Jane Barratt discusses the benefits and disadvantages of buying and renting a home. She explores how to compare the purchase price and rental price of comparable homes. And she also covers the importance of calculating the opportunity cost when buying a home.
- For most people, their home is the single biggest expense and, sometimes, their only investment. Owning your own home is a symbol of security and a big commitment. So there's a lot of emotion that goes into that decision. But is buying a home the right thing to do? Or is renting a home a better option? There's some math that you can do to help you take the emotion out of the decision to buy versus rent. First, in order to do a fair comparison, you have to be able to compare the purchase price and the rental price of a comparable home. If you know the size and location of the home you want, find comparable homes on a site like zillow.com.
For a quick comparison, you can turn to something called a price to rent ratio. This is a super simple way of comparing rental and purchase prices. Take the purchase price of a house and divide it by the annual rent you would pay for the same house. If you get a number above 21, it generally means that it's cheaper to rent than buy. Let's say you find a house for sale for $350,000 and a comparable one for rent for $2,000 a month. The price to rent ratio is 14. So, it's a better deal to buy than rent.
But, if we look at an expensive market, like San Francisco, with a purchase price of $1.2 million to buy or $4,000 a month to rent, the ratio is 25. So, it's cheaper to rent than buy. But life is never as straightforward as that. There's a lot of things that can impact this calculation. So, let's look at them. First of all, there's the interest rate on your mortgage. Your interest rate is the single largest expense associated with the mortgage. And the longer the term of your mortgage, the more that you'll pay in interest. Even with rates near historic lows, interest rates still have a significant impact on the cost of home ownership.
But there are other costs associated with owning a home. When you buy, there's closing costs and extras, like mortgage insurance. Then, when you own your home, there's maintenance fees, insurance, property taxes, and other fees, like condo fees. And, when you sell, you'll also have to pay costs, like broker fees and capital gains taxes. And, if this wasn't enough, you'll also have to calculate something called opportunity cost. If you drop $20,000 on a down payment for a home, you have to give up the gains you may have received had you invested that money instead.
That opportunity cost should be added into the cost of owning a home. And, historically, if you invested that money in the stock market, it would return about 5% per year. I'm making home ownership sound very expensive, aren't I? So, are there any financial benefits that home owners get over renters? Yes, but only in some countries. In the US, in particular, there's a tax deduction that you can claim for the interest you pay on your mortgage. So, you can lower your taxes when you have a mortgage. So, how does this all add up? Check out one of these great buy versus rent calculators at Trulia, Realtor, or the New York Times.
When you go to these sites, you'll find one more variable that effects this calculation. I've left this till last because I think it's the hardest to predict. The length of time you stay in your home. Essentially, the longer you stay in your house, the more economical it is to buy. Because we can't see into the future, we can't say what our property will be worth when we sell it. Nor will we know what our rent will be in the future. Remember that making big decisions like renting or buying also needs to take into account quality of life factors.
And, with those, there is no right answer. But look at all the variables in front of you so you can make as informed a decision as possible.