Rent vs Buy: Real Estate

When it is time to move out and find a new home, you may ask yourself, “Should I rent, or should I buy?” There are many factors that should be considered when answering this question. Three considerations that are most important in the rent vs buy analysis are the following:

  • Finances
  • Time
  • Freedom

Finances: Initial Cost

The initial cost of purchasing a home may be prohibitive to some would-be buyers. The first step is to closely analyze your budget and calculate what amount you can afford as a down payment. Typical conventional mortgages require a 20% down payment, whereas Federal Housing Administration (FHA) loans require as little as 3.5% down. Buying a home is expensive, and closing costs and third-party fees can quickly escalate. Closing costs can be anywhere from 2-5% of the negotiated purchase price.

The purchase of a home can leave you house rich and cash poor. Putting your entire life’s savings into a down payment sounds tempting, especially to buy a dream home. There are several costs that are overlooked, like moving fees, home improvement costs, furnishings, utilities, and maintenance. Prospective home buyers should have a rainy day fund for unexpected home repairs. An example is the replacing of a roof or repairing a deck once infested by termites. Even the best home inspection services can fail to find major repairs.

Finances: Monthly Payment

Monthly mortgage payments should be comfortable to pay and fit into a budget that includes food, car loan payments, car expenses, utilities, clothing, entertainment, retirement contributions, and a rainy day fund. Mortgage payments should be roughly equal to what would be paid in monthly rent payments. If the estimated mortgage payment is significantly higher than a similar home’s monthly rent, it might be better to rent than buy. This might be a sign that the housing market is inflated and that there might be a looming housing market correction. Reaching or overextending a monthly housing budget can cause severe stress, which can lead to poor financial decisions.

Rent vs Buy: Real Estate

Take a Deep Breath: Rent vs Buy

At this point, the initial hurdle of purchasing a home may seem impossible and fraught with costs. The initial start-up cost of a rental is so much lower. A rent deposit is typically equivalent to two months’ worth of rent to cover a security deposit and the first month’s rent. It may appear that there really isn’t a reason to continue the rent vs buy discussion, but let’s analyze a few other factors.

Finances: Appreciation and Income

A home is most likely the largest asset a person will own in his or her lifetime. No other asset in an investor’s portfolio is likely to consume the majority of a monthly budget. A home is an amazing asset that can appreciate over time and outpace inflation. During down markets when a home may not appreciate as quickly or be valued below the purchase price, a home can be partially rented and generate income to help offset mortgage payments. Services like airbnb allow for temporary renters if permanent renters are not an option. There aren’t many investment vehicles that allow the owner to generate income on the underlying equity that has lost value.

Treat a home as a long-term investment. In the rent vs buy spectrum, owning a home is like owning AAA investment-grade corporate bonds. Renting is like buying an equity option; the renter never owns the underlying investment instrument. In fact, renters are paying the monthly mortgage for the home’s owner.

Finances: Taxes

Owning a home can provide a huge tax advantage when it is time to file your taxes in April. The majority of a monthly mortgage payment in the beginning of loan repayment is applied toward interest. All interest, according to IRS publication 936, attributed to a secured mortgage can be deducted on form 1040. Money paid toward rent cannot be deducted on form 1040, giving an advantage to buying real estate in the rent vs buy analysis.

Time

Finances will always be a driving factor in the rent vs buy decision process, but time also should be considered. A typical home owner will live in his or her house for 13 years, according to the National Association of Home Builders. The purchase of real estate should be considered a long-term investment, much like the purchase of a bond or certificate of deposit (CD). A potential home buyer/owner should plan to reside in his or her home for over a decade to take full advantage of home appreciation.

Renting may be a better choice if an ideal location has not been found and a long-term commitment cannot be made. Family considerations, such as school districts, day care, grocery stores, and public transportation should be a factor. Buying a home requires a large initial investment that may not be unwound easily. Though financial factors should be heavily weighed, mental well-being is extremely important; feelings about a neighborhood should not change during the time of ownership.

Freedom

If you are faced with the rent vs buy question, it may come down to this last factor of freedom. Renting provides a large degree of freedom. A renter will be free from costly repair and maintenance bills, whereas the landlord will need to have funds set aside to cover these expenses. The cost of replacing a roof or paying to fix water damage caused by a flood can be tens of thousands of dollars, which would not be the responsibility of a renter.

Though a real estate owner welcomes the opportunity to lock him or herself into a home for 13 years or more, the renter will have the ability to leave at any time. A person facing the rent vs buy decision may want the freedom to leave or break a lease at a moment’s notice. This gives him or her the opportunity to take a new job in a different state or move to a nicer neighborhood, which is not as easy to do when a home needs to be sold first. Selling a home can take months, which is not ideal for someone wanting to move quickly or have access to cash from his or her largest asset.

Conversely, a renter may not be protected by rights afforded to an owner. A renter may have his or her lease terminated at any time. A family trying to lay down roots and establish themselves in a neighborhood and school district may be forced to leave because of rising rental costs.

Conclusion

Finances will no doubt be the largest factor in the rent vs buy decision making process. Finding a comfortable monthly budget for either renting or buying is crucial to a stress-free life and a healthy mindset. Time and freedom are also critical components that may not be easily quantified in a calculator. These factors may even be more important than finances, which makes them difficult to assess. Long-term goals should be included in the rent vs buy analysis. Thinking in terms of 5-year periods may paint a clearer picture when evaluating time and freedom.

  • Have money set aside in addition to a down payment (feel comfortable with the down payment).
  • Monthly mortgage payments should fit into a monthly budget as would rent.
  • The ownership of real estate can appreciate and generate income, unlike real estate that is rented.
  • Real estate ownership can reduce tax consequences by deducting interest on form 1040.

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