The longest ongoing debate about where you live is if you should buy or rent. This is an important decision because it will likely be the biggest purchase of your life and not something to be rushed. That being said, there are reasons to consider one over the other and everyone should weigh all factors before making the decision to purchase.
Years ago, I posted a tongue-in-cheek flowchart to help you decide if you should buy or rent. While it was meant to be a little humorous, there were definitely some important points within it. This year I want to write out this detailed post so that anyone who comes across this can make a thought-out, educated decision about what to do for your individual living situation.
As mentioned above, there are many factors that will determine whether you should rent or buy. The saying goes you should be ready, willing and able. Personally, emotionally and financially is what the saying really means. Your personal situation in life refers to a steady job and desire to set up roots for a prolonged amount of time; your emotions should be in check, meaning you are excited, willing, and confident in a purchase; and your finances are sound, meaning you’re able to make the purchase with savings and a steady income for the foreseeable future.
I’ll break them down further in order to give you a clearer picture about which road you should take.
Are you personally ready for buying a home?
One of the biggest factors when deciding when to buy or rent is where you plan to be in the future or where you’d like to be. Part of the enjoyment of living in Chicago is residing in different neighborhoods until finding one you particularly enjoy more than the others.
Do you feel you want to move around within Chicago or even outside of Illinois? Is there a possibility you may move to a different part of the country for personal reasons or for work? You may want to continue renting. If you may have to move for work, sometimes your employer will help with the costs of selling a place, but that shouldn’t be something to rely on.
Even if you do decide to buy and want to move, you should keep open the possibility of renting out your place. The downturn in the housing market from 2007-2010 has made several homeowners unintentional landlords. Perhaps they don’t particularly want to be a landlord, but they may not want to sell if it means taking a loss on the property.
If you’re ok with being a landlord or even plan to be one, make sure your building allows rentals and be aware of what the cap is (percentage of allowable rented units versus owner-occupied) so that you can thoroughly prepare for the possibility of renting. Some buildings have a wait list to rent out a place and it could take several years to be able to rent yours out.
If you are looking to stay for the long haul, it’s a general rule of thumb to stay 3-5 years or longer. The longer you stay, the more the fees from buying and selling your place are spread out. There are transfer taxes, realtor fees, title fees, attorney fees, etc. that you will incur whenever you are buying or selling a home. By staying longer, these fees become less burdensome and allow more of a potential profit when you do sell.
When you’re searching for a place, you also want to make sure you are prepared for the long haul. Is your job stable and requiring you to stay in one place for awhile? Do you have plans to get married and have kids in the near future? What about that pet you’ve always wanted, is the potential list of places dog/cat friendly? It won’t make much sense to buy a 1 bedroom if you want to have kids in the next year or two. Maybe you should continue to rent for that time and save more for a down payment on a 2-3 bedroom.
Are you emotionally ready to make such a commitment?
For a large majority of the population, buying a home will be the largest financial decision to make in life. Just because you are personally ready based on your job situation and life position, does not mean you are emotionally ready to pull the trigger. You have to want to purchase a house because you know it’s the most financially smart move for you and you’re aware of the benefits and risks.
One of the big differences between renting and buying is the responsibilities that come with homeownership. Maintenance costs, insurance, utilities – these are all now your responsibility to take care of in your home. You no longer have a landlord to rely on to fix a water heater in the dead of winter. You should know how to handle most issues that may come up or at least have the number of a good handyman.
If you’re buying a condo, there are homeowners association fees that you must pay along with the other owners in the association that go towards common area fixes, building maintenance, trash removal, common insurance – as well as some bigger costs for high rises like elevator maintenance and doorman salaries. It’s your duty to contribute to the association and protect your investment.
Additionally, you are now responsible for taxes and insurance on your new home. Property taxes are a big consideration when factoring in the location you want to buy. Homeowners insurance protects you and your lender with the investment in the home. They’re rolled into your mortgage payment: the T and I in PITI (principal, interest, taxes, insurance). They’re put in an escrow account by your lender each month and paid for you when due.
It seems like there are many additional costs when considering buying versus renting. But keep in mind that when you’re renting, if your landlord did their due diligence, they probably have a good deal and have you covering all of their mortgage payment for them plus more.
For a vast majority of the country, when considering homes of similar quality, it is almost always better to buy than rent in the long run. Most people will upgrade when buying though (additional bedroom, better quality appliances, more square footage, etc.) and that accounts for the higher monthly cost for housing.
The last part of being emotionally ready to buy is understanding the risks involved and riding the waves of the market volatility. Over the long term, real estate prices have continually gone up, but as we saw in 2007-2010, there can be big losses in the short term. The housing crash of that time was due to a number of factors including predatory lending, 0% down financing and other suspicious activity. Fortunately stricter guidelines were enforced to help stabilize the market and it has bounced back nicely.
