Understanding the rent versus buy decision
Buying a house is probably the most important financial decision most of us make. Our monthly rent check is also probably our biggest expenditure each month as well. How do you determine whether to rent or buy? There are pros and cons of each.
Pros and cons of renting
Renting an apartment has its advantages. The biggest one is maintenance. If anything goes wrong in your rental, it is someone else’s problem. Maintenance costs are an often overlooked, but important consideration in the rent versus buy decision. Another advantage is the freedom to move when the lease is up. If you are planning on staying somewhere for only a short period, renting will be a much better option. Renting is generally cheaper than buying, and you don’t need much more than a security deposit and the first month’s rent to get into a new apartment. The disadvantages of renting include annual rent inflation, less favorable tax treatment, the fact the apartment is not yours, and missing out on the passive savings involved with homeownership.
Pros and cons of buying
Buying a house has many advantages as well. The biggest advantage is that it is an easy way to build up your assets for the future. Every month you make your payment, the amount you owe decreases. Assuming stable or increasing home prices, over several years, that equity build begins to add up to real money. Second, real estate has been increasing at 6% annually for the past several years. If the median home price is $168,000, that 6% amounts to over $10k a year. Another benefit is the mortgage interest deduction, which may allow you to deduct any mortgage interest on your taxes in most cases. Finally, if you have a 30-year fixed rate mortgage, your principal and interest payment will be the same for the next 30 years. Only the property tax and homeowner’s insurance portion of your payment will increase. If the property is in a development with a homeowners’ association, those fees could increase as well. While inflation is low today, that wasn’t always the case. For many decades, you could count on 5% inflation.
Homeownership does have its negatives, though. The biggest one is the up-front money required. You will almost assuredly need a down payment unless you are qualify for a VA loan, and the minimum is 3.5% for a FHA loan. 20% is a typical down-payment. Lower down payments will increase the interest rate on your loan and could necessitate mortgage insurance, which is tacked on to your mortgage payment. Closing costs are also a big expense, and this is where the first-time homebuyer usually gets surprised. Incidentally, closing costs are the biggest reason why you don’t want to buy for short periods – they can be substantial, and include everything from transfer taxes, title fees, appraisal costs, escrow payments, and more. Before buying, it is important to determine Las Vegas closing costs, or wherever you are planning on buying, to make sure this is within your budget. Second, you have to take into account maintenance costs, which include everything from routine pest spraying to periodic replacement of the roof or driveway.
Doing the math
Currently, the benefit (in terms of cost disadvantage) is skewed towards buying, although it has been better in recent history. I examined the median house price and compared the expected mortgage payment for a first-time homebuyer using a FHA loan (which only requires 3.5% down) versus the median asking rent. The mortgage payment is based on the historical prevailing mortgage rate at the time (rates are different now), the median house price, mortgage insurance, taxes, homeowner’s insurance, mortgage interest deduction. As of 12/31/16, the median asking rent was $864 a month, according to the Census Bureau. The median house price was $167,700. So, to do the comparison, here is the math:
It is important to remember that this is an illustrative example only, and the particulars of your individual situation will almost certainly differ. The point is to demonstrate how to set up the analysis. The mortgage insurance, property taxes, homeowner’s insurance and tax benefits are based on rules of thumb and will vary based on where you live, what you decide to cover, etc.
The historical difference between the two options
If you plot these two numbers over time, you can see that the relative attractiveness of buying over renting is not as good as it was 4 years ago, but that was an unprecedented time. Historically, the monthly cost of homeownership was about 29% more than the median asking rent. Today, the difference is 9%.Rental inflation has historically been around 3.5% or so, which means that difference will be eliminated in about 3 years. After that, buying is cheaper than renting.