DR 059: Should You Rent a Home or Buy One?

Is renting or buying a home better? How do you determine which is right for you? Is there a basic rule of thumb you can use to make this decision?

A reader named Joe recently wrote in asking if it’s better for him to rent or buy. This is a timely question, and it’s one many people are struggling within today’s housing market. The bottom line is that there’s no right decision to make here. For some people renting will be better, and for others buying will be better. This is subject to change over time, too. Right now, you may be better off renting, but later you may want to buy.

So instead of telling you the "right" answer to this question, I'd like to empower you to make the best decision for you and your family. First, we'll look at a framework that will help you make your decision. Then, we'll talk about a wonderful, wildly complicated spreadsheet for those who really want to crunch the numbers.

Not a number cruncher? We'll talk about a few rules of thumb that can help you make this decision. Then, I'll give you a couple of excellent online tools you can use to further analyze this question.

More than Numbers

While I'm mostly focusing on numbers here, it's important to understand that this decision - like so many other financial decisions - is and should be about more than economics. You'll need to take other factors into consideration, as well.

For my wife and I, for instance, we wanted a place to call our own. That was important to us, and we like owning. That's not necessarily something you can put a number on, but it's an important part of our equation.

On the flip side, some folks don't want the headache of owning. It's not even so much a question of money, but when something breaks, they'd rather just call the landlord to deal with it.

So once you get through analyzing the numbers, be sure to factor in other, less tangible considerations, too.

A Framework for Analyses

First, let's set out a framework for analyzing this question. On one level, analyzing this question is simple. You just need to figure out which option - renting or buying - is going to cost you more money.

But getting the information to compare the economics of renting vs. buying is more complicated. Let's break it down.

Costs of Renting

Figuring out the cost of renting is pretty easy. How much rent are you going to pay for the type of property you want to live in? You can complicate it a bit by figuring up how much your rent will likely go up over time. We can assume, for example, that your rent is likely to rise 2 to 3% a year. You can evaluate that over a period of a few years or even a decade. That's still easy to do. And you don't have to think about what your rental property will be worth at the end of the lease term because you don't own it. You're just figuring up the amount of rent you'll pay.

Resource: 3 Things You Should Know Before Signing a Lease

Costs of Buying

But on the buying side, things get more difficult. For most of us, buying a home is the most sophisticated financial transaction we'll ever take part in.

For starters, you have to think about financing. Most people don't pay cash for a home, so you have to think about your down payment, and the interest you'll pay on financing. You also have to factor in closing costs both when you buy and when you sell.

Then there are tax considerations. Owning a home comes with some tax advantages and disadvantages. For instance, your mortgage interest and real estate taxes are deductible, but the fact that you have to pay property taxes in the first place is a disadvantage of owning a home. When you sell a home, you may be able to exclude a certain amount of the capital gains from taxes, which is the most significant tax benefit of owning.

Another complication is home valuation. Over the long term, home values generally rise. But, as we know from the not-so-distant past, sometimes home values go down. And depending on where you live, valuations can fluctuate significantly over time. So you need to factor in the appreciation or depreciation of your home as an asset over time.

And then, of course, you need to think about the costs to maintain a home. You can get a pretty good estimate of what those costs will be. But I can tell you as a homeowner that sometimes you'll be surprised by unexpected maintenance costs. My wife and I sure were surprised this past winter when our furnace went out. And now we have a problem with our roof that's going to cost another $1,300 to fix. You may also have to pay monthly homeowner's association fees.

Making the Comparison

On paper, this framework of comparing the costs of renting and the costs of buying isn't difficult. You figure up each side of the equation, and compare them.

Keep in mind that the things I've mentioned here are just a high-level overview of costs to include. When you're looking at the economics of this choice, you want to be as detailed as possible.

If you want to really dig into the details, check out this spreadsheet from Khan Academy. The Khan Academy is a great education website with loads of resources, and they have a series on renting vs. buying where they put together this complicated spreadsheet. You can input the purchase price, down payment, interest, appreciation, your marginal income tax rate, inflation, and other information. The spreadsheet will crunch the numbers for you.

Four Rules of Thumb

Spreadsheets and comparisons are great, but you also need to take some things into account. Here are four general rules of thumb to consider:

The Five Year Rule

First, think about how long you’ll stay in the home. By and large, the longer you stay in the home, the more you should favor buying over renting. There’s no set-in-stone rule here, but as a general rule, I think if you plan to be in the home for five years or more, buying becomes a more attractive option.

That doesn't mean that if you plan to be there for less than five years, you should definitely rent. It also doesn't mean that renting is out of the question if you'll be in the home for five years or longer. But as a general rule, you want to plan to be in a home for five years or more before you seriously consider buying.

Part of the reason for this is the cost of selling a home. When you sell, you generally pay 6% in realtor fees, plus county taxes, transfer taxes, and other fees. Then, as part of the deal, you may agree to pay some of the buyer’s closing costs. In my real estate investments - single-family homes I own in Ohio with a good friend - we typically assume a cost of 8 to 10% of the purchase price.

