Real Estate 014: To buy or rent, that is the question
/For people who are looking to move, there is always the question that one asks themselves, “is it better to buy or rent?”. At the time of this writing, the US real estate market has seen close to 8-9 years of solid year over year appreciation. While no one has a crystal ball, history tells us that the real estate market goes up and down through different cycles that last as short as 6-7 years to as long as 10-12 years. Whether you are single, newlywed, or have a growing family, the decision to buy or rent can have multiple trickle effects to your financial situation and future trajectory. It is a very important decision. Many people see their friends buying their homes, market going up, and wonder if they need to buy now as well. Let's take a look at some of the pros and cons of buying a house vs renting as well as other factors to consider before making this decision.
Before you even jump into the idea of looking for a house to purchase or contacting a realtor for showings, you need to have your finances in order. This can include reviewing your credit score through your annual free checkup via the three major credit bureaus (Transunion, Equifax, Experian) or you can sign up for free services such as CreditKarma.com (I personally use this and love the ability to check my score through a “soft inquiry” that doesn’t negatively impact your score. ALthough the credit score you see on Credit Karma may end up being lower than what your mortgage lender actually sees when they pull your FICO score, in my experience, it has been very close (+/- 5 to 10 points).
Although its widely accepted that owning your own home is part of the “American Dream”, there are alot of things that come along with owning your home. You have to ask yourself if you are ready to handle the extra costs and maintenance that comes with owning a home. Furthermore, look at other areas of your finances to determine if you can withstand any sudden life changes (e.g. new baby, loss of job, job relocation):
Do you have an emergency savings account with roughly six months of expenses?
Do you have any large student loans or credit card debt that may have variable interest?
Do you have down payment + closing costs saved for your new home?
Will your new mortgage be under 30% of your debt to income ratio? (DTI) - Lenders look at this as a metric to determine if the borrower’s capacity to repay the loan.
Does your job require you to move frequently? (e.g. state to state or military)
If you have answered “yes” to any of the above, there is a good chance you may need to wait a little longer before you decide to purchase and think hard about this move.
Assuming you have decided that renting is out of the question and you are ready to buy, let's consider some of the pros and cons of buying a house.
Advantages
1. Building Equity
By purchasing a house with “other people’s money” (e.g. bank or private lender), you are able to lock in a payment (typically fannie mae 30 year fixed rate mortgages) where you build equity as long as you are current on your loan. As the loan is being amortized over 30 years, the first 12-18 years will mostly be interest payments, however, you still will increase share of ownership compared to a lease situation. Furthermore, as your payments are fixed (unless you have variable interest mortgage), you are not impacted if your landlord wants to raise rents 5-10% each year over the next 10 years, or are you impacted if the landlord decides to sell and not renew your lease, in which case you are forced to move.
2. Tax Benefits
The US tax code allows us to deduct interest associated with your home’s mortgage as well as property taxes. Note: There may be other tax favorable treatments, but please consult your CPA to determine what fits your unique situation. Further, starting 2019 tax year, the standard deduction has increased to $12,000, meaning your the break even point on standard deductions vs itemized (tax benefits mentioned above) has gone higher. You need to evaluate the price point of the home, as well as possible tax advantage amounts before assuming one is more beneficial than the other
3. Appreciation
Generally speaking, US real estate has appreciated over a long period of time. However, there also have been multiple down turns that have had negative consequences to homeowners who wanted to sell. I personally consider appreciation to be icing on the cake, as speculation can be a very dangerous gamble from an investment standpoint.
4. Pride of ownership
As a homeowner, you have the freedom to do make updates to your home as you please (within laws/regulations, HOA guidelines, etc.). This means that there is no landlord to stop you from using nails to hang picture frames, paint the baby room purple, or have a vegetable garden in the back lawn. Furthermore, some view a home as a long-term situation compared to leasing, as such you may psychologically feel more attached to your house, neighborhood, and feel grounded.
5. Using Leverage (Bonus - Investor’s Perspective)
This last advantage has been mentioned less by potential buyers evaluating decisions as most new homebuyers do not think like an investor. However, as an investor myself, I like to purchase my primary residence as I know there are a couple different ways to make money.
In my neighborhood, I was renting a 2 bedroom apartment for close to $1,800 a month. However, after 1 year, I decided to purchase a 3 bedroom townhome which resulted in monthly expenses of $2,700 a month. When normalizing the tax benefits I would receive on this property, I was able to credit about $300 a month to the “buy” side ($2,700 - $300), making it a $1,800 vs $2,400 decision, with the difference being $600. I ended up renting out one of the bedrooms for $750 a month which actually made my decision to buy $150 cheaper per month. Furthermore, the price of the home increased $70,000 over two years when I received an appraisal for a HELOC (home equity line of credit). Using this HELOC, I purchased two additional rental properties that cash flowed $700 a month after all expenses - $200 HELOC payments = $500 additional cash flow, which further brought my “buy” side down to -$650/month. Looking back, this was a no brainer for me, and I would gladly make these decisions again as I am creating equity in my primary home and two rental properties, have tons of tax benefits, reduced my cost of living, and did this all using other people’s money. Note: Not all home purchases can result in my experience, in fact, if you buy too much of a house in coastal markets of LA, NY, SF, etc. then you will probably lose money most of the time vs leasing. However, if you buy slightly undervalued properties at the right time (historical low interest rates 2012-2015), then you have a good chance of success.
Disadvantages
1. Lack of Flexibility
Due to the costs associated with buying, maintaining, and selling a home, there are fixed costs that require you to wait, or season, before you will break even. For example, if you have purchased a home and 6 months down the road you need to sell, unless the home has appreciated 10% or more, closing costs (transactional + commissions, etc.) alone may put you in the red. If you are not sure that you will be staying in a certain location or job for 2 or more years, it may be best to rent until further notice.
2. Dealing with maintenance
As a renter, when there is a leaky pipe, or broken toilet, you call your landlord. Unless there was excessive damages caused by you, the landlord is responsible for wear and tear, as well as general upkeep of the home with due notice. Once you become a homeowner, that switch is flipped and you are responsible both financially and mentally dealing with the stress of the repair.
3. Opportunity Cost
The difference in total cost of owning a home - leasing = financial opportunity cost. You may be better off using the difference to invest in the stock market, real estate, or other self improvement to get you that promotion or new job with better pay and benefits. Also, there are intangibles such as being able to easily relocate to other market, from LA → SF to work for a startup tech company or move from NY → Thailand to drastically lower your cost of living, be with family, or live a lifestyle by design. A mortgage will most likely be the biggest expense in your personal finances, so make sure that it doesn't become your golden handcuffs.
In conclusion, be sure you have adequately planned for any unforeseen expenses that come with home ownership - foreclosure can be a painful and detrimental to your financial health for many years. Furthermore, if you have big life changes ahead of you (e.g. marriage, new job, new child), remember to factor in how each of those events may change you stance in wanting to root yourself in a new home.
As always, please make sure you do your due diligence and talk to your CPA/Attorney/Financial Adviser before making any investment decision.
Good luck!
