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To Rent Or Buy? How To Make A Smart Decision

By TaxWealth -

Source: Forbes

Homeownership is a cornerstone of the American Dream. But it’s also really darn expensive. If you’re a renter wondering whether it’s time to buy a home, there’s a lot to consider. It’s not always an easy decision.

Before you make the choice to rent vs. buy, learn about all the factors you should weigh first.

Should I Buy a House? 4 Factors to Consider

1. Your Financial Situation

The first step in deciding whether to buy a home or continue renting is taking a look at your financial situation. Buying a home is a major financial commitment. Not only should you feel financially prepared, but your lender needs to agree. That means meeting some criteria.

Down Payment

Most likely, you will need to take out a mortgage loan to afford the property you’re eyeing. Most conventional mortgage lenders require a 20% down payment. A down payment of this size shows lenders you’re committed to making your monthly mortgage payment—and it allows you to avoid paying private mortgage insurance (PMI).

It is possible to put down less, particularly though government-backed loans for first-time homebuyers. With Federal Housing Administration (FHA) loans, for example, you may be able to put down as little as 3.5%. However, you’ll also have to pay an upfront mortgage insurance premium as well as monthly premiums.

Ultimately, you’ll need to decide whether it’s more important to put down less money now and get into a home quicker, or spend time saving up a down payment that will allow you to save money in the long run. Either way, you should have that down payment saved up before you begin applying for mortgages.

Savings

Your down payment isn’t the only savings you need to have on hand. In addition to being on track with retirement savings, you also should have plenty of emergency cash set aside.

It’s dangerous to put every dollar you have into an illiquid asset like property. If you experience a financial emergency such as losing your job or a major medical procedure, you could fall behind on mortgage payments and lose your home. Lenders want to see that if the unexpected did occur, you’d be able to keep up on your loan payments until you got back on your feet.

It’s a good idea to have at least three to six months’ worth of expenses saved up. However, especially during a fragile economy, you might feel more comfortable with eight or even 12 months saved up, especially if you have a family to support or income that fluctuates.

Debt-to-income Ratio

Beyond your cash savings, lenders also will look at another important number: your debt-to-income ratio (DTI). This is the percentage of your gross monthly income that gets funneled away to paying your debt obligations. For example, if you earn $4,000 a month before taxes, and you have $1,000 per month in credit card and student loan payments, your DTI is 25% ($1,000 / $4,000).

When it comes to a mortgage, lenders actually look at two DTI measurements when deciding whether to approve your application. The first is your front-end DTI, which looks at only your potential housing costs in relation to your monthly income. Ideally, your front-end DTI should be below 28%. The second is your back-end DTI, which compares all debt—including your potential mortgage costs—against your income. Lenders usually require a back-end DTI of 36% or less.

If you have a lot of debt that causes your DTI to be above these numbers, it’s a good idea to work on paying it down before considering buying a home.

Credit Score

The health of your credit also plays an important role in getting approved for a mortgage. Lenders want to see that you’ve been a responsible borrower in the past and have a strong track record of managing and paying back debt. One way they gauge this is by looking at your credit score.

Most conventional mortgage lenders prefer a credit score of at least 640 in order to qualify. If your score is higher—in the 740s and up—you can expect to get the best interest rates and loan terms. If your score is in the 600s, your lender will likely charge you a higher interest rate and maybe qualify you for a smaller loan amount.

Again, some government loan programs allow for lower credit scores. For example, it’s possible to qualify for an FHA mortgage with a score as low as 500, but only in certain situations.

2. Cost of Renting vs. Buying in Your Area

Being financially capable of buying a home is a great start, but you should also double-check that it makes sense from a purely mathematical standpoint. There are plenty of emotional reasons to buy a house, which are certainly valid. But if you want to know that you’re making the best financial decision, it’s important to evaluate the cost of renting vs. buying in your neighborhood.

According to one study of the nation’s top 50 metropolitan areas, it’s cheaper to own a house in 24 markets and cheaper to rent in 26, assuming a 30-year fixed-rate mortgage at 5% interest and a 5% down payment. Cities in the Midwest and South particularly leaned toward buying.

To find out how your area stacks up, you can use this rent-versus-buy calculator from the New York Times. Using details about your ideal home and rent information specific to your market, the calculator can help you determine if renting or buying makes more sense for your specific real estate market.

3. Your Preferred Lifestyle

Think about where you want to be five years from now. If you’re not sure, or you hope to be a digital nomad bouncing from city to city, homeownership is probably not for you. Buying a house requires a significant upfront investment, and you likely won’t break even on it for about five to seven years.

Also consider what type of lifestyle you want in general. Do you like the idea of spending weekends at Home Depot and DIYing projects around the house? Or would you rather have a predictable rent payment every month and leave the maintenance to your landlord?

