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When Does it Make Sense to Buy a Home Rather than Rent?

A reader writes in, asking:

“Do you have any advice for how to determine when it is better to buy rather than rent? I’ve heard rules of thumb regarding ‘price to rent’ ratios and breakeven points. But I’m trying to move beyond rules of thumb so I can be a little more sure of my decision.”

Looking at price-to-rent ratios can help you to quickly get an idea of locations in which buying is likely to make more sense than renting (or vice versa). But when it comes time to make an official decision, I think the best way to assess the situation is to compare your expected total economic cost of housing over the period in question under each scenario (renting and buying).

To be clear, this is purely a financial analysis. Most people will have significant non-financial preferences in one direction or the other as well, and it would be a mistake to ignore such preferences.

How Much Would It Cost to Rent?

The simpler side of the analysis is renting. For example, if we assume that you will be living in the location in question for 7 years, you would want to tally up the total cost of renting (i.e., rent plus renters insurance) over those 7 years. Be sure to account for the fact that your rent will typically increase over that period.

How Much Would It Cost to Own a Home Over the Period?

On the “buy a home” side, you would again want to tally up all of the monthly/annual costs you would incur over the period. Things like:

  • Mortgage payment,
  • Property taxes,
  • Homeowners insurance,
  • HOA fees if applicable,
  • Estimated maintenance costs (making sure to account for the condition of the home in question), and
  • Any interest/dividends/capital gains that you’re missing out on as a result of having made a downpayment.*

Then you would want to add the one-time costs:

  • At the time of purchase (e.g., mortgage application fees, escrow fees, and other closing costs), and
  • At the time of sale (e.g., realtor commissions and other closing costs).

But then there are two “negative costs” to include as well:

  • Any tax savings you receive as a result of the mortgage interest deduction, and
  • Any equity that you build up in the home as a result of paying down the mortgage and appreciation in home value.

Of course, almost all of these inputs will be estimates. That’s simply the nature of the beast. It is important, however, to try a few different scenarios (e.g., one in which the various estimated costs related to buying turn out to be lower than you’d anticipate, one in which they’re normal-ish, and one in which they’re higher than you’d anticipate) to see how much the overall result would be affected.

Similarly, most people probably aren’t exactly sure how long they’ll be living in the location in question. If that’s the case for you, I’d suggest running the analysis using different lengths of time (e.g., 4 years, 7 years, and 10 years) to see how the math changes.

Looking at the Results

What this analysis will generally show is that the longer you stay in the home, the more likely it is that buying will make sense, for a few reasons:

  1. You’ll often find that the annual costs of owning a home (i.e., the costs excluding the one-time buying/selling costs, but including the negative costs of tax savings and equity buildup) are cheaper than the annual costs of renting. As a result, the longer the period you look at, the better buying will look, as there’s a greater length of time for those savings to overwhelm the one-time costs.
  2. The greater the length of time, the faster the rate at which equity builds up, as a smaller portion of the mortgage payment is dedicated to interest.
  3. Rent increases over time whereas mortgage payments do not (assuming we’re talking about a normal fixed-rate mortgage, that is).

*For people with a background in finance or a related field, rather than including forgone earnings on the downpayment, if you want to be as precise as possible with your analysis, you would actually want to discount all of the costs in this analysis (i.e., calculate their present value in order to account for the fact that dollars today are worth more than dollars in the future).

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