For most people, from new college graduates to empty nesters with too much space, the decision of whether to buy or rent a home can prove very difficult. A number of emotional and financial factors play into the decision, and each has its own benefits and drawbacks. Home ownership often has unseen costs, while renting is sometimes more expensive, but all repairs are the responsibility of the property owner. The question of equity is also an important one. With home ownership, individuals build equity over time, but these people are not as free to move should opportunities arise in other parts of the country.
Before deciding whether to rent or purchase a new home, it’s a good idea to consider the following:
The Complete Financial Picture
Before deciding whether to rent or buy, individuals need to take a clear financial inventory to see which option is most financially feasible. When purchasing a home, individuals need to make a down payment that is typically between 5 and 20 percent of the home’s purchase price and then pay the closing costs, which are usually an additional 5 percent. Such expenses significantly exceed the security deposit required to rent rather than buy.
With a purchase, individuals also need to consider maintenance costs. As a good rule of thumb, a mortgage payment should not exceed about 30 percent of monthly income and other monthly debt payments should also not exceed about 35 percent of gross pay. Altogether, this leaves about a third of income to go toward repairs and account for emergency expenses.
Renting helps people stay on a tighter budget because this housing cost is a fixed monthly expense. Whereas homeowners may find themselves needing new appliances, roof repairs, or window treatments at any given time, renters only need to turn to the landlord for such repairs. For some homeowners, the constant expenses of repairs can become overwhelming and prevent them from saving or investing as much as they would like. Renters, on the other hand, typically know exactly how much they can invest or save from each paycheck and can potentially make more money investing their money wisely rather than using it to care for a real estate investment.
The Long-Term Costs and Benefits of Renting and Owning
When conducting a long-term cost/benefit analysis of owning versus renting, the major issue to consider is equity. In terms of equity, most people see home ownership as the superior choice because each payment builds equity, while rent payments are forever lost. Individuals can convert equity into cash by using home equity as collateral. However, equity takes time to build and most payments in the first few years go mostly toward fees and interest. Thus, if homeowners move after only a few years, they will have built virtually no equity in the property. Plus, the process of selling a home costs money, so people could actually lose money.
Ultimately, homes are an investment, and individuals could end up “underwater” with their mortgages if the real estate market takes a downturn, especially if they did not secure the ideal mortgage. For most people, their primary residence is the largest asset in their financial portfolio. Price appreciation can earn them a great deal of money over the long term, thus enabling them to earn a profit upon selling. This can be especially helpful as individuals enter retirement age and seek to move into a cheaper home and live off the equity from the sale of their previous residence. However, depreciation can also occur. Although this situation is rare, there are parts of the country where homes have recently lost value.
The other major issue that people need to consider is the fact that money spent on mortgage interest and property taxes is deductible on federal income tax returns. This tax break does not exist for renters, although renters do get small tax breaks in some states. Also, much of the profit from selling a primary residence is exempt from federal taxes. People who take out home-equity loans can typically deduct some or all of the interest from federal taxes. However, these tax breaks are really only helpful if individuals have itemized deductions that are greater than the standard deduction. Even if itemization gives people a greater dedication, individuals can only deduct a portion of mortgage interest payment depending upon their tax bracket. Furthermore, home ownership entails property tax payments that continue even after the home is paid for in full.
Lifestyle and Work Considerations
Before purchasing a home, potential homeowners need to look carefully at their jobs and their personal lives. If a job is insecure, then perhaps it is not the best time to buy. A mortgage can lock people into both jobs and cities, so if individuals are not ready to set down roots, then perhaps renting is the better option. Also, people need to plan for the future more when purchasing a home as opposed to renting. People who purchased a “starter” home in 2005 intending to sell and buy something larger a few years later faced a harsh reality. If individuals are planning to have children, they may want to make sure that they have enough space now rather than betting on the ability to purchase something larger down the line.