Rent vs Own

To rent or not to rent…that is the question!

This debate is becoming more and more popular as many people sit on the fence of home-ownership, wondering whether renting or owning is the right thing to do financially. Even though many people would love to own, unfortunately they’ve been misinformed as to their ability to do so.  The good news is that I’m not here to try to get you to buy a home. On the contrary! I want to share some cold hard facts and the math behind the age-old question of “Should I rent or should I buy” in order to help you make an informed decision.

What are the barriers to owning a home?

The barriers to home ownership fall within two main issues (a bit like a duel-edged sword): credit and personal decision.

Myth-busting the Monthly Payment

Right out of the gate, I’d like to tackle the “monthly payment”. It’s not actually a barrier to buying. Even though that is one of the most important factors to consider, it fits in more as part of the decision of whether or not to rent or own. We’ll get into that later.

Credit

If your credit is below 620, then you are in a bit of a pickle if you want to own a home.  Most lenders set 620 as the drop dead mark of what they will even consider.  Some lenders will accept as low at 580, but there have to be some serious compensating factors.  Bottom line—credit is a big deal and if your score is 620 or less, then time (and perhaps some credit repair) is your best solution.

Down Payment

What about down payment? Isn’t this a barrier to owning? Quick answer… not really.  The only time this actually becomes a barrier is for high income earners who don’t qualify for down payment assistance and don’t have the necessary minimum down payment. We’ll also discuss down payment solutions later.

Debt to Income ratios

This is a fancy way to say that you don’t qualify for home ownership. If you decide to rent, it’s not as much of an issue.

Your personal decision

This may sound weird, but I’ve met people who simply want to keep their options open and don’t want to own! They don’t want to bog themselves down in one place and feel stuck.  Maybe they aren’t sure if they will like the place or be happy long-term in this home or neighborhood.  Perhaps they look at owning as a risk and feel that renting provides more security.  Either way you cut it, sometimes the decision to rent isn’t backed by logic or math—it’s just personal preference… and that’s OK.

Is Renting or Owning the Right Decision?

Now let’s make the assumption that you want to own at some point in the future and there aren’t any foreseeable barriers in doing so. We are just looking to decide if it’s the right decision.

What do we need to consider?

Monthly Payment.  This is the biggie in the mind of most potential home buyers. “Will I pay more if I buy than if I rent?”Good question. The answer is that we have to look at a few more items than just rent payment vs. mortgage payment. First, we need to compare the total amount of rent payments to the total amount of mortgage payments for the time you would own.  We also have to factor in that rent payments increase at least every 1-2 years (unless you have an amazing landlord!). Mortgage payments are fixed. Add it all up and you’ll have your total cash outlay. It’s been my experience that when you factor in rent payments over a 5-6 year period that owning comes out even or a tad ahead.

It is possible that renting can be cheaper for the short term. Typically, I see this happen when the client rents a smaller home or a home in a less desirable location. This may be an OK decision to get the payments down, especially if it’s going to be temporary.

Down payment.  If you don’t have the funds for a down payment to buy a home, this is definitely something to consider!  In fact, it may be a barrier to buying, but keep reading… there is help!

