When it comes to deciding between renting or buying a house, the answer is not all that clear-cut. Some people may not be ready for homeownership for a variety of reasons, including the significant upfront costs and unpredictable maintenance expenses. Before buying a house, consider homeownership costs as well as your personal circumstances.
What's the Difference Between Renting and Buying?
|Upfront costs||Security deposit, first and last month's rent||Down payment and other closing costs|
|Ongoing costs||Monthly rent||Mortgage payment, maintenance expenses|
|Qualifying||Landlords may look at credit history and score, rental history, and income||Lenders consider credit history and score, income, the amount of your monthly debt payments in relation to your income, the size of your mortgage payment in relation to your income|
The upfront costs associated with renting are the security deposit, the first month's rent, and possibly the last month's rent.
There are also upfront costs associated with buying a house to consider. Most importantly, you will need to get a mortgage, which will require a down payment of at least 20% of the purchase price if you do not want to pay for private mortgage insurance (PMI). In other words, you save money if you can put more money down at the beginning.
Let's say that you are willing to pay for PMI, so you put down 15% of the house purchase price. If the house is valued at $285,000, the down payment would be $42,750. The calculation, however, does not end there. You would also need to keep in mind closing costs, which would include PMI fees, to finalize the purchase. These costs can add another 2% to 4% to what you have to pay for a house: $5,700 to $11,400, respectively.
You will also have a locked-in monthly cost if you rent, at least for the term of your lease. This is something you might not enjoy if you have a variable rate mortgage, although even in such cases, rates do not tend to go up literally overnight.
Your insurance costs will be less as a renter. Generally, you only need to insure your own property within your rental home.
If you buy a home, your long-term homeownership costs will be determined by your mortgage rate, home maintenance costs, property taxes, and insurance costs.
Home maintenance costs are unpredictable, and not everybody has the wherewithal, much less the desire, to tackle home repair projects themselves. You should make sure that you have enough money to pay for these repairs.
A good rule of thumb is to set aside between 1% and 3% of the house purchase price each year to cover maintenance.
Online mortgage calculators can help you get a good idea of the monthly costs of a property you are considering. You can also calculate the costs on your own by adding up your mortgage payment, including principal and interest, your homeowner's insurance premiums, private mortgage insurance if applicable, your property taxes, and a fudge factor for maintenance costs.
To buy a home, lenders look at several aspects of your financial life. These include:
- Your FICO score: You're unlikely to receive a good mortgage rate if your FICO score is below 620. Try to fix your credit before applying for a mortgage. You can order your credit report for free online.
- Debt ratio: Lenders consider two types of debt ratios when approving a mortgage: front-end and back-end. The front-end ratio is your mortgage payment plus taxes and insurance (PITI) divided by your monthly earnings. The back-end ratio adds your other monthly debt payments to your PITI payment before dividing that total figure by your earnings. Evidence indicates that borrowers with higher debt-to-income ratios are more likely to have trouble meeting monthly payments.
The Price-to-Rent Ratio
The price-to-rent ratio rule of thumb is one way to judge whether it's better to rent or buy if you've been saving and looking at a home purchase. First, you'll need to know how to calculate it to see how it works.
How to Calculate the Price-to-Rent Ratio
To calculate the price-to-rent ratio in your area, follow this formula:
Median home price / Median annual rent = Price-to-rent ratio
To find these numbers for your area, you'll need to do a little internet sleuthing. You can find the figures on websites like Zillow, the National Association of Realtors, local news media, or government organizations.
How to Interpret the Price-to-Rent Ratio
Price-to-rent ratios of 15 or less indicate that it's a good financial decision to buy (if you're able). On the other hand, price-to-rent ratios of 21 or more tell you that the housing purchase market may be overpriced, and it might be a financially smarter choice to rent instead.
Other Factors to Consider
Buying a house is a big financial decision, and you need to make sure that it is the right choice to make in light of your personal circumstances. Take the following into account before you commit:
- Job stability: You need to have enough money to be able to pay mortgage and maintenance costs. How secure is your job? Is there any possibility of a layoff in the future? How hard would it be for you to get another job immediately after a layoff? Unemployment compensation is rarely enough to cover mortgage payments.
- Possibility of relocating: Are you likely to be transferred to another city within the next two to three years? Your property would need to appreciate enough to cover the cost of selling if you are forced to move that soon. You should plan to stay put for a while when you buy a home. Additionally, there is an added benefit if you do intend to remain in the residence for a considerable period of time. Your home will gradually appreciate, so you will ultimately own an asset worth more than what you paid for it.
- Trade-off for freedom: Unless you purchase in a community with a homeowners association (HOA), you will be able to do anything you want with your own home. If you value your freedom, buying might be the better option from an emotional standpoint. But your freedom will come at a cost since you will be solely responsible for all the issues that arise from your home.
There will be no landlord you can go to for resolution of these issues. You are the owner of your home, and you have to be comfortable with that.
The Bottom Line
Buying a home is a big commitment, and qualifying for a home is a process. Consider your lifestyle, your financial status, and the cost of renting versus buying in your area. If you want to build equity, you have money saved, and you anticipate staying in the area for at least a few years, buying could be a good fit. If you're not sure where life will take you, or you don't have a significant amount saved up, renting could be a better fit.