On the life decision scale, buying a house is often closer to marriage than it is
to the purchase of a car. It can be one of the best decisions you make or something
you bitterly curse forevermore.
And like marriage, the rent vs. buy decision is unique to the individual, requires you
to try to predict your life for the next few decades, and depends on too many factors
to summarize in one article.
But fortunately, with housing there are five fairly simple numbers we can look at to
help suss out when buying a home is clearly a bad financial idea.
I’ve rank-ordered them, starting with…
1.) Housing (and savings) as a percentage of your income
The first and most important metric to check is whether you can afford it. Duh, right?
But believe it or not, too many people mess this up. Instead of thoughtfully considering
what they can afford for themselves, they go with whatever their banker tells them they’re
approved for. Or blindly buy something comparable to a friend or rival. Big mistake!
What you’ll mostly see online and from bankers is a rule of thumb to keep your housing
costs below 30% of your gross income — basically, what your employer reports on your W-2.
Let’s say your job pays you $50,000 a year, or $4,167 a month, and you expect to make at
least that much in future years. Using 30%, that means your monthly mortgage and any home
equity loans (or rent if you don’t own), taxes, insurance, condo or homeowners’ association fees,
and utilities should add up to $1,250 or less.
For context, about half of renters and a third of homeowners with a mortgage fail to get
to 30% or less. But please don’t use “Tommy’s mom let him spend 50% of his earnings
on a condo” as an excuse to overspend — remember, WAY too many people are pretty darn
awful with their money. That’s why the majority of folks who receive Social Security depend
on it (vs. income from savings) as their primary source of income.
So if you value your financial independence, get as far under 30% as possible. Under 20%
is a tough goal in many housing markets, but if you can achieve that with a 30-year fixed mortgage,
you’re probably in really good shape unless your income takes an unexpected hit.
Looking at it another way, here’s your gut check: How much of your gross income are you saving?
The average American saves less than 5% of gross income. The median is likely
much worse given that 41% of people don’t even have a $500 emergency fund and
that the millennial generation as a whole has a negative savings rate(!).
What should you be saving? At a bare bones minimum, 10% of your gross income
(ideally not including principal payments on your mortgage). A gold star if you can get to 20%.
Using that $50,000 a year income, 10% puts you at $416 a month and 20% puts you at $833 a month.
If you’re buying a house that has you saving less than 10%, you’re either paying too much
for the house or you need to reassess other expenses like transportation, vacations, food,
child care, etc. Alternatively, you can think about how you can increase your income without
proportionally increasing your expenses. That could include sharing the house with a renter.
Rules of thumb necessarily abstract away from your personal situation. A single person in
their 20’s is treated the same as a couple in their 40’s with three kids. And there will always
be compelling-sounding, I’m-a-special-flower excuses to put off saving till tomorrow. Regardless,
though, living below your means should be an always-on phenomenon and the 10% savings
minimum holds. That’s even more so the longer you wait.
2.) Price-to-rent ratio
While your housing costs as a percentage of your income helps you figure out if you’re
spending too much on housing, it doesn’t tell you whether you should be renting or buying.
The price-to-rent ratio helps here.
Simply take the price of the house you’re looking at and divide it by what you could rent it for
on an annual basis.
If a house costs $200,000 to buy and you could rent it for $12,000 annually
($1,000 a month), the price-to-rent ratio is 16.7.
Put another way, it would take 16.7 years’ worth of rent to buy the house in cash today.
I used this example because monetarily that 16.7 figure is roughly the indifference point
between renting and buying. When you get much lower than 16.7, buying becomes more
attractive. When you get much higher than 16.7, renting becomes more attractive.
Don’t get too carried away with the decimal places, though. There are many more financial
and non-financial factors to consider, so 18.2 doesn’t mean an automatic rent and 13.7 isn’t
an automatic buy. But at some point, the numbers get compelling. For instance, at 10 times rent,
I’d be very tilted toward buying. At 25 times rent, I’d be very biased toward renting.
What might surprise you is the variability of the price-to-rent ratio, both across the nation and within metropolitan areas.
SmartAsset recently compiled the ratio by U.S. city. San Francisco tops the list at an
otherworldly average of 45.9, over seven times higher than Detroit at 6.3.
If you live in high price-to-rent cities like San Francisco, New York, or my home area of
Washington, DC, extreme caution is warranted if you choose to buy. Fortunately, even in
these areas, there’s a lot of variability. In these “sellers’ markets,” you may have to use
bargain hunting tactics — trolling less desirable areas, foreclosures, extreme patience —
just to get to a somewhat reasonable price. Or you may be better off renting.
Nothing wrong with that… and don’t let anyone socially pressure you otherwise.
