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by Maurie Backman
May 23, 2018
by Maurie Backman
May 23, 2018
We all need a place to live, whether it's a one-room apartment or a sprawling multi-bedroom house. The question is: Does it make more sense for you to rent or buy?
When you buy a home, you'll encounter expenses like your monthly mortgage payment, property taxes, insurance, maintenance, and repairs, not to mention the opportunity cost of putting a chunk of cash into your down payment. When you rent, meanwhile, you'll need to factor in costs like insurance and a security deposit as well.
Though there are many tools out there -- including our own rent vs. buy calculator -- that can help you navigate the finances behind that decision, ultimately, there are logistical factors to consider as well. Here, we'll review the advantages and drawbacks of both owning and renting a home so that you can draw the best conclusion for yourself.
There are numerous costs associated with homeownership, some of which may be more obvious than others. Here are the primary expenses you'll need to think about:
The costs associated with renting a home are far less extensive than with buying. First, there's your rent payment itself, which will be dictated by your lease. You might also be required to put down a security deposit, which can either be a preset figure as determined by your landlord, or the equivalent of a month's rent. Your security deposit protects your landlord in the event you damage your home beyond what's considered normal wear and tear. Generally speaking, you'll get your security deposit back if you treat your home with respect, but you also can't count on that happening.
Furthermore, it's a smart idea to get renters' insurance to protect yourself from personal property loss in the event your rented home is robbed or gets damaged by a flood or fire. Your annual premium will depend on the amount of coverage you choose and your deductible under that plan.
Now that you understand the costs that go into owning a home, here are some of the benefits you might enjoy when you buy. First, homeowners who itemize on their returns are entitled to a number of potentially lucrative tax breaks, including the mortgage interest deduction and property tax deduction. With the former, you can deduct the interest you pay on a home loan of up to $750,000 (prior to 2018, that limit stood at $1 million, and homeowners with existing mortgages are grandfathered into the old system). With the latter, you can take a total $10,000 deduction for your state and local taxes, which include your property taxes. Furthermore, if you're self-employed and conduct business out of your home, you may be eligible for a home office deduction as well.
Another benefit of buying a home is that you'll get a chance to build equity in it. Equity represents the amount of your home you actually own. Once you pay off your mortgage completely, you'll have 100% equity in that property. If your home value rises over time and you sell it for more than what you paid, you stand to make money. Having equity in your home can also come in very handy in retirement, because if you find yourself in need of money, you may have the option to get a reverse mortgage, which gives you access to another income stream. (There are, however, some drawbacks to going this route.)
Owning a home also grants you a degree of stability. As long as you keep up with your mortgage payments, you can't get kicked out of your home. When you rent, there's nothing to stop your landlord from not renewing your lease once it comes to an end. This stability can be extremely important for families with children. In some cases, having to move even a few blocks away could put you in a completely different school district, which might negatively impact your kids, so buying a home can help you avoid that unwanted upheaval.
Finally, when you buy a home, you get to make your own rules. Want a dog? You don't need to run it by your landlord (though you may need to get approved from your HOA, if you have one). Want to rent out a room in your house? That option is yours. Owning your own property gives you the freedom you don't get when you're limited to somebody else's terms.
While buying a home certainly has its advantages, there are drawbacks to consider as well. First, owning can be riskier than renting from a financial perspective because of the many unknowns you'll face. Remember, you never know when your heating system might fail or your foundation might start to sink. These repairs could cost thousands, and they could sneak up on you out of nowhere. Having a fully loaded emergency fund will help offset the financial blow, but if you're the type who doesn't cope well with surprises, buying property might cause you to lose sleep.
Another negative of homeownership is the opportunity cost of sinking lots of money into a down payment because that's money you could be doing other things with, like investing. Imagine you put down $40,000 to buy your home, and your home never increases in value for the 30 years in which you own it. In that case, your return on investment is essentially $0. (Of course, this is not a perfect calculation, as you might benefit financially in others ways by owning property, such as saving money on taxes; but for the purpose of our example, that's what we're looking at.) However, if you were to invest that $40,000 for a 30-year period at an average annual 7% return, which is actually a few points below the stock market's average, you'd wind up with about $304,000.
Furthermore, if you buy a home and are forced to move due to circumstances outside your control, you'll risk having to sell that home at a loss if prices happen to decline in your area. Similarly, if you don't stay in your home for at least a few years after buying it, you probably won't manage to recoup your closing costs, even if you happen to sell that property for the exact same price you pay for it. Remember, a home is a fairly illiquid investment in that it can be hard to sell, so if you want to move but can't get enough money for your property, you could end up stuck where you are.
Finally, though homeowners are still eligible for tax benefits, they aren't as generous as they once were. As stated above, there's now a lower loan threshold for claiming the mortgage interest deduction, and the state and local tax (SALT) deduction, which includes property taxes, is no longer unlimited but capped at $10,000. Therefore, if your state income taxes equal $6,000 and your property taxes equal $6,000, you'll lose part of that deduction. Plus, because the standard deduction has nearly doubled from what it was in previous years, it may not make sense for you to itemize in the first place, in which case you won't get any of the aforementioned write-offs.
