Should You Buy a House or Just Keep Renting?
You are out of debt and you have started to channel your money towards your next big financial goal: buying a home.
For a long time, it seemed like the conventional wisdom was that you grow up and buy a house because that’s exactly what you do . But lately, people are realizing that this is not always the smartest financial move. Obviously, the housing crisis during the Great Recession has a lot to do with this – people question the standard assumption that home ownership equals financial stability.
To learn more about buying a home, watch the video below:
How do you know if it’s right for you? Should you buy a house or keep renting?
Home ownership is not a good or bad idea in and of itself. Like many other financial decisions, it all depends on your situation . Sometimes buying a house is a smart thing to do; in other cases it really isn’t. Whether this makes sense for you will depend on several different factors. Here are some things to keep in mind.
Don’t consider home as your main investment
The biggest argument for owning a home is that it is an “investment.” But many people overestimate the ROI on this investment.
People tend to believe that assets are valued at home, but this is not always the case. Yale economist and Nobel laureate Robert Schiller is openly discussing the topic, cutting numbers . He believes that the housing market as a whole does not bring much long-term profit. In fact, it barely outstrips inflation. He told USA Today:
“If you look at the history of the housing market, you will see that it has not been a good source of capital gains. This is a housing service provider … Capital gains have not even been positive. From 1890 to 1990, inflation-adjusted real house prices remained virtually unchanged. ”
The Washington Post analyzed Schiller’s data in 2014 and reported that a century earlier, house prices had only risen 0.3% per annum, adjusted for inflation. On the other hand, the S&P 500 had an annualized return of 6.5%. This is an awful big difference.
While this single real estate asset can help protect you from inflation, a well-balanced portfolio of stocks and bonds seems like the best investment. But many people’s portfolios are mostly home value. You wouldn’t have invested 80 percent of your portfolio in bonds just to guard against inflation (if you weren’t getting close to retirement), so why would your house be the same amount? This is an argument against buying a home as an investment.
You may still be able to calculate the housing market on time and sell at a higher price than Schiller’s data suggests. But most experts agree: while housing is an investment, it is not a good investment. So if this is your only basis for buying a home, it probably isn’t the best one.
Decide how much you can afford
When deciding whether you can afford a purchase, the first step is to figure out how much home you can buy.
One rule of thumb for determining this number is that the value of your home should not be more than 2.5 times your salary . Of course, this gives you a rough figure. This does not take into account your net worth or your other financial goals.
Once you know the number you are working with, you have a better understanding of whether buying a home is a smart financial move for you.
Estimate the alternative cost of renting and buying
While your home may not be the best investment, in the end it is still yours . Even if it barely trumps inflation as an investment, after all, it belongs to you, and it costs something.
When you rent, you don’t own anything – the money goes to someone else. Therefore, many people argue that you should buy a house because one day you will pay it and it will be yours instead of continuing to pay rent for the rest of your life.
This argument is about opportunity cost : the value of an option you give up in order to choose something else. If you decide to rent, you are missing out on the opportunity to own the asset. Who cares if it doesn’t outstrip inflation? You have an asset – a house that you can show for all your money.
But not everything is so simple. You should also consider the alternative purchase price. There is a down payment. Closing costs . Payment of mortgage interest. What are the opportunity costs of doing this? How much could you earn by investing this money in the market?
Sometimes, over time, you can make more money by renting and investing than by buying. But whether this is so depends on several factors:
- Rent cost : If your rent is cheaper than a mortgage for similar housing in your area, you can invest the difference and get higher long-term returns.
- Down payment and mortgage interest rate : It’s the same story here. If you invested $ 50,000 instead of using it as a down payment and invested the amount paid as interest over time, how much more would you have in the long run? In some cases, you will have more than the value of your home.
- Where do you live : The housing market is influenced by many factors and changes, but where you live matters a lot. Your rental and housing prices can be very different from the national average.
The New York Times has a helpful interactive calculator that takes this all into account. Enter all of your details – home price, interest rate, home growth rate, closing costs, rental costs, and more – and you’ll get a detailed understanding of what the costs and opportunity costs are.
Most rental and purchase calculators simply tell you how much you will save based on your home estimate and your down payment, interest, and monthly payments. But this calculator takes opportunity cost into account in the equation, and that makes all the difference.
Consider your total net worth
Many experts say that your home should be no more than 20-40% of your total net worth. Over time, you will ideally invest less in real estate as your portfolio grows, but this percentage will rise again as you get closer to retirement. These are general guidelines and will depend on other factors such as age and risk level.
As we said, the bottom line is this: your home shouldn’t be your main asset. You don’t have to give up all of your savings, especially retirement savings, just to become a homeowner.
If that sounds unwise, you should at least maintain a healthy emergency fund before buying a home. You must also prepare savings for other expenses that will inevitably arise – maintenance, decorations, improvements, and so on.
Avoid being a “poor home”
We talked about following the 20% rule . This is a very general rule of thumb that you should not buy a home until you can afford a 20% down payment. Here’s an example of following the rule:
- You don’t have to pay for private mortgage insurance
- You do less so your mortgage payments are lower
- You will usually pay a lower interest rate (or at least pay less interest in the long run because you will have a smaller loan)
- This ensures that you can truly afford the home.
But some argue that this rule is overkill, and 20% is too much to spend on a home. Arguments against the rule:
- In some areas, houses are so expensive that no one can afford to pay that much.
- It makes sense to invest less money and invest the difference.
- This is too much of your fortune to give up right away. You don’t want to be poor at home.
Twenty percent less or less, the fear that you are “poor” is justified . You don’t want all of your net worth tied to your home, and that’s essentially what it means to be poor at home – when you can’t afford to make ends meet because you’ve spent everything on a home.
On the first and last point, one might argue that you should just keep renting and save until you can afford to shell out 20 percent (and still be able to pay your monthly expenses with ease).
Obviously, after the down payment, you should have enough money to cover your mortgage and monthly expenses. But besides making ends meet, you also want to be financially secure. This is why it is so important to consider your net worth.
And as we said earlier: you don’t need to buy a house. Don’t give up on financial fundamentals and buy a home for emotional reasons or because it is expected of you .
Whichever guideline you use to decide whether you can afford a home or not, the conclusion remains the same. It’s usually better to shoot than live in the poor. The risk of living from hand to mouth is not worth it.
Of course, apart from monetary factors, you also need to consider your long-term goals. If there is a good chance that you will sell the house in five years, then it will probably be cheaper to rent (any rent versus purchase calculator will likely tell you the same thing). Maybe you will move to work. Maybe you want a bigger house for your family. Your personal milestones should play a role in your decision.
At the end of the day, buying a home is a personal choice that you will have to weigh based on your own circumstances. The decision to own a home is not inherently smart or stupid – it depends a lot on individual factors and your financial situation. But weighing those considerations should at least point you in the right direction.
This post was originally published in 2015 and was updated on June 30, 2020 by Lisa Rowan. Updates include the following: revised accuracy links, updated formatting to reflect the current style, revised feature image, revised article to merge and update some content.