Buy vs. Rent
Many factors must be carefully evaluated when deciding whether to buy or rent a home. If a home can be purchased significantly under market value (20%-50% less) and also renting out the home can generate a profit after all factoring all expenses, buying a home can generally be a great investment as the buyer can do well financially either selling the home or renting it out. See the examples below in helping you determine if you should buy a home for sale or rent a home.
- Unstable Living Situation - If buyer is unsure of living situation in the next couple of years, renting may be better as it is easier to end a lease and move.
- Insufficient Emergency Fund - If down payment and closing costs leaves buyer with less than 6 months of living expenses, renting may be a safer option to ensure sufficient emergency funds (at least 6 months of living expenses saved in case of unexpected events such as a layoff). Do not include 401k, retirement or brokerage accounts as part of your savings because the value of those can easily change, especially if the stock market declines.
- High Monthly Ownership Costs - If total monthly cost (mortgage, tax, insurance, water & sewer, etc) of owning a home is almost double or more than the cost of renting, renting may be a better option as tax benefits from deducting mortgage interest and property tax may not be significant. For example: 2 bedroom condo in San Francisco with a total $500,000 mortgage has a monthly mortgage of $3,000, $500 property tax, $400 condo fee, $100 insurance for a total of $4,000. If rent for similar condo is $2,500/month, renting would be safer.
- Caution in Declining Markets - If the market is declining significantly such as Miami, Las Vegas and Phoenix, renting may be the safer choice for non-active home buyers, but can be a great investment opportunity if the home is a short sale (lender allows seller to sell the home for less than what is owed on the mortgage) or bank-owned, also known as REO (Real Estate Owned). REOs are properties that have been foreclosed and did not get sold to another buyer at auction so the bank has taken back ownership and trying to sell them at a discounted price, sometimes as low as 60% below market value.
- Roommates / Tenants Reduce Costs - If buyer is willing to have roommates or plans on buying a multi-family home where the other unit(s) will be rented out, buying would be a good option if monthly rental income will nearly cover all monthly costs, in which buyer can essentially live for free while having the mortgage paid down.
- High Savings Account - If buyer has a lot of cash saved (i.e. over a year of emergency funds after the down payment and closing costs), buying a home may be a good option if the home can be bought at least 20% less than current market value and total monthly expenses of owning a home is not more than double the cost of renting.
- Fearful of Home Repairs - If buyer does not like to deal with home repairs (which shouldn't happen too frequently unless it is a "problem" home), either renting a home or purchasing a condo may be the better option as the building's management company can resolve the issues.
Exercise:
Jeff Adams, 35 years of age and Jane Adams, 32 years of age live in Glendale, CA and are planning to purchase a 3 bedroom house instead of renting their 2 bedroom apartment for $2,000 a month as they are planning to have a child. 3-bedroom houses in the area sell for about $450,000 and rent for similar homes in the area go for about $2,500/month. Based on the information below, should Jeff and Jane purchase a new home or rent a 3 bedroom house for $2,500/month?
INCOME & ASSETS- Combined Annual Income: $120,000
- Combined Checking/Savings Account: $65,000
- Combined Retirement Account: $120,000
- Combined Brokerage Account: $30,000
- Car loan: $400/month with 2 years remaining
- Student loan: $300/month with 5 years remaining
- Credit card debt: $2,000
- Average monthly costs including rent, food, gas, utilities, debts: $3,500
- Savings needed for 6 month emergency fund = $21,000 (6 x $3,500)
Solution:
- Find maximum down payment amount. Subtract 6 month emergency fund ($21,000) from total checking/savings account, which leaves $44,000. 75% maximum limit of checking/savings account would leave $48,750 maximum for down payment.
- Calculate maximum debt to income ratio. 36% of $10,000 monthly is $3,600.
- Calculate maximum monthly mortgage payments by subtracting $3,600 from total monthly debt (only $700 because credit card debt should be paid off in full first) which would leave $2,900.
- Use the calculator on the side. Assuming a $450,000 house that will have a $405,000 30-year fixed mortgage (down payment is $45,000 or 10%) at 6.00% interest ($2,450/month for principal and interest) with property tax of $400/month and PMI of $150/month, total monthly payment will be about $3,000 so given the minimal $100 difference, Jeff and Jane qualify to buy a $450,000 house.
- The wise home buyer however, should try to buy the $450,000 house for $400,000 or lower which would make monthly payments even lower and allow buyer for a nice profit should the need come to sell the home. Also, if the home buyer can qualify for a lower down payment, such as 5% (or 3% with FHA backed mortgage) that would be ideal because the return on investment (ROI) would be even greater should the house need to be sold. Of course monthly payments would be slightly higher by putting a smaller down payment, but this leaves the buyer with more cash on hand for an emergency fund or for other investments, possibly purchasing another home in the future and converting this one into a rental property.
