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Understanding the Rent vs. Buy Decision
Should I rent or buy? This is the all-important, life-changing question every potential homeowner will face. For our Rent vs. Buy Calculator, we evaluate the decision from a purely financial standpoint. We base the calculations on many assumptions, such as constant home value appreciation rates and constant rental fee increases rates in the future. We assume the user can afford to either buy or rent. We strive to give users the best results possible. However, because our calculator cannot precisely predict the future, the result is an estimate based on input values only. Also, this calculator is intended for use by U.S. residents only.
In the real world, numbers cannot reflect many intangible human elements involved in the Rent vs. Buy question, such as the value of homeownership or not having to deal with landlords. Sometimes, buyers want the ability to do things such as paint their walls a specific color or house ten cats without hearing complaints from landlords or neighbors. Conversely, renters might prefer the peace of mind that comes with a predictable monthly rent instead of paying a large upfront down payment and closing costs. Whether renting or buying, consumers need to factor personal preferences into this decision.
What to Expect When Buying a Home
Homeownership is a relatively new phenomenon in society. It did not become easily accessible to the average Joe until the mid-twentieth century. Before this time, homeownership was common only for the wealthy.
In the U.S. today, homeownership is as American as bald eagles and hot dogs. Moreover, the federal government offers tax incentives for owning a home, a strong reason not to rent. Furthermore, many believe that mortgages build equity. Considering these factors, one can easily see why buying seems to make more sense than renting, at least on the surface.
While a mortgage can technically build equity, it is not significant in most cases. Robert Shiller, a leading economist, conducted a study of home prices in the twentieth century. His study found that the average appreciation rate for home prices after adjusting for inflation came to only 0.2%. Moreover, after factoring in yearly maintenance, repairs, and annual property taxes, most homeowners will find that their home purchase investment merely breaks even.
However, home markets vary widely across different regions. A house in San Francisco will appreciate at a very different rate than a comparable home in Wyoming. Hence, the decision to buy may come down to intangible factors. For most people, primary homeownership is an investment in family, long-term stability, happiness, and shelter, not a speculative way to increase the dollar amount of their total assets.
Owning a home also includes some one-time transaction costs and recurring maintenance costs. The former mainly refers to the costs associated with buying and selling the house, such as the down payment, closing costs, and commission fees. After adding such expenses, the cost of buying and selling a house can be very high, often reaching 10% or more of the home's value.
Understanding PITI - The Four Pillars of Homeownership Costs
The recurring maintenance costs mainly refer to the four most significant costs associated with homeownership called PITI, an acronym standing for principal, interest, taxes, and insurance, charges typically in descending order by amount. PITI does not cover all costs, but this abbreviation represents the largest expenses.
P - Principal
The principal is the amount borrowed from the lender. It builds the highly sought-after equity of the home. It is part of the monthly mortgage payment and often represents the most sizable portion of the PITI. Also, it is the only part of the PITI that accumulates equity.
I - Interest
The second part of the monthly mortgage payment is the interest, which is the cost of borrowing the money, usually a percentage of the principal. Banks typically express it as an annual percentage rate or APR. Mortgage interest is tax-deductible, something homeowners should not forget during tax season!
T - Taxes
Property taxes are annual levies paid to the home's city, county, school district, or other ruling jurisdictions. Prospective buyers can find a ballpark figure for the annual property tax of any home by going to the website of the ruling jurisdiction's appraisal district. This information is usually public, and in most places, homeowners will pay between 1% and 3% of the home's value annually.
I - Insurance
Lenders typically require buyers to obtain homeowners insurance for disasters such as hurricanes and fires. In addition, traditional home loans with down payments of less than 20% will generally require private mortgage insurance (PMI), which protects lenders in case of a default. Some owners also purchase a homeowners' warranty, which can help with repair costs.
What to Know When Renting
Rent is the act of paying a landlord for the right of use on a residential property. The primary cost of renting a home is the monthly rental fee. Other costs include the security deposit, application fee, and possibly, insurance.
A rental home is typically considered a temporary residence. Its main advantage is the flexibility of negotiable lease terms, which generally range from a few months to a few years. Therefore, it makes sense for those with an uncertain future to rent instead of buy.
Notes regarding renting
- Negotiating the rent and terms of a lease can help lower monthly bills. Just like car buying, it does not hurt to poke and prod a bit to see if the landlord will budge on rental costs.
- Try to get everything in writing, including promises made by landlords or renter responsibilities. It is easy to take verbal agreements as is, but written agreements will be your friend when unexpected situations arise.
