You’ve always been told that buying a home is the ultimate achievement — the physical, brick-and-shingles, fenced-in-backyard embodiment of the American Dream. Yet only about one-third (37%) of millennials between the ages of 25 and 34 own homes. And of those who do, 63% reportedly regret their home purchase, with a quarter citing “unexpected maintenance or hidden costs” as the top reason. In more than half (59%) of U.S. housing markets, in fact, it is cheaper to rent than buy.
So what’s the deal? Is it worth plunking down your savings on a piece of property? Or wiser to keep renting for a period of time or until the end of time? The short truth: If you’re able to afford the down payment on a home that is likely to appreciate, and you plan to hang onto the property for at least five years, you should go for it. The long answer is everything below.
1. Should you rent your home or buy one? Let’s run the numbers.
The most important first step in the rent/buy decision is, of course, determining whether you can afford to buy a home, and if so, if you can afford as much of a home as you need. Before going any further, take a look at the following numbers:
- Emergency savings: You should only consider purchasing a home if you already have three to six months worth of expenses saved in an emergency fund. We know we tell you this all the time, but hey, that’s not going to stop us from saying it again: Having an emergency cash reserve in a high-yield account — we like our FDIC-insured Wealthfront Cash Account, which currently has the highest interest rate on the market, according to Bankrate, 2.51% APY — is one of the most fundamental building blocks of good financial health, it should come before any other investments, including buying property.
- Down payment: Although you can purchase a home with a down payment that’s as little as 3% of the purchase price in some cases, doing so means taking on more debt. Unless there’s an incredibly compelling reason to take the plunge before you have a 20% down payment, it’s generally a good idea to wait until you have more cash to offset the amount you have to borrow. Twenty percent might sound like a lot, but it will save you money on interest and private mortgage insurance (PMI), and put you on more secure financial footing as a homeowner. Plus, don’t forget you’ll also need enough cash on hand to cover closing costs, which typically equals about 3% of the purchase price.
- Debt-to-income (DTI) ratio: Lenders look at your “front-end” and “back-end” DTI when deciding whether to work with you. To calculate your front-end DTI, divide your projected monthly housing expenses (mortgage plus taxes plus insurance) by your monthly gross income; for the back-end, divide all of your monthly expenses (including projected housing, loan, and credit card payments) by your monthly gross income. Most lenders are looking for a front-end DTI below 28% and a back-end below 33%. If you’re not there yet, you should wait to buy until you’re in a stronger financial position.
- Credit score: The higher your score, the better your chances of getting approved for a mortgage with a lower interest rate. Not to be dramatic, but even a single percentage point matters here. On a $400,000 mortgage, for example, the difference between a 4% and 5% interest rate would cost you $68,000 over 30 years. It’s worth doing whatever you can to boost your score before calling the mortgage broker, even if that means holding off longer on buying a home.
- Investment accounts: Whether or not and when and how much to dip into your investments in order to have cash for a down payment…that’s a personal call that depends on a number of personal variables. Make a plan you feel good about, and do you. That said, pulling from your retirement accounts for a down payment is basically a cry for help. Please don’t make us come talk you down. Leave your retirement alone. Making a withdrawal means you’ll likely face fees and taxes, not to mention removing a vital source of compound growth and diversification from your future income. Purchasing a house isn’t a good idea if it requires you to put your retirement at risk.
2. Think about your 5-year plan (or, you know, think about making one).
Let’s assume all your numbers add up, and you’re in great financial shape to buy a place. Hey, congrats. So now it’s time to ask yourself: “Where do I want to be in five years?” If the answer has a definitive geographic location tied to it, then buying a home is a strong option. But if you aren’t quite sure where you’ll be living beyond the next few years, you might want to consider renting until you sort that out. Not only does renting offer more flexibility for you to lock down where you want to be, but it’s also typically cheaper in the short term.
You should only buy a home if you plan to be in it for at least five years. That will give you enough time to recoup the costs of buying and selling, such as legal and bank fees, commissions, and inspections through appreciation. For example, if your home appreciates 2% a year, then in five years it will appreciate by 10%. Because of agents’ fees, it will cost you 6% of your home’s value to sell it. You’ll also be paying closing costs up front, and an annual maintenance cost of 1%. This is why it’s so essential to aim to buy a home that is likely to appreciate — our free planning feature can be incredibly helpful in scoping this out before buying a place by showing you trends and predictions based on data from multiple sources — and to not sell it for at least five years.
