According to a recent Wall Street Journal Article, now is the worst time to buy a home instead of renting. Due to higher mortgage rates the average monthly mortgage payment nationwide is 52% higher than the average monthly rent. The last time this premium was anywhere near these levels was just before the housing crisis in 2006, when it peaked at 33%. Over most of the past 20 years it has been flat or negative.
This new era of relatively higher inflation and interest rates is a chance to re-evaluate many financial planning and investment assumptions and determine if they still hold up or need to be adjusted. In today’s post I will evaluate the pros and cons of being a homeowner or a renter for your primary residence from the standpoint of sound long term financial planning and in light of the potential impacts of higher inflation and mortgage rates.
I will be focusing on the financial aspects of the own vs rent question. There are of course many non-financial reasons to choose to rent or own and in many cases these will outweigh the financial.
Renting Pros
Renting is usually more cost effective: As noted above the average rent is currently significantly lower than the average mortgage payment. There are also generally more price points and types of living options ranging from a studio apartment to a single-family home.
Less Maintenance and Hassle: Renters enjoy the benefit of having the landlord responsible for home maintenance. This means that you don’t have to worry about costly repairs like a broken oven or a leaking roof. Beyond the hassle factor this could be a significant cost savings,
No Down Payment: The capital costs of purchasing a home can be significant. For example the median listing price of a single family home in Seattle is currently $829,000. A typical conforming loan requiring a 20% down payment would mean an up front investment of $165,800. While these funds can be recouped when and if you sell the home, and could possibly be borrowed through a home equity loan, they will be mostly illiquid.
Renting will also involve some up front costs such as a security deposit, however these will be significantly smaller. And, any funds not going towards a down payment can be invested in other assets such as stocks or bonds.
Investment Potential: Let’s say you are evaluating rent of $2,500/month vs. a mortgage payment of $3,000/month. If you invested the $500 savings each month into a Roth IRA and earned 8% per year the account would be worth $745,179 in 30 years (the typical length of a fixed rate mortgage.)
Easy Relocation: Rental agreements typically last one year, providing flexibility for relocation. The process of selling a home, on the other hand, can be time-consuming, costly, and risky.
Renting Cons
Rent Increases: Rents tend to increase over time, often in line with local inflation rates. In some years these increase can be larger however, and can vary significantly by location. In 2022, the average rent increased 13.83% in Washington and 25.59% in Florida. For comparison the overall nationwide Consumer Price Index rose 6.5% in 2022.
Stability Concerns: Your apartment building could be bought by an investor looking to raise rents, or a homeowner might decide to move into the property themselves or sell it when your lease is up.
Lack of Equity: While residing in a rented property, any increase in property value benefits the owner, not the renter.
Buying Pros
Potential Appreciation: A home is an asset that can increase or decrease in value. Nationwide, home prices have tended to rise over time, although this will vary significantly by location. Home prices will typically be most impacted by supply and demand in your local market. Outside forces such as the level of interest rates will also be a factor. For many homeowners their home ends up being their largest asset.
This is of course a double edged sword as home prices can go down in the short term, and can go down permanently in a market that is losing jobs and population.
Tax Benefits: Congress has designed the tax code explicitly to encourage home ownership. Mortgage interest on your primary home is tax deductible up to $750,000 if you qualify to itemize deductions. Capital gains taxes are not owed on your home up to $500,000 for joint filers who have lived in the home 3 of the last 5 years.
The 30 Year Fixed Mortgage: Another way the government encourages home ownership is through incentivizing banks to offer a long term mortgage at a fixed interest rate. This is a significant advantage for the homeowner especially if they can lock in a relatively low interest rate. The rate will be fixed for the term of the loan and the lender will be unable to increase the rate even if market interest rates increase significantly as we have seen in the past year. However, if market interest rates decline a homeowner can choose to refinance (for a cost) to a lower rate mortgage.
Sweat Equity: Because the home is an asset there is a potential to increase its value through rehabilitation and upgrades. For example, adding a room to a home may increase its value.
Imputed Income: Perhaps the best reason to own a home is so that you don’t have to pay rent! Eventually your home mortgage will be paid off and your housing costs should be significantly lower than renting the equivalent dwelling.
Buying Cons
Maintenance Costs: A rule of thumb is to assume that your home will require maintenance costs equal to 1% of the home value annually.
Property taxes are a significant expense and they tend to increase over time. It is possible that by the end of a 30 year fixed mortgage term the current property taxes will be as high or higher than the initial mortgage payment!
Property taxes fund state and local governments and will vary significantly by region. For example, in Washington state property taxes take approximately 0.98% of the assessed home value. In Illinois, it is 2.27%.
Location Constraints: Perhaps you purchased your “forever home” and then 9 months later you are laid off or your dream job is offered to you in a city across the country. Between Realtor commissions, taxes, and prep costs its reasonable to assume selling your home will cost between 7-10% of your selling price.
In a real estate market with declining prices it is possible that your home equity could fall below zero, meaning you owe more on your home that it could be sold for.
Mortgage Rate Differential: This is a big issue for homeowners who took out a mortgage prior to the recent run up in rates and would now like to move. Going from a $500,000 thirty year fixed mortgage rate of 3.5% to 7.5% means the difference between a $2,245 monthly mortgage payment and a $3,496 payment!
