Should You Rent or Buy a House

Should You Rent or Buy a House

A formula for the biggest investment decision you’re likely to make

It’s often hard to remember the buying a home is an investment fraught with some of the risk of Wall Street. And much as you might wish to own a place of your own, you might feel a bit better about parting with your down payment if you were convinced that you were making a savvy investment. A quick rule of thumb: You can assume you’re probably better off renting if you do not itemize deductions on your tax returns or if you plan to move in a few years.

Gaylon Greer, professor of real estate at the University of Memphis, has devised a more sophisticated formula by adapting for potential homeowners a calculation used to decide whether to rent or buy. Keep in mind the Greer’s calculation only considers the financial aspects of the decision. Here’s how it works.

Consider the hypothetical predicament of Tracy and Jeff Summers, who are renting an apartment in Chicago for $1,200 a month. They are considering buying a similar-sized home for $200,000 and plan to live in the house for seven years.

Step 1: Figure out the yearly financial cost for each scenario. For renting, that would be the Summer’s annual rent of $14,400. For buying, it would be the after-tax costs of mortgage payments, property taxes, and maintenance.

Greer suggests estimating annual maintenance costs at about 1 percent of the house’s value for a new home and up to 3 or 4 percent for an older house. The local tax assessor can give you property tax rates.

New York, Chinatown, Mulberry street. Photo by Elena.

The Summers estimated spending about $2,000 a year on maintenance and paying $8,000 in property taxes. Their yearly mortgage payments come to approximately $16,000, assuming a $180,000 mortgage at 8,1 percent. However, the total yearly cost a buying is brought down substantially once you factor in the fact that property tax and mortgage payments are mostly tax-deductible. Since the Chicago couple falls into the 39,6 percent income tax bracket, they can roughly estimate that the government pays that percentage of their costs. Therefore their total yearly costs for buying would be $16,000.

Step 2: Figure how much you will recoup when you sell your house. You should expect about 8 to 10 percent of the final value to be consumed by transaction costs, such as brokerage and legal fees. After subtracting their transaction costs, the Summers estimate getting $290,000 for their house after living there for seven years. And they will still owe about $165,000 on their mortgage, so after taxes their net gain will be roughly $90,000.

Step 3: Estimate how much you might make if you had invested your money in something other than a home. You can use tables to give you the value today of a dollar available at various points in the future. These tables are based on a determined percent rate of return on high-grade corporate bonds. These numbers can change – if they do you can use a present value table found in any finance book.

Let’s see an example:

Year 1, cost or benefit $16,000, factor .9259, present value equivalent $14, 814,40.

Year 2, cost or benefit $16,000, factor .8573, present value equivalent $13, 716,80.

Each number corresponds to a year, so for year one, the factor will be .9259. Multiply that number by the annual cost of $16,000 to get a “present value equivalent” for the first year cost of ownership. Continue with similar calculations for each year you plan to live in the house. At the end you will add what you expect to recoup from selling the house and the down payment. You should end up with something like this (parenthesis indicate negative numbers):

Year 6 ($16,000) Factor .6502. Present value equivalent ($10,403,20).

Year 7 (cost) or benefit $90,000. Factor .5835. Present value equivalent $52,515,00.

You should be able to calculate the total, which include down payment to buy and net present value equivalent.

Step 4: Go through the same calculation for renting – minus the down payment and net gain for selling. The lower cost is the best financial option.

The bottom line for the Summers: They should buy the house. Figuring the present value of their money, they will come out ahead by over $20,000 if they purchase the home.

Of course, even if the result favors renting, you might decide to buy the house you saw because it has such a lovely view from the kitchen window. That’s simply a different definition of present value.

It’s Harder the First Time

With lower mortgage rates, first-time homebuyers can afford more expensive houses. The National Association of Realtors’ first-time home buyer index shows the ability of renters who are prime potential first-time buyers to qualify for a mortgage on a starter home. When the index equals 100, the typical first-time buyer can afford the typical starter home under existing financial conditions with a 10 percent down payment. The first-time buyer median income represents the typical income of a renter family with wage earners between the ages of 25 and 44 years. The 1994 first-time buyer index shows that the qualifying income needed for conventional financing covering 90 percent of a $93,000 starter home was $28,699. Yet the median income of prime-time first buyers was $24,998, a difference of $3,701. Even so, a typical first-time buyer could afford a home costing $78,300.