One of the most common questions I hear people asking about when it comes to housing is the decision to buy or to rent. Given the size of the monthly expense and potentially large down payment, it is probably a fair question. However, I find that many people don’t apply the proper analysis in making the decision. It is not always a question of dollars and cents. You need to understand what home ownership means and if it is a good fit for you and your lifestyle. I just recently made this decision and learned some valuable lessons from it. Now, I want to share my learnings with you.
Considerations when deciding buy vs. rent (in order of importance):
Flexibility (or lack there of) – If you rent, the world is your oyster and you can live anywhere you can afford to. When you buy, not so much. The housing market is liquid enough that you can sell your house quickly if the price is good enough. Otherwise, you could be waiting a long time to sell your house and recoup your closing/selling costs. I think this is the most important thing to consider when buying a home. Do you love the area and the house enough to be in it for at least 5 years? If you don’t, you probably shouldn’t be buying.
Market Analysis – If you answered yes to the first question, then you need to perform some market analysis in your area on home prices and monthly rents for your target properties in your area to decide the next step. You need to make sure your monthly payments on your house including utilities, taxes, HOAs, and insurance. You might even include the opportunity cost of the down payment if you had planned to invest the down payment money otherwise. I would compare this figure to the monthly rents including utilities. If rent is less than house payment, then you rent. If rent is higher than house payment, it isn’t always a given that you buy. I personally would want my savings over my projected time horizon of living at the house to be substantial. For example, saving $50 a month over 5 years is $3,000. I’m not sure that is worth all of the potential risk you have being a homeowner because things do go wrong.
Property Analysis – Assuming you can commit to buying a house and the rental market makes it a rational financial decision then you need to find a property to purchase. This is the most difficult step especially if you or whoever you are buying the property with doesn’t view it as a financial decision and attaches more emotion to it. I know you have to live there, but I’m not sure heated bathroom floors and custom closets are worth overpaying for. I would only consider overpaying for a house if I planned on being in the house forever and even then I would be hesitant. Forever is a looong time! Try to purchase a property at or below market value in a desirable location. It is not always easy, but it can be done if you are patient enough.
I recently just sold my first home and will be looking to purchase another one in the next year. Let’s look at how I did in my first purchase to see if I followed my own advice.
Requirement 1: Can you commit to being in a home for at least 5 years? We checked the box on this first requirement. My wife and I had good jobs with no plans of changing them and no plans for expanding the family. Bottom line is that we planned to be there for 5 years and couldn’t see any reason for that to change. Spoiler alert: We sold after 2 years…whoops!
Requirement 2: Does the rental market make buying a smart decision? I also think I scored a passing grade on this item as well. The rental market was commanding $1,600+ in rent and we were able to purchase similar properties under $230,000. With interest rates being favorable, it amounted to a payment of around $1,300.
Requirement 3: Can you find a property you like at or below market value? We were fortunate enough to be in a buyer’s market when searching for a home and purchased a home for $205,000 that appraised for $215,000. Seeing the appraisal being above the purchase price means I completed requirement 3.
In the end, we came out ahead in the buy vs rent scenario by almost $500 or $600 a month when you include what we made from selling the house. I believe our success was mostly due to following these principles and maybe a little bit of luck. I know they are very simple in nature even though there are so many factors to weigh in deciding whether to rent or buy. On the flip side though, I do think they provide a useful framework for making a practical decision when people sometimes act irrationally when it comes to home ownership (see 2007 financial crisis).
What do you think? Are there any big misses in my guidelines? Do you perform a similar analysis when deciding whether to buy or rent?
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Rent is money that gets paid every month, never to be seen again.
A house will appreciate in value over time. There’s only a finite amount of land available. The key is location, location, location.
True that rent is never seen again, but if your circumstances do not allow you to stay in a home for long period of time then it is the way to go. I agree with location and I think this was the key that allowed me to sell my home so quickly. It is in a trendy location and the market was heating up.
Paying retail for homes is a suckers bet. If you get your own contractor’s license, and act as the general contractor, you can typically save 15-30%. Being the general contractor doesn’t mean you pound nails. It means you coordinate other contractors. And if saving 15-30% isn’t enough incentive to take a contractor license exam prep course and learn the basics of home building, then just rent. Or be a sucker.
And you need to realize that demographics are against you seeing much appreciation over the long term. Forget thinking your home will only increase in value as previous generations enjoyed. That only happens when there’s a growing population trend. With birthrate at replacement levels only due to relatively high immigration (which seems unlikely to continue considering the growing anti-immigrant sentiment in the US), coupled with Baby Boomers selling and moving into smaller homes or retirement communities, there is likely to be excess supply of large single family homes, which means stagnant or declining home prices. So I’d think long and hard before buying a home thinking it is some sort of forced savings/investment.
Yes, I agree completely on paying retail. I don’t have any experience with being a general contractor, but saving 15-30% sounds pretty good to me! Is this what you did with your current home?
I also agree with your market analysis though I think it applies more generally (macro). I would assume areas with a strong job market would continue to appreciate. For instance, I am in VA and we didn’t appreciate as much in the run-up but also didn’t fall as much during the downturn. I would say we are at or above pre-recession levels and I think it is due to strong business being in the area.
Good solid write up but one thing you mentioned had me shaking my head:
“Try to purchase a property at or below market value in a desirable location. It is not always easy, but it can be done if you are patient enough.”
This really isn’t possible. I know different parts of the country have widely different markets but if the area is desirable, you are not going to get it for less then market value unless; 1. You are an all cash buyer and time stops so all other buyers somehow don’t come to the table with an offer as well. 2. Well there is no #2
For example, we have been looking to sell our house in Phoenix, AZ. We are projecting to walk away (after fees) with about $100-$125K after being in the home 4 years. We plan on downsizing our house (since we decided we didn’t need 1700+ square feet) and trying to get into a house that is smaller and/or we can split (for a rental situation) in Portland, OR. Now even though we are downsizing to be in a similar “desirable” area in Portland (similar to desirability of our Phoenix hood) we are actually looking to pay more, lots more then what we will sell our house for – right in the 400-450K range. Houses we have looked at that are not even “the house” are going pending in a day, with multiple offers (one house has 24 offers on it in 2 days) and for way over list price. To me this is the “market value”, people are willing to pay this so right now this is what the house is worth.
Now tell me what type of circumstances would allow me to get into a desirable area for less then market value? You are either going to be buying someone else’s problems which no one else want to fix or you really aren’t going to be in a desirable area (unless you are the only one that finds it desirable and in that case you are going to have trouble selling it down the road unless it becomes much more desirable).
We aren’t ok spending these absurd amounts of money or getting into bidding wars but the one thing I will say is that even though things may cool off, unless you are in a bubble. If you buy a solid house, in a solid neighborhood (that LOTS of other people want) it’s safe to say you won’t have much problem selling it down the road unless something drastic happens (your neighborhood basically takes a nose dive, crime, etc). Most of these type of places will just continue to be popular and desirable.
Take that with a grain of salt based on your location and circumstances. I guess that hardest part to figure out is if you are actually buying in a bubble or not.
Thanks for the comments. I agree that there are situations like yours where it is difficult to find houses for what you think is a market price. My advice was more general and the point was that don’t get caught overpaying for something as large as a house. It puts you in a really bad position.
If I were in your situation, I would consider throwing my down payment into TIPS or some low risk investment and renting for a year to see what the market does especially if you think people are overpaying right now. Are you looking at only MLS properties or FSBO? Have you considered working with a wholesaler/investor to purchase a property? I would love to hear what you end up doing in your current situation. Good luck!