Many are wondering about renting vs. buying. Here is a scenario to consider:
I’m out of debt, and I’m now saving for a down payment on a home. It’s always been my dream to be a homeowner. But lately, I read a lot of arguments against it in favor of renting. How do I know if it’s a good idea for me? Should I buy or keep renting?
For a long time, conventional wisdom seemed to be that you grow up and buy a home because that’s just what you do. But lately, people are realizing that it isn’t always the smartest financial move. Obviously, the housing crisis has a lot to do with that—it’s made people question the standard assumption that homeownership equals financial stability.
Homeownership isn’t a good or bad idea on its own. It has everything to do with your own situation. Sometimes, buying a home is the smart thing to do; other times, it really isn’t. Whether or not it’s smart for you will depend on a few different factors. Here’s what you should keep in mind.
Don’t Think of a Home as Your Main Investment
The biggest argument for owning a home is that it’s an “investment.” But a lot of people overestimate the return on this investment.
People tend to believe that homes are appreciating assets, but this isn’t always true. Yale economist and Nobel prize winner Robert Shiller debates this topic openly, having crunched the numbers. He says that, overall, the housing market doesn’t have a great long-term return. It barely outpaces inflation, in fact. He told USA Today:
“If you look at the history of the housing market, it hasn’t been a good provider of capital gains. It is a provider of housing services...Capital gains have not even been positive. From 1890 to 1990, real inflation-corrected home prices were virtually unchanged.”
The Washington Post analyzed Shiller’s data and reported that, over the past 100 years, home prices have only grown at a compound annual rate of 0.3%, adjusted for inflation. The S&P 500, on the other hand, has had an annual return of 6.5%. That’s an awfully big difference.
While that single real estate asset might help protect you against inflation, a well-balanced stock and bond portfolio seems to be a better investment. But a lot of people’s portfolios are mostly made up of their home value. You wouldn’t put 80 percent of your portfolio in a bond simply to protect against inflation (unless maybe you were nearing retirement) so why would your home make up that same amount? That’s the argument against buying a home as investment. As Forbes contributor Jamie Hopkins says:
when making the decision it is important to understand that buying a home might not be a great financial investment and to not forgo all of your investable assets in order to purchase a home because you are really purchasing a right to housing and not a long-term investment designed to generate income.
You might still be able to time the housing market just right and sell at higher rate than Shiller’s data shows. But most experts agree: while housing is an investment, it’s not a great investment. So if this is your only basis for buying a home, it’s probably not the best one.
Decide How Much You Can Afford
In deciding whether you can afford to buy, you’ll have to figure out how much home you’re planning on buying in the first place.
One rule of thumb for figuring out this number: your home should cost no more than 2.5 times your salary. Of course, this just gives you a ballpark figure. It doesn’t consider your net worth.
Once you know the number you’re working with, you’ll have a better idea of whether or not buying a home is a smart financial move for you.
Weigh the Opportunity Cost of Renting Vs. Buying
While your home might not be the best investment, in the end, it’s still yours. When you rent, you don’t own anything. This argument touches on opportunity cost: the value of an option you’re giving up to choose something else.
But it’s not that simple. You also have to consider the opportunity cost of buying. There’s the down payment. The mortgage interest payments. What’s the opportunity cost of those? How much could you earn by investing that money in the broad market, instead?
Sometimes, you can actually earn more money over time by renting and investing than buying. But whether or not this is true depends on a few factors:
- Your rent cost: If your rent is cheaper than your mortgage, you may be able to invest the difference and earn a better return, long-term.
- Down payment & mortgage interest rate: Same story here. If you invested $50,000 instead of using it for a down payment, and also invested the amount you paid in interest over time, how much more would you have in the long term? In some cases, you’d have more than the value of your home.
- Where you live: The housing market depends on many factors and changes, but where you live is a big one. Your rent prices and home prices may be a lot different than the national averages.
Consider Your Total Net Worth
Many experts say your home should only be between 20-40% of your net worth. Here’s the asset breakdown finance site Financial Samurai recommends for new homebuyers:
- Real estate (your new home): 40%
- Stocks: 50%
- Risk-free investments (CDs, Money Market accounts): 10%
Over time, you’ll ideally have less invested in real estate to grow your portfolio, but that percentage will rise again as you near retirement.
The point is: your home should not be your main asset. You shouldn’t give up your entire savings, especially your retirement savings, just to become a homeowner. Ideally, your home should not be your main asset—it should only make up 20-40% of your total net worth.
If that sounds unreasonable, you should, at the very least, have a healthy emergency fund saved before buying a home. You should also prepare savings for other expenses that inevitably pop up—maintenance, decorations, improvements.
Avoid Being “House Poor”
We’ve talked about following the 20% rule. It’s a very general rule of thumb that says you shouldn’t buy a home until you can afford a 20% down payment. The case for following the rule is:
- You won’t have to pay Private Mortgage Insurance
- You borrow less, so your mortgage payments are smaller
- You usually pay a lower interest rate (or, at the very least, will pay less in interest in the long run because you’ll have a smaller loan)
- It ensures you can truly afford the home
One might argue that you should simply continue renting and saving until you can afford to put down 20 percent (and still pay your monthly expenses with ease). As we’ve said before: you don’t have to buy a home. Don’t forego financial basics and buy a house for emotional reasons, or because it’s expected of you.
Whatever guideline you use to decide if you can afford a house or not, the takeaway is the same: it’s usually better to rent than it is to be house poor. The risk of living hand-to-mouth isn’t worth it.
Of course, beyond the money factors, you also want to consider your long-term goals. If there’s good chance you’ll sell the home in five years, it’s probably cheaper to rent. Maybe you’ll move for a job. Maybe you’ll want a bigger home for a family. Your own individual milestones should play a part in your decision.
Ultimately, buying a home is a personal choice you’ll have to weigh, considering your own circumstances. Homeownership is not inherently a smart or dumb decision—it depends a lot on individual factors and where you’re at financially. But these considerations should at least put you in the right direction.