Because of the way mortgages are amortized, the amount paid toward the principal starts out shockingly minuscule and grows slowly over time. Say you take out a $300,000, 30-year fixed rate mortgage at a 4.5% interest rate. When you make your first $1,520 payment, a whopping $1,125 of your payment would go toward interest, and a mere $395 to paying down your principal. (The word you’re looking for here is “oof.”) It would take nearly 15 years until your payments became more principal than interest.
|While you’ve probably heard about the tax benefits of homeownership, the recent tax law changes have made renting more favorable to many Americans. Although you can deduct the interest paid (on mortgages of up to $750,000), you’ll need to itemize — which has become less common after the standard deduction increased to $12,000 for single and $24,000 for joint married filers. The amount of state and local taxes (SALT) you can deduct is now capped at $10,000, too.|
3. Renting vs. Buying doesn’t have just one clear answer.
Let’s get one thing out of the way: A home is not always “a good investment,” and renting is not always “throwing money away.” At the very least, when you pay rent, you’re getting shelter in return, which isn’t nothing. If you’re paying rent, congratulations! You have a place to live, and that puts you in a better position than a lot of people, and that’s not a bad fact to centralize in the “renting vs. buying” debate — you have shelter, so any additional advantage you can derive from your housing situation is gravy.
Beyond having a literal roof over your head, renting your home might be what enables you to save money for a down payment on a future home purchase or to start a business. It might allow you to live in proximity to a job in a city where you can’t currently (or ever) afford to buy a home. If you can unhook yourself (and you really should) from the housing hierarchy that makes us believe renting is fundamentally inferior to owning in all cases, you’ll be less likely to make an emotional grab at owning a home and open yourself up to the possibility that renting could more advantageous per your goals and circumstances.
The long-term returns of owning a home aren’t so clear-cut either. According to Nobel Prize-winning economist Robert Shiller, between 1890 and 1990 the return on investment on homes has hovered around — wait for it — 0%. On the other hand, the S&P 500 averaged annual returns of approximately 10% between 1926 and 2018.
That might be why scholars from Florida Atlantic University say that renting is often a better financial move than buying. Their research suggests that continuing to rent, and investing the cash you’d otherwise put into a house (for a down payment, repairs, taxes, etc.), could eventually create more wealth than buying.
The catch: You have to be disciplined enough to actually invest the extra money and not spend it on, say, a new Tesla or a thousand Tuesdays’ worth of takeout sushi. We’re not saying you can’t buy a car or order takeout (we would never), just that you have to decide on a budget and build financial plans that include investing on the regular — and you have to stick to it. If that seems challenging, then throwing your cash into property could be a smart way to lock up your assets for your future self so your present self can’t go too wild.
4. Scope your location
No debate between renting and buying a home would be complete without a close examination of your particular housing market. Think about the type of home you want — size, amenities, style, etc. — and then research the hell out of rental and purchase prices of comparable homes in your area. (Warning: You may become addicted to Zillow during this part of the process, but honestly there are worse things.)
Once you’ve got those numbers in hand, plug them into one of the many online “renting vs. buying” calculators designed to help you make this decision. If you’re more of a DIY person, calculate the price-to-rent ratio by dividing your city’s median home price by its median annual rent. Generally, the lower the ratio, the smarter it is to buy; the higher, the more likely you could be better off renting.
Although it might be tempting, it’s inaccurate to make an apples-to-apples comparison of your hypothetical monthly mortgage payment and current monthly rent. Homeownership comes with an inevitable slow drip (or crippling deluge, depending on your luck) of additional costs, including repairs, taxes, and insurance. For maintenance and repairs alone, experts advise budgeting 1% of the home’s purchase price annually. That’s why we recommend using the calculators to give you at least an idea of what makes sense for you.
Finally, you should study up on your region’s real estate trends and predictions. If you live in a location where home prices are rising faster than inflation, you could come out ahead if you choose to buy. Conversely, you would be better off renting if there is very little appreciation.