- Upon moving in, take pictures of the apartment to evaluate its condition. If the landlord tries to charge for damages to the property, the lessor holds proof of the property's pre-existing condition.
- By federal law, landlords may not refuse rent to anyone based on race, sex, religion, disability, national origin, or familial status. At the state or local level, laws against housing discrimination may also apply.
- For fixed leases, landlords may not raise rent prices on existing renters during the lease term.
Should I Consider Buying or Renting?
At least from a purely financial perspective, this decision comes down to two important questions:
Do I have enough savings to purchase a home?
Purchasing a home typically involves a considerable upfront price, including the down payment, closing costs, fees, and other expenses. Hence, the first step when deciding to buy a house is to see if one's available savings will cover the upfront costs. Please use our House Affordability Calculator to estimate the ability to cover these costs.
Will I live long enough in the home?
The time one intends to stay in the house is probably the most critical variable in determining whether to buy or rent, assuming a buyer can afford both. As a general rule of thumb, the longer the intended stay, the more it makes sense (financially) to buy. Otherwise, one should consider renting.
Typically, owning a house involves significant one-time buying or selling costs. Compared with renting a similar home, the recurring maintenance cost is lower than the monthly rental fee. If one stays in a house long enough, it justifies the massive buying and selling costs and makes the average total monthly cost of owning a home lower than renting.
Factors That Impact the Calculation
Major Factors
Average Investment Return (AIR)
This external opportunity cost is difficult to calculate accurately. This involves factors ranging from whether there's a downturn in the market to the home's location. Worldwide economic factors can also affect returns. Annual stock market returns generally exceed mortgage interest rates historically. The lost opportunity costs associated with building equity in an owned home are therefore evident.
Home Appreciation Rate
For most people, purchasing a home is the largest investment they'll ever make. Not surprisingly, the higher the estimated appreciation, the more sense it makes to buy. The most common way to estimate this is to research the most recent comparable sales within the same zip code. On average, home values appreciate by about 3-5% a year in the U.S.
Mortgage Interest Rate
Considering the size of a home purchase, one can expect the amount of money going towards interest to be relatively high, even in an environment of low mortgage rates. Borrowers can calculate this cost simply by inputting the interest rate listed on the mortgage papers from the lenders.
Minor Factors
Though not as crucial to the process as the variables above, borrowers need to determine the effects of additional factors to receive the most accurate results.
Buying Costs Include:
- • Property taxes
- • Homeowners' insurance
- • Maintenance
- • Repairs
- • Condo or HOA fees
- • Buying and selling costs
Renting Costs Include:
- • Application fee or upfront cost
- • Security deposit
- • Renter's insurance
- • Monthly rental fee
- • Rental increases over time
Advanced Financial Considerations
Market Volatility and Timing
Real estate markets experience cycles of appreciation and depreciation that can significantly impact the rent vs. buy decision. During market peaks, rental yields may be more attractive, while market downturns often create buying opportunities. Consider local market indicators such as inventory levels, days on market, and price-to-rent ratios when timing your decision.
Economic factors like employment growth, population trends, and infrastructure development in your area can influence long-term property values and rental demand. Research these fundamentals to make informed predictions about future costs.
Life Stage and Mobility Factors
Your current life stage significantly influences the rent vs. buy decision. Young professionals who may relocate for career opportunities benefit from rental flexibility, while families seeking stability often favor homeownership. Consider job security, relationship status, and family planning when evaluating your timeline.
Remote work trends have changed traditional location constraints, allowing more flexibility in housing choices. Evaluate whether your income sources are location-dependent and how this affects your long-term housing strategy.
Hidden Costs and Tax Benefits
Homeownership involves numerous hidden costs beyond mortgage payments, including special assessments, emergency repairs, and opportunity costs of down payment funds. However, tax benefits like mortgage interest deduction and property tax deduction can offset some expenses, particularly for higher-income earners in expensive markets.
Renters should factor in potential rental increases, moving costs, and security deposit requirements. Calculate the total cost of ownership including utilities, maintenance, and improvements versus comprehensive rental costs over time.
Investment Portfolio Diversification
Consider how homeownership fits into your overall investment strategy. Real estate typically represents a large portion of net worth for homeowners, potentially creating concentration risk. Renting while investing in diversified portfolios may provide better risk-adjusted returns and liquidity for some investors.
Evaluate the correlation between your local real estate market and your other investments. Geographic diversification through REITs or other real estate investments may provide exposure without the concentration risk of direct ownership.