To Rent Or To Buy? The Financial Issues

When making the decision to rent or buy a place to live, there are two broad categories of factors to be considered. The first and most obvious category represents the financial aspects of your decision. The second category is a set of personal and emotional factors, which are more intangible yet play an important role in the decision to rent or buy. Let us look at the financial factors – namely, the initial and ongoing costs, as well as the long-term pros and cons – of owning your home.

Examining Your Finances

The first step in the decision-making process is to determine whether you can afford to purchase a home. Issues to consider include your ability to make a down payment (generally between 5% and 20% of the home's purchase price) and pay closing costs (which may come to an additional 5%). These costs are likely to substantially exceed the initial payment and security deposit that would be required if you were renting instead of buying. Of course, having enough money to cover the initial purchase of a new home is only half the battle. 

Before moving into your new home, you'll need to put some thought into how much it's going to cost you to stay in it after you take up residence. Many financial experts suggest that your monthly mortgage payment not exceed 28% of your gross monthly income, and that your total monthly debt payments not exceed 36% of your gross monthly income. If you go beyond these limits, you may run into trouble because, in addition to paying the mortgage each month, you would have to factor in home maintenance. From carpet to window coverings, new appliances to a new roof, everything costs money and nothing lasts forever. Renting may be a little easier on the pocketbook because it provides a fixed-dollar cost for monthly expenditures, which are paid along with the rent. Besides perhaps increasing from year to year, the rent remains steady; if maintenance issues arise, the landlord pays for the repairs. Instead of spending your money on a new roof, you can invest it or spend it as you like.

If you've done the math, can afford to make the initial purchase and service the ongoing debt, the next factor you have to decide on is whether this purchase benefits you financially. A rent-controlled apartment in New York City, or a place in a suburban location outside of a major city, quite possibly charges a month's rent that is significantly less than a monthly mortgage payment for properties within the city. Of course, even if the monthly cost of renting is less than the cost of buying, there are long-term financial considerations that must be taken into account.

Long-Term Cost/Benefit Analysis

Proponents of buying often cite the ability to build equity, the tax breaks, and the investment value of a home as solid reasons to buy instead of rent. While these arguments have merit, there are downsides to all of them. This chart outlines the positive and negative long-term realities of the equity, tax breaks, and investment value associated with buying a home.

  Pros Cons
Equity Some of the money you give to pay the mortgage goes directly toward building equity in your home. You will never again see any of the rent money that you pay. Home equity can serve as collateral for a loan, enabling you to convert the equity into cash. Equity takes time to build, and payments made during the first few years of a mortgage go primarily toward interest on the loan. Should you move after living in a home for only a few years, you may have little or no equity in the property. After paying the costs of selling the home, you could end up losing money.
Tax Breaks Unlike money spent on rent, the mortgage interest and property taxes you pay are both deductible on your federal income-tax return. If you sell your primary residence at a profit, much of your gain is likely to be exempt from federal taxes. If you take out a home-equity loan, some or all of the interest on the loan may be deductible on your federal income tax return. First, the tax breaks on interest and property taxes apply only when the amount of your itemized deductions is greater than the standard deduction amount. Thus, you and your spouse have a standard deduction of $9,700 and itemized deductions of $8,000. You are better off taking the standard deduction because it's greater than the itemized amount, but you therefore receive no tax break on the mortgage interest you paid. Even when itemization provides a greater tax break than the standard deduction, you are allowed to deduct only a portion of your interest payments. For example, if you are in the 33% tax bracket, you get a $0.33 tax deduction for every $1.00 you pay in interest on your mortgage. While some tax break is better than none, you need to ask yourself if it really makes sense to spend $1 in order to get a $0.33 tax break. The benefit of the tax break does not exceed the benefit of paying for the home in cash (if possible) and forgoing the tax break. Every dollar spent on the interest adds to the amount over the purchase price of your home that you will need to reach just to break even when you sell it. Owning a home means having to pay real-estate taxes annually. Thus, even after your mortgage is paid off, you'll still have to keep making payments to someone to keep it.
Investment Real estate in the form of your primary residence is likely the single largest asset in your portfolio. Over the long term, price appreciation can be significant. Many homeowners downsize their primary residence when they retire; they sell at a profit, purchase a less expensive home, and use the profits to supplement their income. While history shows that your home will  likely appreciate over time, there are no guarantees of this. There are always areas of the country in which homes have lost value, with owners unable to sell them for an amount equal to or greater than the purchase price.

Do the Calculations

A variety of online calculators are available to help you evaluate the financial aspects of the rent-vs.-buy decision, but keep in mind that you need to estimate a range of variables, including the number of years you will stay in the home. (Check out this Monthly Mortgage Payments calculator here.)

To estimate the investment profit the home will provide for you, you must assume the yearly rate of appreciation on the home's value. The results provided by a calculator, as well as the investment evaluations you make, are only as good as the assumptions used to calculate them, and don't forget to consider the cost of ongoing maintenance. After you have carefully considered the financial issues, it's time to explore the non-financial issues. In part two, To Rent or Buy? There's More to It Than Money, find out about a host of other factors you will need to take into consideration.

To learn more about the home costs, see Mortgages: How Much Can You Afford? and The Home-Equity Loan: What It Is And How It Works.