Just as buying a home has its benefits, so does rent. When you rent, there's no need to sink a huge chunk of your savings into a down payment. Typically, you'll be required to pay a month of rent up front along with a security deposit. In some areas, you may be required to come up with your first month's rent, last month's rent, and that deposit. Either way, you're generally not talking about nearly the same amount as a down payment, which means your money isn't tied up. You can invest and grow it, or use it for other short- and long-term goals.
Another benefit of renting is that your housing costs are fixed for the duration of your lease. If you sign a two-year rental agreement that requires you to pay $1,000 a month, that's all you'll be on the hook for during those 24 months. You won't need to factor maintenance and repairs into your budget.
Along these lines, you won't have to deal with the hassle of tackling maintenance and repairs. Those are somebody else's problem -- namely, your landlord's.
Furthermore, renting a home usually gives you more flexibility to pick up and move than buying a home allows for. When you rent, you're typically able to sign shorter leases with one-year terms, and often, once your first year is up, your landlord will allow you to continue renting on a month-to-month basis provided you're a tenant in good standing. This means that if you suddenly get a job offer in another state, you may have the option to give your landlord 30 days' notice and move out without any sort of financial penalty.
Even if you do have to break a lease, the financial consequences could be far less severe than having to sell a home at a loss. Imagine you sign a one-year lease for an apartment that's $1,000 a month, and you wind up breaking it three months early. You may, in a worst-case scenario, need to forfeit $3,000, which certainly isn't ideal. But now imagine you purchase a home for $300,000 whose value drops to $260,000. If you need to sell that home unexpectedly, you stand to take a $40,000 loss.
Though there are plenty of good reasons to rent a home, you'll face a few drawbacks, too. For one thing, when you rent a home, it's a pure expense, since you don't get an opportunity to build equity. A home that you buy, on the other hand, is more of a hybrid expense/investment, which means it does offer the opportunity for financial gains while serving the key purpose of putting a roof over your head.
Another negative associated with renting is that when things break in your home, you're at the mercy of your landlord or management company to have them fixed. This means that if your hot water stops working, you may be forced to find someplace else to shower for a week until that repair is made.
Similarly, when you rent, you're subject to somebody else's rules. If, for example, you're eager to get a pet, you may be banned from doing so as a renter. Similarly, some rentals prevent you from conducting business out of your home (though this isn't always the case, and this restriction will often depend on the nature of the business at hand).
Finally, when you rent, you're not guaranteed that you'll have the option to live in your home indefinitely. Once your lease expires, there's nothing to stop your landlord from selling that property or renting it to somebody else, at which point you could find yourself out of a home. This can be especially worrisome if you have children since it could mean uprooting them and having to switch schools.
Also, from a financial perspective, you're taking the risk that you won't manage to find a similarly priced home once your lease runs out. Homeowners who sign fixed mortgages, by contrast, get to lock themselves into the same monthly payment for the duration of their loans -- though as we learned above, the monthly costs associated with owning a home are by no means static. Even if you sign a 30-year mortgage, you might conceivably pay a different amount each month when you factor maintenance, repairs, and rising property taxes and insurance premiums into the mix.
Clearly, the decision to rent versus buy is a big one, so yours will depend on a number of factors. If you have the funds available for a down payment, have good enough credit to get a favorable interest rate on a mortgage, and feel ready to take on the responsibility of owning, then buying is a great way to build equity, snag some potential tax breaks, and gain some stability. Similarly, if you're set in your career and plan to be at your job for a long time, you're less likely to want to move, in which case buying could make sense. The same applies if you have a family and want your kids to grow up in the same neighborhood throughout their childhood.
On the other hand, if you don't have the down payment needed to buy a home, and saving for it will prevent you from meeting other financial goals, then you may want to rent instead. The same holds true if you're a recent college grad and you don't really know where you want to settle down. Furthermore, if you've recently relocated for a job, you may be better off renting for a year or two and making sure you like the area before investing in a home. And if you're a retiree on a limited income and budget, fixing your living costs might be a safer bet financially than bearing the unknown expenses that come with buying property.
Regardless of whether you choose to rent versus buy your home, know that your housing costs should not exceed 30% of your take-home pay. If you're renting, that 30% includes your monthly rent payment plus renters' insurance. If you're buying, that figure should, at the very least, encompass your mortgage payment (including any PMI premiums that might be tacked on), property taxes, insurance, and HOA fees, if applicable. To play it even safer, factor predictable maintenance into that 30%, which gives you a bigger cushion to absorb sudden repairs.
Keeping your housing costs to 30% of your income or less will leave you with more wiggle room to cover your remaining expenses. It's also a good way to help ensure that your home, whether you rent or buy it, doesn't prevent you from saving for things like emergencies, retirement, and college.
Remember, your home should, ideally, be a place you enjoy retreating to at the end of the day or spending time in on weekends. But the last thing it should ever be is a major source of financial stress.