Hopefully we will not see something similar to that crash in our lifetime but it goes to show the importance of long term planning. Someone who bought right before the crash may be unlucky, but housing prices are coming back and in due time they won’t be underwater anymore. There are fluctuations in the market and it’s important to be emotionally ready to handle these swings. The market will stabilize under normal conditions.
Are you financially able to buy a home?
The last factor to consider when deciding to buy or rent is probably the most important – the financial aspect. You could be personally and emotionally ready to buy, but if you don’t have the cash, it is not a smart idea or even one that’s possible for you at this time. Many people want to realize the American dream of owning a home but for many it’s just not possible when looking at finances. Let’s delve into it more.
The first question to ask yourself is if you have enough savings to even buy a home. Plenty of people think they’re able to buy only to realize they only have enough for 3-5% down payment on a suitable house for themselves. While it’s possible to get financing with only a small percentage down (like FHA loans), it’s best to wait until you have at least 5-10%, with the best option being 20%+. This will give you a more competitive interest rate as well as the best chance of securing financing.
However, sometimes people believe because they have enough for a down payment they’re set. This is far from the truth. There are closing costs involved in every transaction ranging from transfer taxes to attorney fees to title fees and more. Generally you’ll want an extra 1-2% of the purchase price to cover these unless you can get the seller to give some closing credits. But it’s best to get a lower price on the home than negotiate in closing costs since a higher home price means paying more interest over the life of a loan.
But we’re not done there. After the down payment and closing costs, you still want to be able to show 6 months of an emergency fund or some sort of financial cushion to fall back on should the worst happen (job loss, injury, etc.). The lender will want to know you have a few months mortgage payments saved up in the event something unfortunate should occur.
As you can see, a substantial savings cushion is needed before purchasing a home. There are also things to consider like annual maintenance costs but I’ve covered that and we’re mainly concerned with the present financial situation to determine probability of securing a loan.
There are a couple of guidelines used by conventional lenders to determine if an applicant has adequate income for a loan: the housing expense ratio and the debt-to-income ratio (DTI).
The housing expense ratio, also called the front end ratio, is calculated by the monthly housing expense (principal, interest, taxes, insurance or PITI) divided by stable monthly income. This is income that is expected to remain stable for the foreseeable future. Lenders will want to see this number not surpassing 28% for a conventional loan and 31% for an FHA-insured loan.
So if my housing expense is expected to be $2,000/month and gross monthly income is $7,200 then my ratio equals $2,000/$7,200 or 27.8% which is acceptable.
The debt-to-income ratio, or the back end ratio, is total monthly debt obligations (including a mortgage) divided by the income, with different percentages as guidelines for lenders. For a conventional loan you’d want the ratio to be less than 36% and for an FHA-insured loan you’d want the ratio under 43%. For a veterans affairs (VA) loan the number is 41%.
If we take our previous example and add a $400 student loan debt payment to the total, we are looking at $2,400/month. Divided by our $7,200 take home pay we now are at 33.3% which is still under the ratio and therefore qualifies.
There are two other aspects to the financial side of deciding whether to buy or rent, but both should be determined on a case-by-case basis. These are the mortgage-interest tax deduction and the opportunities to invest elsewhere.
The mortgage-interest tax deduction is just what it says: a deduction on your taxes based on the amount of mortgage interest you pay. However it is very dependent on your individual situation. Are you married or single? What’s your tax bracket? Will itemizing your deductions be greater than the standard deduction? These are important questions that will determine if you get a break on taxes with your mortgage interest paid in addition to other items. It is best to consult your accountant on this matter.
Additionally, everyone has a different scenario in terms of their investment strategy and what they’re comfortable with in terms of risk. Perhaps someone was burned by a bad real estate deal in the past and prefers to keep their money in the stock market. Or they have a relative looking to start a business and want to invest in that instead. There are a plethora of other places to stick your extra money rather than your home and maybe you’d prefer an investment that’s more liquid. Either way, this is a person-by-person issue and again best to consult your accountant or financial advisor on what is best for your individual scenario.
Everyone knows that purchasing a home will be the largest decision financially in his or her life. It’s not something that should be rushed in to. It should make sense for your situation – personally, financially – and you need to be emotionally prepared for not only homeownership, but the process of buying a home. It can also be one of the most satisfying purchases you ever make as well. The responsibility and dedication that comes with saving up for a home and making the purchase is extremely rewarding.
If you’d like to talk more about renting versus buying, feel free to reach out to me anytime at 847.373.8114 or by email at email@example.com. I’m also active on Twitter and Instagram (@AndyHasdal) or Facebook if you’d like to connect there to keep me in mind for a decision down the road.
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