These costs can seriously eat away at any price appreciation. For that reason alone, a minimum of five years in the home is a rule of thumb Id use.

Interest Rates

The second rule of thumb is that the lower the interest rates for mortgages, the more likely buying is a better option. This gets complicated, though, because as interest rates go up, home prices can often stagnate. You may get an offsetting benefit when interest rates go up, holding prices down. But not always.

We’ve seen historically low-interest rates for a number of years now. Mortgage rates today aren’t at the lowest we’ve seen, but they’re still extremely low. Today rates for a 30-year fixed-rate mortgage are in the 4-5% range. Of course, your credit score is a big determining factor here, but rates are still quite low.

Human Nature

Renting is often a better option because the rent is significantly lower than a mortgage payment on a comparable home. If you were to buy, however, paying the mortgage would act like a forced savings plan. Each month's mortgage payment would reduce the loan balance, assuming it's an amortizing loan as most are. This raises several questions.

If you choose to rent, what are you doing with the money you save from avoiding an expensive mortgage? If you save and invest the money, the decision to rent can be very profitable. If you spend it carelessly, the benefits of renting evaporate.

If you’re good at saving and investing, you may not need the automatic savings that come with homeownership. But study after study shows that homeowners have a higher net worth than those who don’t own homes. I think we could reasonably debate why that is, and I don’t think there’s a single explanation. But I do think that the automatic savings feature of homeownership is a big part of the reason.

Similarly, those who buy a home often squander the equity they eventually build up in the home. If you’re treating your home like an ATM by getting a home equity line of credit to increase your lifestyle, you’re making bad financial decisions.

If you’re constantly refinancing to stretch your loan back out over thirty years, or doing a cash-out refinance to pay off credit card debt just so you can go spend more, you’re being your own worst enemy.

There's no single answer to this rule of thumb. If you're going to rent, what will you do with the money you'll save on a month-to-month basis? If you're going to buy, what will you do with the equity in your home when temptation comes knocking?

The Rule of 15

Finally, you need to think about the purchase price for a home versus the cost of monthly rent for a comparable home. If rents are relatively low compared to higher purchase prices, renting becomes more favorable. If the opposite is true, buying becomes more favorable.

And that brings us to the rule of 15. If you can buy a home for less than 15 times the annual rent payments for a comparable home, buying is typically a better deal.

So let’s say that you could buy a home for $150,000. If you rented a comparable home, you’d pay $10,000 a year. In this case, you’re right on the borderline. Your rent is exactly 15 times the purchase price of the home. In this case, as rents rise, you’d lean more towards buying. As rents drop, you’d lean more towards renting.

Again, this is just a general rule of thumb. If you run this calculation in your situation and the price-to-rent ratio is 18, that doesn't automatically mean you shouldn't rent. And if the price-to-rent ratio is 12, that doesn't automatically mean you should buy.

But this is a simple way to get a starting point for evaluating what's best from an economic perspective. If you can buy a home in your market for less than 15 times your annual rent, you're generally getting a good deal. If the ratio is much higher than that, it just means you'll have to stay in a home longer for buying to become a better deal than renting.

What I've found is that in more expensive areas of the country, the price-to-rent ratio is usually much higher. For instance, in very expensive areas of California or the East Coast, you might have to pay $750,000 for a home you could rent for $30,000 a year. That's a price-to-rent ratio of 25.

But if you compare that to Ohio where I'm from, the price-to-rent ratio is typically more like 11 to 13, so you're usually much better off buying.

Tools to Use

One tool to help you figure out this Rule of 15 for your area - or an area that you’re moving to - is on Trulia, a real estate website. The tool is a rent vs. buy map of the United States. It lets you put in how long you’ll be in the home, how much interest you’ll pay on a mortgage (using current market rates), and whether or not you itemize your tax deductions.

Then, the dots on the U.S. map will change color to show you where you're better off renting and where you're better off buying. It's a good tool to get a feel for where it's best to rent and where it's best to buy.

Also, this is helpful because you can easily evaluate different scenarios, such as living in a home for three years versus living in a home for seven years.

Another useful tool is a rent vs. buy calculator on the New York Times website. This is a very detailed calculator where you can input monthly rent, your down payment, your interest rate on a mortgage, annual property tax percentage, and other information. It calculates how long you need to stay in a home to make buying a better decision than renting.

One of the best parts of this calculator is that it provides a very easy-to-read graph. And it gives lots of data - like the annual costs of buying versus renting. Like the Trulia tool, this one makes it easy to change your assumptions, and it'll recalculate the values for you.

As long as you put accurate information into these tools - or into the Excel spreadsheet listed above - you’ll get a good starting place for choosing whether renting or buying is better in your current circumstances. Then, you can use these other rules of thumb - as well as other personal, non-financial information - to make the best choice for you and your family.

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