3.) Size of your down payment
Mortgage is just a fancy name for debt — usually the largest debt we’ll take on in our lives.
Fortunately, the larger the down payment, the less scary that debt becomes – for both you
and your lender.
That’s why lenders require you to pay private mortgage insurance (PMI) of as much as 1.5%
of your original loan amount per year until your skin in the game (i.e. equity) reaches 20%.
Not paying that extra fee alone is reason enough to do a 20% down payment. But also
remember that you’re committing to 360 months of payments, so saving up 20% of the
price of the house helps ensure you have the discipline to see it through, is a check
against buying beyond your means, and is just a smart, conservative thing to do.
In fact, in an ideal scenario, you save at least 30% of the price of the house — 20% for the
down payment and 10% as a cushion against unexpected expenses. A leaking roof or
an unexpected electrical problem can eat into that cushion quickly.
On a $200,000 house, that means saving $40,000 for a down payment and an additional
$20,000 as a cushion beyond your regular emergency fund.
If you think a 20% down payment plus a 10% emergency cushion is too onerous, consider
that in the early 1900’s, down payments of 50% were commonplace. That’s $100,000 on
a $200,000 house.
I’ll end this section with one real-world consideration that muddies the waters a bit. Folks who
have a hard time saving for a down payment probably are poor savers in general. Those are
also people who are often saved in retirement by the home equity they’ve built up for decades.
What this means from a practical standpoint for folks who have a hard time saving
is that if you limit your housing costs to a low percentage of your income and ensure
that your price-to-rent ratio is also low, it may make sense for you to buy with a
lower-than-recommended down payment. You’ll want to make darn sure that you have a
good 10% emergency cushion in any case, though. It doesn’t do any good to “buy” a
house only to have the bank take it back from you in a few years.
4.) What’s the least amount of time you’re committed to staying in the house?
The longer you stay in a house, the more advantageous it is versus renting.
If you stay the full term, you’re locking in your mortgage payment against 30 years’ worth of inflation.
Meanwhile, every time you sell a house, you’re paying something on the order
of 6% of the house price to real estate agents and then another 2% to 5% in closing costs.
Not to mention any moving costs and potential double mortgage payments during the transition.
All-in, we’re talking something in the neighborhood of 10%, so $20,000 on a $200,000 house.
That’s roughly as much as a late-model used car, five to 10 fantastic vacations,
or maxing out your 401(k) for a year.
Also, on a 30-year fixed mortgage, you’re mostly paying interest in the early years.
When you get a new mortgage or refinance, you reset the timeline.
For these reasons, a lot of people use five years as the minimum you’d want to stay in a house you buy. That’s not an awful rule of thumb, but I’d likely push for an even longer time period.
Let’s say a couple I’m friends with is in the market for a house. Let’s say further that they
know for a fact they are going to sell the house in five years — either because it’s a starter
home or otherwise. Unless the price-to-rent ratio is amazingly low, I’d ask them to really
think about whether the costs, risks, and pain of owning a house are worth it versus
just saving up more money to buy when they’re ready to fully commit.
At 10 years, I get much more bullish on buying.
There is an exception and a caveat, though.
The exception: If you are willing and able to rent out your house to cover your mortgage,
insurance, taxes, homeowner fees, maintenance, and any property management costs,
it could make sense to buy at five years or even fewer.
The caveat: We’re all pretty bad at predicting our futures, even five or 10 years hence.
Just be as honest as possible with yourself based on your history and really consider
5.) Your credit score
Here’s one a lot of people don’t consider. For obvious reasons, lenders give lower interest
rates to people who have a strong history of paying back what they owe. On a mortgage,
the difference can currently be as much as 1.5%.
On a $200,000 house with 20% down, that means someone with a credit score of 740
or higher (850 maximum) could save about $140 a month versus someone with a
low-but-approvable credit score. $140 a month may or may not sound like a lot to you, but that’s a whopping $50,000 discount over the life of a 30-year mortgage.
For that reason, it may make sense to delay a home purchase until you can get your
credit score to 740 or above. On a more game theory note, if you’ve had poor credit in the
past, you may want to prove to yourself that you can handle a mortgage. Living with foreclosure
constantly hanging over your head isn’t the American Dream.
Could you come out ahead buying a house that costs you 50% of your gross income,
that’s 30 times a comparable annual rent, and that sports a 5% down payment? Absolutely.
And you could win a million-dollar game of Russian roulette, too.
But I wouldn’t advise it.
Getting safely on the right side of each of the five numbers we’ve discussed above —
especially the first two — will get you far in disaster-proofing your housing decision.
I wish you all the best as you weigh the options. If any of the above helped you in your
housing decision or if anything above could be better, I’d love to hear from you on Twitter.