  • Down Payment Assistance Programs (DPA).  Across our country there exist many, many down payment assistant programs that can sometimes provide up to the entire down payment for the purchase of a new home. Some are low or interest-free loans that only get paid back when you sell. Others are grants from government entities designed to help people achieve the dream of home ownership.  Obviously look for the grants first, then the down payment loans.  These types of assistance programs have income restrictions.
  • Low Down Payment Programs.  If you don’t qualify for DPA programs, consider a low money down program. There are conventional programs now with as little as 3% down payment and government programs requiring only 3.5% with pretty much any credit score considered!  Considering that renting typically requires 1st and last month’s rent and a security deposit, you are looking at minimum of 3 to a max of 5 rent payments!  Just 3 rent payments can equal about 2% of the purchase price, so you’re closer than you think!
  • Gift Funds. If you can’t do DPA and don’t have money in the bank, consider getting a gift. Gift are allowed to pay the down payment for the purchase of a new home.  Considering you qualify for a 3% to 3.5% down payment program, the amount of the gift may not need to be egregious.  Zillow did a really nice write up on the rules of using gift funds when getting a mortgage.
  • Retirement Funds.  Last and definitely least in my book is the use of retirement funds for a down payment. I normally shy away from suggesting this as I feel your money should be working and not being used until retirement, but I do appreciate the fact that there may exist a circumstance where the use of these funds is important to get the home you need.  The good thing about retirement funds is that when you pay them back, you are paying back YOU! That’s right, you are essentially borrowing from yourself so you pay yourself back the interest. Additionally, lenders won’t count this payment against your debt-to-income.
  • Return on Investment (ROI).  No one will probably tell you this, but your down payment directly affects the rate of return on your new investment.  So when you rent, you have no return on investment.  There is no ownership, therefore no investment.  When you own, you used the down payment (that’s your initial investment). And when you sell, you will have cash on hand, that’s your return.  Now consider you put down 3% on a $400,000 home.  That’s a $12,000 initial investment.  At the end of 5 years, you walk away with $73,000.  That’s a 608% ROI, or more than 50% per year.  This may seem to be a ridiculous example, but it’s actually not.  Real life numbers of a recent purchase.  Imagine now that you bought that same home using a down payment grant, i.e. you put ZERO money down.  I really don’t need to do the math for you.  Case in point, the more money you put down on a home, the lower your ROI!  Money does not grow sitting in the equity of your home and it certainly doesn’t grow sitting in the bank of your landlord!

How long will you be in the home?  The shorter the time you will be in the home, the higher the risk for buying.  I’ve found a comfortable time to be over 3 years.  If you have at minimum 3 years in the home, you will have more benefits than negatives.  As mentioned above, sometimes renting for the short term can be cheaper. If you know you’re moving (or potentially moving… it’s up in the air) then unless you are getting a smoking deal on a new home, just rent.  Renting, although more expensive over the long term, leaves your options open which is a good thing.  Warning: Don’t use that statement as a scapegoat!    And don’t be afraid of committing to a owning a new home just to “leave your options open”. Commitment issues like that could really hurt your financial future.

Cost to sell.  The most recent study shows the average buyer is expected to stay in their home 13 years!  However, if you are like me and have moved several times during the past 10 years, you need to consider the cost to selling your home.  The cost to sell includes Realtor commissions (buyer and listing agent) and any closing costs paid on behalf of the buyer.  There are minimal settlement charges as well.  Typically, these add up to 6-8% on the high end. I use 6% as the costs to sell since typically the buyer closing costs and others are “built in” to the sales price.

Appreciation.  Home prices normally increase in value. This has been consistent throughout most of history; however, if you weren’t under a rock in 2007 you witnessed a devastating time for home prices. It was the largest measure of home depreciation we’ve seen since the Depression.  The financial crisis, the meltdown… it was awful.  People who purchased homes in 2005-2006 and after the bubble burst saw a slew of foreclosures, short sales, etc. with the primary reason being the absolute collapse in home values.  People were mortgaging their way to financial freedom and then decided to “let go” when home prices crashed.  Some foreclosures happened due to a real “life event” but most home owners just “let it go.” They bought and bailed adding further to the depreciation slide of home values.

I mention all this to set the stage to the fact that we are now SO regulated (I should know!) that this sort of financial collapse has very little chance of happening again.  I’ve been saying for years that we wouldn’t see bank lending rates very high due to the regulation of the banking industry in 1987 and that’s held firm.  Since the financial reform of 2008 every facet of the dollar sign as it relates to the consumer is highly regulated.

So, home prices are going up.  Here is a great resource from the National Association of Realtors. Find your market and you will see that home prices are going up.  In some parts of the country, you’re seeing 5% and up. In my area, it’s about 4%. On a $400,000 home purchase, 4% means a $16,000 increase in the home value!  Factoring appreciation as a buying decision is important.  If you own now, that means that your home will expect to grow in value which builds equity.  Owning a home has always been considered one of the best investments one can make.  However, appreciation can also be a negative factor.  We will look at this more in the dangers of not buying.

