No. 21
Why Read?
Learn how to determine what you can afford
Learn basic calculations for rent vs. buy analysis
Can’t afford to buy? Take my entrepreneurship courses, start a business, sell it, buy a home, repeat
Should I Rent or Buy?
This is Part 1 of a multi-part series of posts on the topic of buying a home. The choice between buying or renting is one of the biggest financial decisions you will make. The decision is not purely financial, but I will focus primarily on the financial aspects of buying. Buying is also more complex than renting which makes it difficult to tell which is a better deal. My hope is to make this decision a bit less complex for you.
If you have either been reading or watching the news, opinions of whether to rent or buy are numerous. Worse is the histrionics about home affordability. Listen up! We have been here before. Reversion to the mean happens. My older brother purchased his first home in the early 80s. His mortgage rate was north of 16%. He survived.
The first step is to determine what you can afford. There are two ways to do this calculation. The first is to estimate what you can afford based on household income-to-debt estimates. The second is based on fixed monthly budgets.
In the U.S., conventional mortgage lenders use two ratios to determine what you can afford – front-end and back-end ratios. (Only a banker can come up with such creative names) Essentially, these are debt-to-income ratios. If you have a favorable DTI (low), you may be able to qualify for a favorable mortgage rate.
What is the Front-End Ratio?
It’s a ratio that determines your risk for a conventional loan based upon monthly housing costs (principal and interest on the loan, homeowners’ insurance, property taxes, and any additional fees, such as HOA/Co-Op fees) divided by your monthly gross income. The general rule is that a household should not spend more than 28% of its monthly gross income on the front-end debt.
Front-end debt ratio = monthly housing costs/monthly gross income × 100%
What is the Back-End Ratio?
Like the prior ratio, it too is designed to assess your ability to pay down the loan. However, it includes everything from the front-end ratio that deals with housing and includes any other recurring monthly debt such as car loans, student loans, and credit card loans. The general rule is that a household should not spend more than 36% of its monthly gross income on back-end debt.
Back-end debt ratio = monthly housing costs + all other recurring monthly debt/monthly gross income × 100%
If you want a more granular view of the numbers, check out this Housing Affordability Calculator. You simply plug in the numbers and percentages and let it do the hard work.
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Let’s assume that you meet the 28/36 Rule noted above. The question of renting vs. buying remains unanswered. Just because you can afford to buy doesn’t mean you should. One critical question is how long you plan to remain in a location. In general, less than 5 – 7 years and it doesn’t make financial sense to buy. Now I know that “people” say that you should start building equity as soon as you can. However, Yale economist, Robert Shiller, did a study that showed that the average appreciation rate for a home after adjusting for inflation was a mere 0.2%! Moreover, after factoring in annual maintenance, repairs, and property taxes most homeowners are lucky to break even at the time of sale.
Renting vs. buying is not a simple swap. When you rent an apartment of home you likely must pay utilities, parking, and a small rental insurance policy. However, when you buy a home, you have loan payments (principal and interest), property taxes, homeowners’ insurance, maintenance, repairs, HOA or condo fees, buying and selling costs.
Other factors to consider when buying are the mortgage interest rate, home appreciation rate, and average investment return. Your loan amount consists of two parts – principle (the money that you agreed to pay back) and interest (the cost of borrowing). Something to realize is that in the early years of paying off a loan most of your payment goes to interest or borrowing cost which is the reason that you don’t build much equity if you don’t remain in the home for a while.
Given that buying a home is the largest investment most people will make in their lifetimes, how much the home will appreciate over time is a major factor in the home buying calculation. The higher the appreciation value, the more it makes sense to buy. This value is difficult to nail down. We therefore must look backward in time to attempt to find a suitable range. In the U.S. that range is 3-5%.
The last item, average investment return, is a measure of the opportunity costs of investing in a home vs. investing in the stock market. Your AIR will change based upon age and the length of time you plan to own your home. In general, the stock market provides a higher return that mortgage rates over time. Therefore, there is a cost that one incurs when they choose to invest in their home vs. the stock market.
All these factors must be considered in the rent vs. buy decision. Lucky for you, I found a simple Rent vs. Buy Calculator where you can enter the data and see if it buying makes sense for you at this time.
What’s the Bottom Line?
The good news is that there are free calculators that can assist you with the rent vs. buy analysis. The bad news, if you are living in a major U.S. city, is this:
Assume you are a single person living in San Francisco and you are currently paying $3200 monthly for a sub 1000 sq.ft. apartment with a 3% annual rent increase, insurance of $15/month, and one month’s security deposit. You want to buy a place that costs $1.2 million and you are prepared to put down 20%. A 30-year mortgage is currently 6.59%. Closing costs are estimated at 4%, property taxes 1.5%/year and will increase by 3%/year, insurance is $1200/year and will increase 3%/year, estimated annual appreciation value is 3%, and selling costs are 8%.
While it gets close at the 10-year mark, given these numbers it never makes financial sense to buy vs. rent!
Wait, what?
Recall my earlier comment about reversion to the mean? Something needs to give. So, either mortgage rates come down in the future, housing prices come down, or both. Most would say that the latter is true. If the 30-year mortgage rate comes back down to 5% and the price of the home comes down to $1 million, then buying would be cheaper if you plan to remain in the house for 13.8 years. Or if the home appreciates at 4% that time is cut in half. The calculation is highly sensitive to mortgage rate, appreciation, and of course price and down payment amount.
Once again, we are only looking at this from a purely financial viewpoint, which as we know has inherent flaws given the difficulty of predicting future rates for all the items in the calculation. Nothing remains constant over the long haul, although in California costs tend to only move in one direction, upwards. You might find that after living in a home for 7 years the market in your geography becomes red hot and you are able to sell at a price that changes the calculus and allows you to trade up.
In my next post I’ll delve into the actual buying process with the help of a career mortgage banker.
Very helpful information and resources for our current market. Thank you for sharing!