Myth: It’s ALWAYS a better deal to buy a home rather than rent.
Fact: It depends on the prices of rent/homes in your area. Crunch the numbers and consider all the carrying costs of owning a home.
Consider this hypothetical example:
Sally, John, and the Condo
Sally pays $1,000 per month to rent a two-bedroom condo. Her neighbor John buys that condo for $200,000.
John plunked a 20 percent down payment, or $40,000. He borrowed the other $160,000 at a fixed-rate 5 percent interest for a 30-year loan. He doesn’t need to pay private mortgage insurance (PMI), because he put 20 percent down. His property taxes come to 1.25 percent.
This means John is paying $1,067 for the same two-bedroom condo. In other words, Sally and John are paying roughly equal amounts. This means that Sally is “throwing money away” while John is building equity – right?
Not necessarily.
Buying vs. Renting
John, as the owner, now needs to pay an HOA fee totaling $200 per month. Sally, as a renter, doesn’t need to pay this fee; her landlord takes care of it.
John’s HOA fee doesn’t “build equity” into his condo. It’s money that gets spent on things like cleaning the gutters, mowing the lawn, planting flowers, pruning trees, shoveling snow and insuring the exterior of the building.
(John’s friend Joe owns a single-family home and does not need to pay an HOA fee, but Joe pays those costs directly. Joe shells out plenty of money at the home-improvement store for things like a lawnmower, sprinker system, power-washer and security lights. Joe also hangs gutters and is saving up to replace his roof.)
John also needs to repair his appliances, pipes and wiring when something goes amiss. Sally can call the building supervisor when her refrigerator stops running, her pipes burst or her oven won’t turn on. John needs to service these problems himself or hire a technician. When his refrigerator breaks, he shells out $1,500 to buy a new one. When his gas stove stops working, he pays $400 for a new one.
Building Equity
Between the HOA fee and the cost of home repairs and maintenance, John shells out an average of $350 per month, or $4,200 per year, more than Sally.
How much equity does he build?
John and Sally both live in their condos for 5 years, before Sally ends her lease and John sells his unit. In that time, John pays an additional $21,000 more than Sally pays.
In that time, John’s mortgage payments primarily get applied to interest. Assuming the condo price stays the same, John holds less than $2,000 in equity above his down payment. He also loses 6 percent in buying/selling commissions and fees.
In other words, he lost at least $19,000.
But What If ...
If Sally and John both lived in their condos for 15 or 20 years, however, the tables turn. At that point, John’s mortgage payments become increasingly applied towards the principal balance, rather than the interest.
John also pays back the loan in cheaper dollars as inflation kicks in. John pays $1,000 per month in 2012 and he continues to pay $1,000 per month in 2032. But in the year 2032, $1,000 has less purchasing power.
Sally, on the other hand, sees her rent rise at the rate of inflation.
Furthermore, John loses 6 percent in buying and selling commissions and fees. If he holds the property for 15 to 20 years, there’s a stronger likelihood that his property will appreciate in value by at least 6 percent, which allows him to break even on those costs.
The Bottom Line
There’s no absolute truth governing whether it’s better to buy or rent. Your decision depends on factors such as:
- The length of time you expect to live in that location.
- The rent-to-purchase-price ratio in your neighborhood.
- The rate at which property is appreciating in value.
- The carrying costs of the home, including maintenance, taxes and insurance.
- The interest rate you can get on the mortgage.