Tax Benefits.  Home ownership has its benefits.  Think of it in its simplest form. The tax benefit of home ownership actually reduces your effective house payment. Let’s say you bought that $400,000 home and put 3% down, financing the rest at a rate of 4.125%.  The amount of interest you would have paid in the first year is $15,879.  The estimated tax benefits would be $4,446.  This is the estimated amount you would “get back” from Uncle Sam.  So, when I say this reduces your house payment, here’s what I mean.  With the extra $4,000 you get back in taxes, I recommend a change in how much is withheld from your paycheck.  Owning a home will allow you to increase the number of exemptions you take on your W4, which will increase your take home pay!  A bigger paycheck just effectively lowered your mortgage payment.  This increase in your spendable income can and should be considered when “stretching” for that home of your dreams.  When you rent, you have zero tax benefits and will continue to get hammered by the tax man.  When you own, the effective payment on a mortgage is lower due to the inherent tax benefits.

Remaining principal on the loan.  Your mortgage payment consists of Principal, Interest, Taxes and Insurance.  That “principal”piece is the only good part of your payment!  If you look at an amortization schedule for a 30-year loan, you will see that more gets applied to the “principal” portion every month!  This simply pays down your loan balance. For the above example on a $400,000 home purchase, borrowing $388,000 at 4.125% interest, at the end of just one year the balance is lower by $6,686.  It’s sort of a forced saving plan.

What are the dangers of not owning?

Now that we’ve discussed the major things to consider, let’s discuss the dangers of not owning. In my opinion, before you make the decision not to own, you have to be OK with the following.

The Simple Negatives

  • Higher monthly payments. If you choose to rent, you could just be paying more, especially when you factor in rising rents vs. a fixed mortgage payment. Figure out the total amount of payments over your expected tenure in the home.
  • Loss of tax benefits. Over the term of being in the home, you would have been able to write off all the interest on the loan. That’s like getting 28% of your interest paid back in CASH from Uncle Sam. Take the total amount of interest paid over the term of your time in the home and multiply by 28%. This will be a BIG number.
  • Loss of equity. Remember that when you pay rent you aren’t investing in yourself, but rather paying your landlord’s mortgage. Every payment made on a mortgage reduces the amount owed on the loan. So really, whose debt do you want to pay down – yours or your landlord’s? Or rather, who would you rather invest in? Yourself or your landlord?

The Cost of Waiting

  • Appreciation. When a home appreciates, you earn equity if you are the owner. If you are
    sitting on the sideline and not the owner, all you can do is watch the home go up in price. Every month… tick, tick, tick.  We are expecting a 4.8% increase to home values this year. See the chart below for some math.
  • Interest rates. When rates go up, payments go up and the cost for the same investment goes up. If you are waiting to buy, it’s rolling the dice on interest rates.  If rates go up the projected .78% in the next year, this will result in much larger payments.
  • Loss of purchasing power. This is the real danger!  The combination of appreciation and interest rates are the perfect storm. If you wait to buy and both home appreciations and interest rates start climbing, the same home you are looking at today is not only worth more, but will cost more. To keep your payments in line with what you are looking at today, you would have to purchase a cheaper home. The question is, what does that cheaper home look like to you today? Well, that’s the home you may have to settle for if you wait until next year or down the road. That or else higher home prices and higher interest rates will force you to push your budget more than you may be comfortable with.

Conclusion.

The last thing I want to do is make a blanket statement that it’s better to own than to rent.  I don’t feel that’s always the case and it’s important to analyze the specific situation of each potential home owner to make the right decision. I hope this shed some light on the positives and negatives of owning vs. renting to help you make an informed decision.

Want more? Download my Rent vs Own mortgage analyzer. This interactive spreadsheet will allow you to run numbers and calculate the benefits of owning for your specific situation. If you have any questions, don’t hesitate to reach out to me anytime at loans@elmendorfteam.com.

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