Often the first decision a person ponders when considering owning a home is whether it is “best” to rent, or to buy. While it is impossible to give a blanket statement on which is “better”, it is possible to give an outline of circumstances which may make one or the other more favorable in your situation.
“The American Dream” more often than not includes the idea of home ownership. For many, the prospect of owning a home has been a daydream since an early age. For this reason, it is not simply a financial decision when debating renting or owning through buying, but an emotional one as well.
If one were to look at a home as strictly a financial decision, than the math rarely points to purchasing as a better option. Long term, the stock market outperforms returns on homes, and the fees involved usually make owning a more expensive option than renting.
A main problem with home ownership is the combination of the fees incurred (down payment, closing costs) as well as the mechanism by which a mortgage amortizes (is paid off). For the most part, a homeowner will have sizable fees and expenses related to securing the home, fees which do not exist in a typical rental. These fees, if spread across a lifetime, could make the financial decision sway in favor of ownership, however, the fact remains that the average American will ‘own’ their home for a mere 6 years (according to the National Association of Realtors). For this reason, these fees are not spread across the typical 30 year mortgage and make the cost of owning the home, and later selling the home, much higher.
In addition, the argument most commonly forged relating to ‘gaining equity’ in homes really only happens toward the end of a mortgage. The way mortgages amortize (are paid down) is structured so that in the beginning, much of the payment only goes to pay down the interest on the loan, as opposed to paying down the principal (the actual loan amount). This creates a situation where by the 6th year (in the average situation), the balance of the loan is very close to what it was to begin with, as most of the payments have went towards paying down interest.
Combined with the selling costs associated with moving, very often the buyer is left with a situation where they lose considerable money in the transactions, and have very little ‘equity stake’ to make up the difference.
However, will all that said there are several benefits with owning your own home.
Gain equity in the house by paying down mortgage
Reap benefits of increasing home prices
Tax deductions for interest portion of mortgage payment and real estate taxes
Locked in payment (if fixed rate mortgage)
High upfront costs
Total responsibility for repairs
Home could lose considerable value, yet must still maintain payments
When lenders look to the credentials of a potential borrower, one of the main factors they look at is ‘capacity’, or the borrower’s ability to repay the loan. A key metric they use to determine this is a debt-to-income ratio.
The most common way to determine the debt-to-income ratio would be termed the ‘front-end ratio’. In this ratio, the lender determines how much of the borrowers pretax monthly income would go towards the mortgage payment. Usually banks like to cap the total % of income spent on all housing related expenses (mortgage payment, insurance, real estate taxes) to 28%.
For instance, if your monthly income was $5,000, the bank would be most comfortable with housing expenses up to $1,400 (5,000 * 0.28).
Overall, the decision to buy or rent a home is not one which can be answered simply one way or another. Each situation is unique; however, one of the most important pieces to keep in mind is the length of time you plan to say at your new residence.