5. Uh oh, time to think about your life.
If you’ve crunched all the numbers, done all the research, and still, no clear answer is popping out at you, we say do two things. First, keep renting for now. If all signs aren’t point toward “buy a home now — it’s undeniably a very good idea!” then you might as well cool it in your rental while you gather conviction (and save more cash for your down payment) about a possible future home purchase. Then, from the comfort of you rental home, spend some time diving into the fuzzier details of your life and future; the myriad intangible things that will color your decision.
Consider questions like:
- Do you plan on having children? Do you know where you want to raise them or where you want them to go to school? What is the home-buying landscape like there?
- Do you see yourself changing jobs in a few years or are you committed to your city for the foreseeable future?
- Are you prepared to trade your weekends of leisure — biking, hitting breweries, brunching — for fixing sinks and mowing the lawn? Because that’s what homeowners do. Signing closing papers is the wedding, move-in day is the honeymoon, and homeownership is the actual marriage. There will be work and rough days, and it’s not as easy to bail if things get really bad like when you were “dating” a rental home. (Yeah, you could call us romantics.)
- What is it about owning a home that appeals to you? Is it having a physical place to make your own, to really invest in personally, not just financially? On the flip side, are you mostly looking to make a financial investment? Is it just a status thing? Do you feel like you should buy a home at this point in your life? Where is that urgency coming from?
Hey, we are not therapists and make no claims about knowing what to do with these answers. We’re just saying…it’s all worth thinking about.
The most important thing to remember is that buying a home isn’t the be-all-end-all of financial adulthood. Renting is not inherently a sign of an immature financial life. For a lot of people, renting could totally be the best move, at least for a period of time. And that’s okay. So make yourself believe that first. It’s honestly pretty freeing.
6. How badly do you want it?
This matters too. When it comes down to it, if the cold numbers still leave you a little on the fence, but emotionally you are honestly in love with the idea of truly owning a home that’s sincerely yours, then go with that. When it comes to home buying, let your logic clear a path for your emotional fulfillment. A home isn’t just a thing you own — it’s a place you live your life. It’s more okay to weigh your feelings as heavily as you want.
*Based on market data provided by Bankrate for similar products as of 5/28/19
This blog is powered by Wealthfront Software LLC (“Wealthfront”) and has been prepared solely for informational purposes only. Nothing in this communication should be construed as an offer, recommendation, or solicitation to buy or sell any security or a financial product. Any links provided to other server sites are offered as a matter of convenience and are not intended to imply that Wealthfront or its affiliates endorses, sponsors, promotes and/or is affiliated with the owners of or participants in those sites, or endorses any information contained on those sites, unless expressly stated otherwise.
Wealthfront offers a free software-based financial advice engine that delivers automated financial planning tools to help users achieve better outcomes. All information provided by Wealthfront’s financial planning tool is for illustrative purposes only and you should not rely on such information as the primary basis of your investment, financial, or tax planning decisions. No representations, warranties or guarantees are made as to the accuracy of any estimates or calculations provided by the financial tool or the information provided in this article. This article is not intended as tax advice, and Wealthfront and its affiliates do not provide tax advice nor do they represent in any manner that the tax consequences described here will be obtained or will result in any particular tax consequence. Investors are encouraged to consult with their personal tax advisors.
Cash Account is offered by Wealthfront Brokerage LLC (“Wealthfront Brokerage”), a member of FINRA/SIPC. Neither Wealthfront Brokerage nor its affiliates is a bank. The cash balance in the Cash Account is swept to one or more banks (the “program banks”) where it earns a variable rate of interest and is eligible for FDIC insurance. FDIC insurance is not provided until the funds arrive at the program banks. FDIC insurance coverage is limited to $250,000 per qualified customer account per banking institution. Wealthfront uses more than one program bank to ensure FDIC coverage of up to $1 million for your cash deposits. For more information on FDIC insurance coverage, please visit www.FDIC.gov. Customers are responsible for monitoring their total assets at each of the program banks to determine the extent of available FDIC insurance coverage in accordance with FDIC rules. The deposits at program banks are not covered by SIPC.
Wealthfront, Wealthfront Advisers and Wealthfront Brokerage are wholly owned subsidiaries of Wealthfront Corporation.
© 2019 Wealthfront Corporation. All rights reserved.