Should I Stay or Should I Go? The “Buy vs. Rent” Question

Financial advisors are often asked “Is it better to rent or buy.”  The answer almost invariably is (or should be) “That depends.”   Your situation is different than your friend’s, co-worker’s, or cousin’s, so while buying may be better for you, renting may be the smarter move for someone else.  Perhaps a better question is “Should I rent or buy?”

Whether buying vs. renting works out better for you depends on a number of factors including rental rates, house prices, mortgage interest rates, and property taxes.  The New York Times Rent vs. Buy calculator (“Is It Better to Rent or Buy” from The Upshot.  Nota bene: much easier to use with a mouse than on a touchscreen) includes 22 variables you can change to determine what’s best for your situation.  22!  You can see why it’s not an easy answer.

If you are just starting this process, the first items you select – house prices, length of stay, and mortgage details – are enough to give you a ball-park answer to the question.  For example, let’s say I want to live in an $802,000 home for the next five years.  Hypothetically, I would put 20% down and get a 30 year mortgage at 3.67% interest.  If I can find the same house at a monthly rent of $3199 or less, then I am better off renting.  If my current rent is $3500, then I could either try to negotiate with my landlord, or buy something instead.  If my cash flow limits me to a rent of $2500 per month, though, then this type of home purchase is probably not a good idea for me.

The calculator next addresses the future – will the home appreciate, will your rent increase, what could you have earned by keeping your down payment invested in the stock market, and what is inflation expected to be.  If you are thinking about buying your “forever house,” these items may not matter very much.  However, if you are moving somewhere for a short period of time, like for a temporary job or for school, these factors are very important.  If the value of your house has decreased over those five years, you are not going to be very happy, and you might actually be in trouble when it comes to repaying your mortgage.

In the example I started above, I assumed our investments would return 4% per year.  If, instead, we realize a 5% annual return, our break-even monthly rent goes to $3351 (vs. $3199 at 4%).   If I assume that a home we buy would remain flat in value after 5 years rather than appreciating 3% annually, then we’d be better off renting up to a rent of $4864.  That’s a huge difference!  To offset the potential of no growth of our home value, we’d have to live in that house for 27 years rather than 5 for buying to make more sense than renting.  That’s not an option, though, if you are required to move for work, etc….

Some of the variables are very specific, like ongoing maintenance and renovation costs, homeowner’s/renter’s insurance, utilities, monthly common fees, and the tax deductibility of those common fees.  Items like this are very hard to estimate without actually looking at specific homes for sale, so I’d consider these to be most useful at the end of a property search.  However, they are extremely helpful in getting someone to think about all the different costs they could realize as a home owner.  I’ve met with people who have bought a house without considering all the costs and found themselves unable to afford their homes.  Performing this exercise before a purchase could help prevent that from happening to you.

“Ok,” you say, “this calculator is interesting, but interest rates are so low that I feel like I have to purchase now before they start going up.”  You’d be right about interest rates: with the exception of June 2012 through May 2013, the rates on a 30 year fixed rate mortgage have basically never been lower.[i]  Sounds like a compelling reason to buy, right?

It’s compelling, but it’s not enough.  There are a dozen things other than interest rates that should dictate whether or not you buy a home.  One of these is the down payment.  Unless you qualify for reduced or no-down payment mortgages, you will need to put at least 20% down to buy real estate.  This money should come from taxable, non-retirement accounts, i.e. savings accounts and investments.

Sometime a home buyer plans to raid retirement accounts to raise money for a down payment.  This is a big “no-no” in financial planning.  Aside from taking the money out of the market and cutting into the long-term compounded growth, withdrawals from 401(k)s, Traditional IRAs, and other pre-tax accounts before age 59 ½ are almost always assessed a 10% penalty on top of the income taxes due on the withdrawal.  Of course, there are always exceptions, like the $10,000 penalty-free withdrawal from a Traditional IRA for a first-time home purchase.  To be safe, though, you should work under the assumption that your withdrawal will be assessed a penalty.  Plus, even an exception is granted, taxes usually will be assessed.

“What about a loan from my 401(k)?”  You could do that, but interest rates most likely aren’t going to increase so fast and with so little warning that you won’t be able to make a purchase at a reasonable interest rate before they do.  A loan from your 401(k) would add interest payments to your monthly cash flow, so why not just save that amount toward a down payment?  Plus, if you leave your job, voluntarily or not, you have 90 days (in most cases) to repay the balance of the loan or it will be considered a withdrawal, and you’ll have to pay the taxes and penalty on that amount.  If you needed the loan to begin with, you probably won’t have the money for the repayment after buying a house.  I think you are better off saving toward a down payment and then investigating your options when it looks like rates are about to increase.

So I come back to where I started: Should you rent or buy?  It depends.  If the Times’ calculator doesn’t help, maybe a financial advisor can.  Feel free to contact me to set up a time to discuss your individual situation and whether buying or renting makes the most sense for you.

 

[i] 30 Year Fixed-Rate Mortgages Since 1971, Freddie Mac, http://www.freddiemac.com/pmms/pmms30.htm.