Whether you want to buy or rent you need to determine how much of your money you want to spend on housing. The more money spent on housing will subtract from retirement savings, food, travel, entertainment, and more. There is no correct budget that is right for everyone. You must determine your priorities when making the budget. Once you have an ideal amount to spend on housing you are halfway there.
Why total house payment can exceed rent, but still be Cheaper
Now if you decide to buy a house the total mortgage payment plus property taxes, insurance, and maintenance can actually be higher than than comparable rentals. This is because if the home is lived in long enough and the majority of it has been paid off, then you now have an asset that can be sold to offset the higher amount spent while living there. Conversely, If you were to rent you could invest the money you saved each month with the lower rental rate by not buying. So in the end if you buy a house you get some home equity, if you rent you have larger investment assets.
Before you buy a house, understand that if you sacrifice other investments completely that you are non diversified. Having all or the majority of your wealth in a home can work out just fine under ideal conditions, but if housing lags stocks and bonds in the future, it could turn out to be an unwise decision financially.
Therefore, beyond just making a budget for how much you can afford to spend on housing it is important to consider how many you would like to contribute to retirement savings.
Homes are the least liquid Asset
Further it is important to understand money in a house you live in is very illiquid. Stocks can be sold in minutes logging into your computer or even a cell phone. To sell a home, you must list it for sale, find a willing buyer, and pass escrow to collect your money. As long as you are able to live in the home for a long time, and have an emergency fund plus some diversified investments, then you are better insulated from loss, should you need to sell the house and move for any reason.
How to compare monthly rent to the purchase price of a Home
The New York times has a wonderful calculator to compare rental rates to home prices. You still have to give estimates for many unpredictable factors moving forward, but at least it takes into account opportunity cost in buying vs renting. Earlier I mentioned that it is possible to have a higher payment on a home you own vs rent and still come out ahead. Using the calculator can help you determine what these levels are. It will show what an equivalent monthly rental rate would equate to in terms of total purchase price of a home.
So buying a home at the right time, or accepting one with less features can actually save you money over renting long term. The problem is most of us do not know how much we really should spend, and find it all too easy to go well beyond our budgets. By setting a budget including healthy retirement savings and using the calculator you can determine an appropriate price to pay for a home.
Mortgage vs Cash and then Rent
Even if we can sort out if it is better to rent or own, we still have a second choices as outlined above. There are strong opinions about whether you should buy a home with a mortgage or cash, so I think it comes down to what is right for you.
Let’s compare the benefits of these choices. I did not list the mortgage interest dedication, because for the majority of people the standard deduction is higher anyways.
- If it is a non-recourse loan you have some protection in the event of a natural disaster destroying the home or choosing to walk away if the home goes down in value. In the stock market we can think of this as owning a put option. The morality of this move would have to be taken into account by each individual.
- Helps stay diversified by only putting a small portion of total net worth into the home, and can possibly make more money in other investments.
- Significantly reduces living costs. More money to invest each moth elsewhere not having to pay rent.
- Essentially earn the money saved on the interest rate. For instance if mortgage rates are 4%, by paying cash you are saving yourself from spending 4% of the purchase price for 30 years on a traditional length loan. This money can be looked at as tax free earning and is a higher rate of return than US Treasuries.
- Feeling of security that the home is paid for.
- Can move relatively easily and cheaply
- Will not lose money if the building is destroyed in a disaster
- Ability to rent the size and location needed at the time in your life to save money, but can still move to something else when goals and desires change. Essentially assured that you are only paying for what your current needs are.