
2. What Locations Are You Considering?
In high-priced real estate markets like San Francisco, renting might be the only affordable option for you. If this is you and long commutes are not an option, end of story. You can stop reading now. Come back after you get a high-paying job at a tech giant, become an executive, or sell your startup for millions of dollars.
In addition to the housing market, you also need to consider how the neighborhoods are looking where you want to live. This is especially true if you have (or plan to have) kids.
You might want to find locations with safe neighborhoods, good schools, proximity to public transportation, are close to work, shopping, and recreation. Of course, as you might expect, areas checking off all those boxes are usually the most expensive places to live.
You will have to find a compromise that works best for you. Do you want to live in the hood to save a few hundred bucks a month? Do you want to live in a tiny closet in downtown San Francisco so you can walk to work? Or do you want a mansion and 10 acres of land in the middle of nowhere? That’s all up to you to decide.
3. Is the Equity Growth Worth It?
Owning a home is often a great way to build wealth. According to data from the Federal Housing Finance Agency, the national average for home appreciation is about 3-5% per year. Really hot markets might appreciate 5-8% per year. Your home will most likely increase in value over time depending on the market and how well you take care of it.
Best of all, money you’re investing money that would have gone to rent otherwise. That’s taking an expense and converting it to an asset (some of it at least). This is probably what most people are talking about when they say “rent = throwing money away”.
However, equity growth is not a guarantee. Sometimes your home can lose value for reasons outside of your control. A major employer could leave the area, causing a significant population decline and a surplus of housing. There could also be a residential construction boom, increasing the supply of houses in your area. Or the housing bubble you got swept up in starts to burst.
You also need to think about the opportunity cost that comes with investing money in a house. When you put money into a house, you lose out on the chance to invest that money elsewhere.
According to historic returns of the S&P 500, the stock market yields an average return of 10% per year. If all your money is going towards your mortgage, you won’t have as much opportunity to participate in those gains. You might also have to cut down on retirement investing (which I highly recommend you look into if you haven’t already).
4. Are You Planning to Live in the House for at Least 5 Years?
Buying a house might be an option if you plan to live at the same place for a long time (at least 3 years), but it makes travelling and relocating harder. It takes time to find the right buyers when you put your house up for sale. It also takes time and money to go through the whole process of signing over the house.
On the other hand, renting means you can move more easily. All you have to do is wait until your lease expires, hand over the keys and you’re ready to go. However, it also means you could have to move suddenly if your landlord decides so (if you’re being a bad boy/girl).
If you feel certain you’ll stay in a home for at least 5 years, buying a home could make sense, because it could be a good fit both financially and practically. If not, renting might be a better option.
Sure, you can buy a home and then sell it within a few years. But, the costs (and hassle) are hardly worth it. You want to minimize the impact of those big upfront costs and all the work that goes into selling your house when you move.
5. How Much Do You Value Home Ownership?
Homeownership gives you more privacy and freedom to renovate. As the owner of your house, you can do whatever you’d like to it (within reason). It also brings intangible benefits such as a sense of stability, belonging to a community, and pride of ownership.
On the other hand, there’s also a lot of responsibility that comes with ownership. You’re responsible for fixing up the house, doing renovations, and taking care of your lawn. If all you care about is getting shelter from the elements, home ownership might not be for you.
6. How Much Do You Value Convenience?
Owning a home comes with a lot of unexpected time commitments. Even after all the hassles from looking at places and locking the deal in, there are always going to be projects around the house that you will need to take care of. You might need to replace a rusted-out pipe, repaint the bedroom, mow the lawn, or fix a leak in the roof.
If you rent, your landlord will take care of all the repairs and maintenance. You never have to worry about surprise repairs (financially speaking). Although, these repairs might not get done as quickly or as well as you would like.
How to Decide
If you still don’t quite have an answer after reviewing the pros and cons and are wondering how to decide, here is a short answer: if you’re able to afford the down payment on a home that is likely to appreciate and you plan to hang onto the home for at least five years, you can probably go for it.
However, here’s a few questions you should check before buying a house. If you can answer yes to all these questions, it might be the right time for you to buy a house. Otherwise, you should probably focus on your other financial priorities first and put the house on hold:
7. Are You Out of Debt?
41% of first time home-buyers make this mistake according to the National Association of Realtors. Don’t be one of them.
No debt means no student loans, personal loans, or credit card debt! You do not want to pile on more debt on top of the debt you already have. You need to kill debt before it has a chance to grow.
Don’t let your feelings drag you into a financial disaster. I don’t care if the house of your dreams is up for sale. If you can’t afford it, you can’t afford it. You really shouldn’t be dumping a boatload of expenses on yourself if your net worth is negative.
8. Do You Have a Full Emergency Fund Saved?
You should only consider purchasing a home if you already have three to six months worth of expenses saved in an emergency fund. If you got laid off today, could you pay your monthly expenses (like your mortgage and bills) for at least three to six months while looking for work?
You do not want to risk losing everything in exchange for buying a house just 1-2 years sooner. Make sure you protect yourself financially from emergencies. They always happen when you least expect it.
9. Do You Have Enough Cash for a 20% Down Payment on a 15-year Fixed-Rate Mortgage?
Although you can purchase a home with a down payment that’s as little as 3% of the purchase price in some cases, doing so means taking on more debt.
Having 20% or more means you don’t pay any PMI. This type of insurance does nothing to protect you. It only protects your lender from going bankrupt if you stop paying your mortgage. You might as well call this giving money away.
10. Will Your House Payment be 25% or Less of Your Monthly Take-Home Pay?
Make sure your mortgage payment (including principal, interest, property taxes, homeowner’s insurance, PMI and HOA fees) is no more than a fourth of your monthly take-home income. You want to leave plenty of room in your budget to achieve other goals, like saving for retirement and putting money aside for your kids’ college funds.
If you’re not there yet, you should hold off until you fix up your finances. You don’t want to buy a house then have to live like your life is an episode of extreme cheapskates just to barely pay off monthly bills.
Conclusion
Long story short, there are two things you need to ask yourself: 1. Can you afford it? 2. Is the price worth adopting the lifestyle of a homeowner?
If you answered yes to both, go ahead and buy. As long as you can afford it, the choice of buying a house vs. renting is just a personal decision you will have to make for yourself. Owning a home sounds nice, but the reality of home ownership is usually different than expectations. If different is good, good for you. If not, you might want to reconsider before buying.
Buying a house is not an easy decision, but hopefully these questions will help you make the right rent vs. buy decision.
If you want to buy a house someday, but need to figure out your finances first, subscribe to get my 60 minute financial planner below. That should set your finances on the right track to achieve your short and long term personal finance goals.
Fun facts: used to lion dance in college, can speak 3 languages (sort of), can lift 400 lbs, once ate a chicken head.
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