A foundational aspect of the American Dream is homeownership. Contrary to popular belief however, it’s not always better to buy a home than to rent a home. Like most things, there are several factors to consider when choosing to rent vs buy.
Primary factors that should affect your decision are:
- Are you financially prepared to purchase a home?
- Do you see yourself staying in the area for at least 5-10 years?
- Can you afford a home of the desired size in your preferred area?
- What does the local housing market look like historically?
Let’s go through each of these four elements as they relate to choosing should rent vs buy a home.
Financial Preparation Considerations
When it comes to finances, you’ll need to consider several different factors. This includes your credit score, debt-to-income ratio, and available investment accounts you may consider using towards the home purchase.
Getting approved for a mortgage with the best interest rates largely depends on your credit score. If you have poor credit, the chance of getting the lowest rate will be significantly lower. This means over the span of your loan, you could be paying tens of thousands of dollars extra in interest. This is especially true in Southern California, where home prices often push the upper limits of loan amounts.
If your credit score needs improvement and you won’t be cosigning with someone with a great score, it might behoove you to continue renting and focus on improving your score first. Once it’s in a good place, you’ll have a better chance of getting lower rates. This will save you a lot of money over the long term. Conversely, if you already have great credit, then purchasing now might be the right option, especially if mortgage rates are low in general.
We also need to take a look at your debt-to-income ratio. There are actually two variations of this that are important to lenders; the back-end and front-end ratios. The front-end ratio is essentially your projected monthly housing costs divided by your gross monthly income. Lenders prefer this to be under 28%. The back-end ratio is more broad and includes all debt, including housing—but also things like car payments, child support, etc. Lenders prefer this to be under 36%.
If your income isn’t high enough to get within these ranges, you’ll likely want to continue renting while you work towards increasing your income, and/or decreasing your debt load. If you already have a high income relative to your debts, then you should be in a good place to purchase.
Finally, if you have non-retirement investment accounts that you can use towards real estate purchases, you should consider these options. In my opinion, it’s never a good idea to use your retirement accounts towards home purchases.
This is because you’ll end up paying high fees for early withdrawal, unless you’re already retired of course. There are other investment account types however that are designed to be real estate friendly. Reach out to your financial advisor if you have such accounts at your disposal but are unclear on the details.
5-10 Year Plans
When the economy is booming and home prices are appreciating, it’s perfectly acceptable to purchase a home with the plan of moving a few years later. After all, many investors make a business out of buying homes and then reselling them shortly after for a profit.
Still, most homeowners live in their homes at least 10 years before reselling them. This is beneficial because even in slower markets, it allows enough time for significant appreciation to occur. Additionally, it allows you to disperse your acquisition costs across the longer term of your home ownership. This makes those costs less impactful than if you were to turn around and resell your home quickly, as you’d incur similar costs on your next purchase.
By acquisition costs, I’m referring to both tangible and intangible costs. Tangible costs include things like closing costs, moving costs, buying new furniture, etc. Intangible costs include things like the time it takes to change your address with service providers, enrolling children in new school districts, finding new gardeners, hair stylists, etc.
Finally, there’s capital gains to consider. If you don’t live in your home for at least 2 years, you’ll likely owe taxes on any profit made from the sale of the home. By living in the home for several years, you’ll avoid that tax expense.
In a declining economy, there’s less guarantee of property appreciation in the short term—and the potential for even temporary depreciation. Thus, it becomes a lot more risky to purchase a home that you plan to sell a couple of years later.
Therefore, it’s a good idea to take a look at your plans over the next decade or so, and if you plan to move again soon, it might be better to continue renting. If you plan to stay in place for at least 5 years, you should consider buying a home.
Desired Home Affordability
Perhaps the most straight-forward question to ask yourself is, can you afford the home you desire in the area you want to live in? In Southern California, this question is particularly pertinent, as the median home value in relation to the median income level is quite a bit higher when compared with other areas in the country. This means houses here cost more, not just in an absolute sense, but proportional to income as well.
First, you’ll want to ensure that you have at least 3-6 months of an emergency fund saved up before you consider buying a home. This is sound financial advice regardless of who you are, but as a homebuyer, having those funds available to cover unexpected expenses that come along with homeownership is crucial.
Out Of Pocket Expenses
Next, you’ll need to make sure you have the cash needed for the loan down payment and closing costs. While impossible to give you a universal estimate that will be exact, I like to use the following equation to get close:
Total Purchase Price (TPP) + Closing Costs (CC) = All In Price (AIP)
AIP – Total Loan Amount (TLN) = Out Of Pocket Expenses (OOOE)
Closing costs typically amount to ~1.25% of the total purchase price. For an $800,000 home for example, expect to spend roughly $10,000. Of course, there are other factors that can impact the costs on a case-by-case basis, so expect to discuss specifics with your lender when making offers.
Something very important to keep in mind here in Southern California, is that conventional loans and those through the FHA and VA have upper limits. As of the time of this writing, the limit for conventional, FHA and VA loans in high-cost counties (like OC and LA) is $765,600. Many homes in these counties are well above that limit, meaning you would have to pay the difference out of pocket, as part of your OOOE, or get a jumbo loan.
As previously mentioned, ensuring your projected housing costs are 28% or less of your gross income is also an important part of ensuring affordability. Keep in mind this includes not only your mortgage payments, but also taxes, insurance, any applicable HOA or Mello-Roos fees, and property maintenance/repairs.
Local Historical Housing Market Trends
The last element to consider is how the local market has fared over the years. Looking back, have properties appreciated in the short, medium and long term? Have they gone up and down, remained relatively stable, or even declined?
Southern California, with few exceptions, appreciates over the medium to long term, regardless of specific location. Coastal property typically sees higher appreciation than inland property of course. By and large however, buying property here is a safe long term play.
However, it’s good to look at shorter term cycles as well. Most people, if given a choice, would want to purchase their home at a time other than the peak of the market, when prices are at their highest. They’d also like to sell their home at a time other than the trough, when prices are at their lowest. Of course, without a crystal ball it’s impossible to pinpoint the peaks and troughs until we’re on the other side of them.
Using Historical Data
Still, by using historical trend data combined with current global, national, state and local events, we can begin to form educated guesses on where the market will go in the short term. Southern California’s housing market follows a roughly ten-year cycle, with the most recent decline occurring in 2008. Therefore, it’s safe to assume that the next correction is due to occur soon.
Again, if you plan to hold your home for the long term, the short term fluctuations don’t matter as much. Over the long term, your home is bound to appreciate. Also, not everyone cares so much about turning a profit on their dream home. They just want to live there and are willing to write off the costs of doing so. I believe it’s still good practice to understand your home purchase in the context of the overall housing market, if only for your own edification.
Bringing It All Together
It’s exciting to think about purchasing a home. It’s understandably less so to audit yourself and determine if you’re in a position to rent vs buy. However, doing your homework now will save you a lot of time, headache and disappointment. This way, you can be sure that buying a home is the right move for you, and hone in on what you’re looking for.
If you decide now isn’t the right time to buy, then that’s ok as well. It’s important to understand that renting does not automatically equate to throwing away your money. Even on the surface, while you’re not building equity, you’re still getting something very important (shelter) for your money. Additionally, it may be a smarter move financially depending on each of the four elements previously mentioned.