Starting Out
Should You Buy or Rent?
Don't beat yourself up if you can't afford to jump into the sizzling real estate market -- you might be surprised what a bargain tenancy has become. Plus: Four places to house your cash while you wait for the right opportunity.
By Erin Burt, Contributing Editor, Kiplinger.com
July 14, 2005
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Over the past few years, my husband and I have often talked of buying our own home. We'd spend Saturday nights ogling houses on the Internet and fantasizing about square footage, grassy lawns and four walls we didn't have to share with our neighbors.
And then he got a job in the San Francisco Bay area, the most expensive housing market in the country -- the median home price here is $689,000. We ran some numbers on condos near his job and discovered that even with our modest savings for a down payment, our mortgage would cost more than his and my take-home pay combined. We found slightly cheaper homes within an hour's commute. Despite the strain on our budget and distance from work, should we buy just to break into the market and hope to turn a good-sized profit when we sell?
Our situation is far from unique. The quandary of renting vs. buying has only gotten tougher as real estate prices nationwide have soared over the past few years. If you decide to buy, you worry about whether your daily budget can withstand the elevated cost. And what if home prices drop and you end up losing money? If you stick with renting, you worry that you're a sucker missing out on future housing price appreciation. And what if you get shut out of the housing market entirely?
My husband and I opted to put our dreams of home ownership on hold in favor of renting. The benefits of buying may get all the press, but renting can actually be a better financial move than trying to break into an overheated housing market.
Price disconnect
Typically, rents and home prices move in tandem. But with rock-bottom interest rates and a plethora of mortgage options (including no-down loans and interest-only loans), renters have been lured to home ownership in droves, driving up home prices and leaving rents flat.
Over the past two years, the median home price in the U.S. rose 16% according to the National Association of Realtors. Rents, by comparison inched up a mere 1.2% according to M/PF YieldStar. The disparity widens in certain areas of the country:
- In San Francisco median home prices jumped 24% over the past two years while rents dropped 7%.
- In Philadelphia, home prices grew 28% and rents rose 2%.
- In the Washington D.C. area, rents increased 6%, but home prices leaped 40%.
In fact, the national gap between the costs of renting and buying is the widest it's been in more than a decade, according to Torto Wheaton Research. That means you may actually save money by renting, at least in the short-term. Rather than overextend your budget to buy in an overheated market, you can rent comfortably within your means and save your money for the perfect buying opportunity when it comes along.
The rent versus buy disconnect has spread beyond areas like San Francisco, Boston, New York and Chicago. In Seattle and Las Vegas, for example, the monthly cost of renting is nearly half the cost of buying, according to Torto Wheaton Research. In Denver, Miami and Washington, D.C., renting costs about 40% less than buying. In Minnepolis and Phoenix, it runs about 25% less. And those figures don't include property taxes, homeowner's insurance and other costs that come with a house, so renting may be an even bigger bargain.
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Buy or rent?
So, should you join the house party or be content to rent? Look up housing prices where you live and then use this calculator to find out if renting or buying is the cheaper option for your particular situation.
Two big factors in the equation: How long you plan to stay put and how much you expect your home to appreciate.
You typically need to stay in a home at least three years to recoup your costs. But consumer advocate Clark Howard says five years is even better, because you never know how the real estate market will fare. To protect yourself, assume your home will appreciate at the rate of inflation or a little more, says Howard.
And you may need to stay longer to come out ahead compared to renting. On the condos I priced in the San Francisco area, I would have had to keep one for at least 13 years in order to save money versus renting for the same period of time (assuming a rate of appreciation in line with inflation). Of course many people buy with the hope that prices will appreciate fast enough to pay off sooner, but that's a gamble, especially with many economists -- including Alan Greenspan -- warning that growth can't continue at its current pace forever.
Even if you plan to stick around long enough for the purchase to pay off, that doesn't mean squat if you can't afford to pay the bills. Your monthly house payment -- including principal, interest, taxes and insurance -- should consume no more than 33% of your monthly gross income. Your total debt payments, including your credit cards and student loans, should remain below 38% of your total pay.
Also, do you have enough cash for a down payment? Typically, you need 20% of the purchase price to avoid paying extra for private mortgage insurance. That's $40,000 for a $200,000 home. And don't forget closing costs, which can add up to 3% to 6% of the purchase price.
Bottom line: Buy a house because it's the right move for your situation and finances. Don't let the fear of missing out on big gains drive you to a decision you may regret later.
If you find that buying is the better bargain and makes more sense for you, learn more about purchasing your first home. Then, check out our Home Buyer's Survival Kit to guide you through the process step by step.
Where to save your cash
Even if renting looks like the better choice for you right now, that doesn't mean you should give up on home ownership. Take this opportunity to save for a down payment and wait for the right buying opportunity to come along. If you expect to buy within the next three years, you should focus on preserving your principal:
- Money-market savings account. Don't park your cash in a bank savings account that yields next-to-nothing. Instead, put it in a high-yield account with Emigrant Direct (currently 3.25%) or ING Direct (3%). They link to your checking account at your bank and you simply transfer the money online. (Shop for other high rates.) You can do without traditional money-market mutual funds -- they simply don't measure up. Some of the highest-yielding money market funds currently yield less than 2%.
- CDs. You can usually get a higher rate with a certificate of deposit. Currently, one-year CDs average 3.4%, two-year CDs yield 3.7% and three-year CDs net 3.8%, according to Bankrate.com And you can find higher rates by shopping around -- we found a handful of banks offering a one-year CD at 4%-plus. The downside: your money is tied up for the CD's term. You'll pay a penalty if you need to tap your cash ahead of schedule.
- Short-term bonds. Generally speaking, the shorter the maturity, the less a bond is affected by inflation and interest-rate changes. Consider a solid bond fund, such as Vanguard Short-Term Tax Exempt (VWSTX), which currently yields 2.47%, or the slightly longer-term Vanguard Limited-Term Tax Exempt (VMLTX), yielding 2.91%.
For a longer time horizon, say five years, you can afford to take on a smidgen of risk to earn more. Consider allocating half your money to a bond fund such as Vanguard Limited Term Tax-Exempt (VMLTX), and the other half in a diversified stock fund such as T. Rowe Price Spectrum Growth (PRSGX), which invests in a wide selection of T. Rowe stock funds.