Homeownership comes with lots of upkeep and periodic costs on top of your mortgage, insurance and property taxes. In fact, the average homeowner spends $3,192 on maintenance each year, and another $1,640 on emergency expenses. On the plus side, it’s your home to design, landscape and upkeep however you wish.

4. The Risks Involved

Finally, know that there are some risks to owning a home. You’ll want to think about these carefully and decide whether renting vs. buying makes more sense based on your risk tolerance.

As a renter, there’s always a chance that your landlord could end your lease or evict you. In that case, you need to find a new apartment. But the most you may lose is a security deposit.

On the other hand, if you aren’t able to make your mortgage payments, you could default on the loan and lose it to the bank. That’s significant money and future equity gone in a flash. Plus, a derogatory mark like foreclosure ruins your credit for a few years.

There’s also the chance that your home’s value doesn’t increase as rapidly as you hoped, or it could even go down (hello, Great Recession). A house can be a great financial investment, but it isn’t always. You shouldn’t buy a house if your plan is to generate all of your wealth from it.

Cost of Buying a House

As you probably realize by now, buying a house is pretty expensive. But you may not realize all of the costs that go into the deal. Before you make your decision about buying vs. renting, consider this breakdown of costs, including:

  • A down payment. You need a down payment when financing a house. So how much should you actually plan to save? The average first-time homebuyer only puts down 6%. If you were buying a home at the national median value of $284,600, that would be $17,076. If you want to save up the full 20% down payment that’s recommended, you would need $56,902.
  • Closing costs. When you close on a home loan, there are additional fees required to cover the lender’s administrative costs. Typically, these are 2% to 5% of the total loan amount. Say you borrowed $200,000—you should expect to pay between $4,000 and $10,000 in closing costs. However, you don’t need to have the cash on hand, as closing costs are often rolled into the loan..
  • Recurring costs. In addition to these upfront costs, there are ongoing expenses you’ll have to pay, too. If you put down less than 20%, that includes PMI. You also have to pay for home insurance, property taxes, ongoing maintenance and more for the entire time you own the house.

Renting vs. Buying Pros and Cons

Clearly, there’s a lot to consider when making the decision to rent vs. buy. If you’re having a hard time weighing the pros and cons, here are the main points to consider.

Pros of Buying a Home

  • The value of your home could go up over time
  • Your payments go toward building equity
  • You can customize your living space the way you want
  • There are some tax benefits to owning
  • It’s a more permanent living arrangement

Cons of Buying a Home

  • If your financial situation changes, you could lose your home
  • Swings in the economy can cause your home to lose value
  • You’re responsible for handling all the maintenance
  • There are additional costs of owning, such as home insurance, maintenance, property taxes, etc.
  • You’re stuck in place for several years unless you are willing to lose money

Pros of Renting

  • Monthly housing costs are fixed and predictable
  • It’s easier to pick up and move when you feel like it
  • You don’t have to spend money on the expenses associated with owning
  • You don’t have to save up thousands of dollars for a down payment or closing costs
  • The savings can be used for other goals, such as investing or paying off debt

Cons of Renting

  • Your rent money doesn’t go toward owning anything
  • You have limited control over how the property looks
  • Rent could increase in the future
  • The landlord could sell the property or decide to stop renting to you
  • There is less sense of stability or permanence

Is Rent-to-own a Good Alternative?

If you’re not quite ready to buy a house, but you’re interested in pursuing it in the future, you might be wondering about rent-to-own deals as a happy medium.

A rent-to-own agreement means you commit to renting a property for a set period of time and then have the option to buy before the lease is up. In some cases, your rent payments go toward the purchase price. You may also be responsible for maintenance and repairs while renting.

Though it might sound like an attractive option, rent-to-own deals can end up poor financial decisions. There is an option fee involved, which is an upfront fee you pay to the current owner for the option to buy the property later. Usually, this fee is around 1% to 5% of the purchase price. If you decide not to buy (or realize you can’t afford to), that money is gone.

Many rent-to-own arrangements are lease-option contracts, meaning you decide whether you want to buy or continue renting at the end of the term. However, if you get involved with a lease-purchase contract, you’re actually legally obligated to buy the home whether you can afford to or not.

So, Is It Better to Rent or Buy?

When it comes to buying vs. renting, there’s really no one answer to which one is better. The decision is very personal and based on dozens of factors.

Ultimately, you will have to think about what your goals are—not just for where you live, but your entire financial picture. Homeownership can give a great sense of control and security, but there is a massive financial investment required that might not be the best choice for you in the long run.

Renting might feel like “throwing money away,” but if you value flexibility, low maintenance living, and the ability to spend your money on other things like investing or travel, it could be the best choice for you. Again, it’s up to you to run the numbers and consider your ideal lifestyle.

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