This question is probably the most common for people in their 20s and 30s. You’re making some serious bank at your job, but you hate to see all that money go down the drain, so should you buy a house or rent one?
First off, real estate is about location, location, location and so is the decision of renting or buying your house. In San Francisco, according to money.cnn.com , the price/rent ratio is about 30. That’s way to high to make owning a home ever make sense financially unless you want the benefits of being a homeowner vs a renter and want to speculate on the frothy tech scene located in that area. On the other end, you have Detroit at 7, if you wanted to buy a house there you could it just might not come with plumbing.
Another city that’s way too expensive to buy anything is NYC. The price/rent ratio is about as high as San Fran. Purchasing a NYC condo is like buying gold, the income you get from it is not going to be substantial compared to its purchase price, but it’s always going to be worth something, and that’s why the rich love to have real estate in the city.
Another way to look at home buying is how long you expect to remain in an area and what your personality is. I really like the flexibility of being able to find the best housing deals on craigslist and not deal with all the issues a homeowner has to handle (the list is too long for here, maybe another post). If you buy, the breakeven is around five years, which is a long time in a young person’s life. If your home goes down in value because the local job market slows down if you bought a typical house you’re stuck, or you can ruin your credit and walk away from the mortgage which millions of people did in the financial crisis.
So first off, if you’re in a big city with lots of young professionals and a strong job market, you should probably rent because the cost of owning is going to be very high and the yield you get on your investment likely won’t be that great. You’ll also be buying a high value asset on debt which could wreck your financial health. If you live in a really low cost of living area the math is going to suggest buying if you’ll be there at least five years. I’m going to reference this calculator from Zillow which says a 30 year mortgage with 20% down for a person with good credit would run about $800/month for a $150,000 home. I rented a house in college that was worth about that and the landlord got about $1400 a month from us. Clearly in that situation mathematically it would have been a fine idea to buy that house instead of renting it as the price to rent ratio was about 8.9. As a general rule, anything less than a 10 ratio is a decent buy if you will be in the area.
The reason for the five year breakeven is that real estate agents cost a lot of money. The average home goes up in value long term by the rate of inflation. Since inflation has averaged around 2% these last few years and a real estate commission is 6%, literally three years of your gains assuming the home goes up in value are eaten by the real estate agent. Another funky thing about buying a home is the amortization schedule, which is a fancy word for how fast your mortgage gets paid off. The way these are structures, the first several years of payments go to the interest and the final few years are where you’re paying off the balance. On that same $150,000 house, you only would have paid off about $12,000 of the original $120,000 loan after five years. Theoretically if the home went up in value you could net a profit, but after considering all the time and money you spent fixing things, the risk you took that the asset’s value could fall, and the various incidental expenses that come up in owning a house, if you’re young, single without kids, and location neutral (meaning you have no strong idea of what city you’ll be located in over the next five years) you should absolutely rent even if the math looks appealing.
Buying a home is something that you do for the intangible benefits rather than the bang to the bottom line. There’s too many factors like where you’ll want to live, how much time you want to put into it, risk that the asset declines in value, and more that make it a big hastle. If you live in an Atlanta, or Ocala, or Detroit I’d think about buying if you really wanted to stay there but if I was in NYC or San Fran I’d avoid it like the plague.
* If you are going to buy, to help achieve extreme early financial independence, I recommend keeping your home to no more than 2 times your income. If you have a spouse, maybe make it 3 times one of your incomes. Some real estate agents will show you homes in the upper end of what the bank will approve you for, which is typically 3.5 times household income, and you will be on the fast track to working until you’re 65. Break free from the mindset that you need a 3000 square foot house to be happy. It’s fine to own one if that’s a small percentage of your net worth and you enjoy entertaining or hosting people, but if you’re just starting out be conservative with what you buy and watch all the benefits roll in. You’ll have fewer things to fix, lower taxes, cheaper repair bills, smaller greenhouse gas emissions, and will spend less time doing things like mowing the yard and trimming the hedges. Millennials, rent a cheap room off craiglist unless your Price/Rent ratio is below 10 and you know you’ll be somewhere for 5 years, then buy buy buy.
** If you want an awesome rent vs buy calculator, the best one I know of is here from the NY Times.
HAPPY HOUSE HUNTING!