Rent vs Buy
The “American Dream” has been defined in a myriad of ways, but one of the more common elements revolves around the concept of home ownership. We’ll try to distill the question of whether to buy or rent, down into a handful of key factors and while we realize that everyone’s circumstances are a bit unique, there are some important elements that apply to anyone making this decision. It is also worth looking at the current market through a historical context, so we have added some additional detail below. We acknowledge for many given the affordability challenges that exist today there may be no choice but to rent for now, but that may very well turn out to be a blessing versus a curse with home affordability at historically low levels.
For someone that spent much of his adult life renting, I can say that decision worked well in that I avoided buying in during the housing boom that would turn into an epic bust at the turn of the century. Had I followed the conventional wisdom at the time, I would have drastically overpaid for a place that I would have resented a few years later. In addition to avoiding that calamity, the excess savings each month allowed me to set aside funds, much of which found its way into the market which has not been a bad thing for the last 15 years. It also meant that I could maintain a degree of flexibility with where I lived which had some qualitative positives. For those of you adamant that homeownership is the best path, all is not lost. The housing market has cycles and it stands to reason in the future there may be better times ahead. Patience is a virtue as they say…
Let’s dive in:
Key Considerations
- Duration in the home: The longer you remain in the home costs like inspections, appraisals and other closing related expenses end up amortizing, should you anticipate remaining in the home for longer than 5 years buying can make more sense
- Underwriting Standards:
- The amount of income dedicated to housing is 28%, this is the principal and interest payment, property taxes and homeowner’s insurance. With this formula if your income is $100,000 you can dedicate $28,000 or about $2,333 a month
- Amount of gross income dedicated to total debt payments equals 36%. Here you are incorporating student loans, auto loans or revolving lines of credit, like a credit card
- The 5% rule can help compare your options. If you multiply the value of the property by 5%, then divide that number by 12 if the amount is less than the equivalent rent on a similar property, then buying makes sense. For example, if you are considering buying a home for $750,000 then if your rent is greater than $3125, then buying makes sense.
- What is really going towards principal early on? For a 5% mortgage in year 1 about 22% of your payment goes to the principal, building your equity by year 10, the figure jumps to 35%, by year 20 it’s up to 57%.
Other Considerations
- Set aside funds: It’s important to be able to continue to save & invest, while covering your housing expenses, at bare minimum a younger investor should be able to contribute enough to capitalize on any employer matching contributions. Ideally, they are saving closer to 10% -15% of their gross income. Buying or renting a property that comprises your ability to do so will have significant long-term implications.
- Emergencies happen: It is important not to use your entire cash reserves for your down payment, make sure you have assets equal to 12 months worth of mortgage payments and property taxes should you need to use your savings to cover these expenses due to any unforeseen circumstances.
- Life insurance coverage: An often overlooked but incredibly important facet to your financial plan, it’s best to have a death benefit that would allow your spouse to retire any outstanding loan balance should you die before your big financial obligations are met.
- Early Principal Repayment: One extra payment equal to a monthly mortgage amount will be applied to the principal of the loan and will shorten the loan balance by 4.5 years, two extra payments would shave 8 years off the loan. This will not change the amount you pay each month but will mean you will pay less interest over the life of the loan.
- Recast: An often-overlooked strategy, a mortgage recast allows you to make a lump sum payment against the loan balance which will allow you to reduce your monthly payments for the remainder of the loan. This is far less expensive than refinancing and the reduced monthly outlay may help you with other cash flow needs or allow you to beef up savings.
There are a few other areas that can be folded into the analysis, like the deductibility of mortgage interest and using home equity for expenses like renovations or education, but we’ll hold off on the details there for now.
Why has buying a home become so difficult in the US? You can attribute this to two main issues, one scarcity, where housing stock has been undersupplied for the last 15+ years dating back to excesses of the subprime mortgage mess that led to the Great Financial Crisis and two, more recently the jump in mortgage rates. With rates at 3.00% for a handful of years, for every $100K borrowed the monthly principal and interest payment would be $421.60, with rates now close to 6.50% the payment has gone up to $632.06 a 50% increase. Other factors like NIMBYism have prevented further development, especially around efforts to build more affordable housing.
A bit of a history lesson… In the early part of the 20th Century many Americans were renters in large tenement buildings often housing families in a dwelling with one or two rooms. The Great Depression saw a 90% drop in new home production and by 1940, homeownership levels were the lowest in a century at 43.6%. Roosevelt’s New Deal ushered in a boom in public housing and better living conditions, yet cities remained congested, and the concept of upward mobility was somewhat limited. It would not be until after World War II with the enactment of the GI Bill ,which had a great emphasis on home ownership (and education) triggering the creation of tract homes like those in Levittown, NY. Low fixed rate mortgages with little to no down payment requirements coupled with demand for a yard and some peace and quiet resulted in a massive housing boom. The proliferation of affordable automobiles also meant freedom from public transportation and thus the modern version of the American Dream was born. To this very day this for many represents that slice of Americana.
For the next 40 years, the price trend for houses sloped gradually up and to the right almost like clockwork, with the growth rate a little north of inflation. But by the 1990s, there was a notable shift in the rate of change as the combination of a population boom (higher demand) and lower interest rates (improving affordability) drove prices materially above the inflation rate creating additional “real wealth,” through the growth in home equity.
To some extent, the seeds of the looming housing crisis had been planted and the aggressive policy response in the face of the bursting of the Tech Bubble and the tragic events of 9/11 meant Alan Greenspan felt compelled to take overnight rates down to 1% further pushing longer term rates lower with it. The rest is history.
The scars of the housing crisis remained fresh in the minds of builders and buyers alike for the better part of two decades and it had some interesting generational effects. Gen X has a home ownership rate of about 69%, nearly 10% lower than their parents the Baby Boomers or the last vestiges of the Silent Generation. Millennials while still “young” are presently running about 7-8% behind the baby boomer generation while slightly ahead of the Gen X crowd. It will be interesting to see how the next decade unfolds, surely an important decision with lasting financial consequences individually and for society as a whole. Recent headlines indicating home prices continue to rise does not mean the train is leaving the station, but that it may mean a few extra months with a roommate or perhaps worse, mom and dad, but there is no better sense of enjoyment than delayed gratification.