Introduction

I am often asked by people whether they should buy a home or continue to rent. The conversation usually centers around this idea that renting is throwing money away. I am not partial to buying or renting but really wanted to dig deeper into the question and provide a more concrete answer.

First, before you waste any more time reading this article, the below discussion is only in reference to Tyler, Texas where you can buy a nice starter home for $90-$110 a square foot. This discussion also rests on the assumption of interest rates between 4%-5%. Interest rates have dropped over the last few months at the time of this writing down to a national average of around 3.7% for a 30 fixed mortgage but we will use 4%-5% for consistency in the four home purchases below.

Now that we are talking only about starter homes in Tyler, Texas (or similar markets) I want to be clear that purchasing a home is a personal, qualitative decision. A personal residence is not an investment. A personal residence is not an investment. Yes, that is worth repeating . A personal residence is personal living expense much like your vehicle. Your personal residence will likely never generate income for your family and that is what investments do, they generate income. So, as you begin to analyze this decision do not get so lost in whether buying or renting is better financially because in the end, both options are personal expenses and it boils down to preferences and priorities.

I see three large areas where owning a home differs financially from renting: (1) the transaction fees when purchasing and selling a home (2) the difference between monthly rent and your monthly mortgage payment and (3) any large repairs or any property appreciation or depreciation. The below discussion is a quantitative comparison between buying and renting.

The Buying Process

Purchasing a home can be exhilarating and stressful. It is fun to think about owning real estate and having a piece of land that is yours, we feel there is something American about it. Still, the process of purchasing real estate is overwhelmingly complex. It is far too easy to close your eyes and plug your ears to all the small fees involved that look so trivial when purchasing a $180,000 property. Below are four properties and the fees associated with purchasing each property when the buyer was able to put at least 20% down.

It is important to note here that the below costs are the true costs of the mortgage but do not represent the amount needed to close. The term “closing costs” is most often used in reference to the amount of money needed at closing in addition to the down payment. Lenders typically require prepayment of 7-12 months worth of property taxes and insurance premiums up front into escrow. This adds to the closing costs but is not a true cost to the buyer as it sits in their escrow account until due.

Fees On Purchase (20% Down)

Home #1Home #2Home #3Home #4
Sales Price$160,000$145,500$163,000$221,500
Square Footage1,5371,3321,6392,287
Origination Fee$380$178$905$995
Admin Fee$895$895-$599
Appraisal$550$550$475$400
Attorney Fee$100$100$100$125
Credit Report Fee$100$79$44$37
Flood Certification$4$4$9-
Tax Service$90$90--
Title$1,045$456$405$473
Home Inspection$325$325$325$450
Pest Inspection$97$97$97$97
TOTAL$3,586$2,774$2,360$3,176

The buyers of the four properties above were able to make at least a 20% down payment which eliminated the need for any mortgage insurance. The lender typically requires mortgage insurance when the buyer puts down less than 20% to protect the lender from a “riskier” loan. The lender is the one who is insured but the buyer is the one who pays the insurance premiums. Lenders offering conventional loans can structure private mortgage insurance (PMI) in different ways, but most of the time there is no up-front cost of PMI. Federal Housing Authority (FHA) loans however, do require an up-front mortgage insurance premium in the amount of 1.75% of the loan. An example of FHA up-front mortgage insurance premium when 10% is put down is seen below.

Upfront Mortgage Insurance Premium

Home #1Home #2Home #3Home #4
Sales Price$160,000$145,500$163,000$221,500
Square Footage1,5371,3321,6392,287
Upfront Mortgage Insurance Premium$2,520$2,292$2,567$3,489

The Selling Process

The time comes when you are ready to sell the home. The typical seller will incur two main costs, title insurance and the real estate agent commissions. The title insurance amount will vary and exists to protect the buyer from any title issues. The real estate commissions on the vast majority of transactions are 6% of the contract price. Assuming the properties did not appreciate or depreciate in value, the closing costs upon sale for the four properties are listed below.

Costs to Sell

Home #1Home #2Home #3Home #4
Sales Price$160,000$145,500$163,000$221,500
Square Footage1,5371,3321,6392,287
Title Insurance$886$826$943$1,203
Real Estate Agent Commission$9,600$8,730$9,780$13,290
Total Fees & Costs to Sell$10,486$9,556$10,723$14,493

Monthly Costs

To this point we have only looked at the costs related to buying a home, what about renting. Typically, the upfront costs to rent a property are small and would include a credit and background check totaling less than $100. The landlord would require a security deposit which is likely refundable so the move in and move out costs of renting are nominal and not worth analyzing. Buying and renting both have monthly costs so let’s compare them.

Monthly Mortgage Costs

Home #1Home #2Home #3Home #4
Sales Price$160,000$145,500$163,000$221,500
Square Footage1,5371,3321,6392,287
Interest Rate5.00%4.875%4.125%4.25%
Avg Principal Payment (First 24 months)$182$169$215$286
Avg Interest Payment (First 24 months)$591$524$496$695
Property Taxes Escrow Payment$285$178$238$330
Insurance Escrow Payment$65$92$65$117
Mortgage Insurance Premiums$90$82$92$125
Total Monthly Mortgage Payment$1,213$1,045$1,106$1,553

The first thing that jumps off the page is the interest component of the mortgage payment. The interest is calculated by taking the interest rate times the outstanding loan balance each month and therefore is highest earlier in the life of the loan. In other words, the interest paid to the bank is front loaded. Next, let’s compare what you could rent these properties for to determine the monthly savings by owning the home as opposed to renting.

Monthly Costs – Mortgage vs. Rent

Home #1Home #2Home #3Home #4
Sales Price$160,000$145,500$163,000$221,500
Square Footage1,5371,3321,6392,287
Interest Rate5.00%4.875%4.125%4.25%
Total Monthly Mortgage Payment (Principal Payment Removed)$1,032$875$891$1,266
Estimated Rent of Same Property$1,425$1,375$1,515$1,675
Rent in Excess of Monthly Mortgage Costs$393$500$624$409

The financial trade off between buying and renting begins to come into focus. Buying a home requires the ability to swallow transaction fees on the purchase and sale of the home whereas renting is a higher monthly expense with no up-front or back end costs. If we take the total fees to buy and sell a property and the monthly savings compared to renting, we can find the break even point. If the property is owned for a period of time shorter than the breakeven point, renting is preferable. If the property is owned longer than the breakeven point the buyer is financially better off than the renter.

Break Even Point

Home #1Home #2Home #3Home #4
Sales Price$160,000$145,500$163,000$221,500
Square Footage1,5371,3321,6392,287
Interest Rate5.00%4.875%4.125%4.25%
Total Fees & Costs to Buy & Sell$16,740$14,783$15,066$21,106
Rent in Excess of Monthly Mortgage Costs$393$500$624$409
Break Even Point (# of Months)43302452

Every time I run the breakeven analysis for someone in my area the results are between two and four years. This means on average if you will live in a home for less than three years it is typically better to rent.

What Are We Forgetting?

There are a number of factors the above analysis does not take into account on both sides of the decision. First, we ignored appreciation on the property. When you own the property and it goes up in value you as the owner benefit from the appreciation upon sale. On the other hand, we have been rather optimistic and ignored any plumbing, heating and cooling, appliance or roofing repairs that crop up on a home owner when they least expect it. The costs of repairs and potential appreciation of the home for a three-year period are nearly impossible to estimate and therefore are considered a wash and not factored in above. That being said, do not ignore these aspects for your specific property.

Bringing It “Home”

My rule of thumb for people looking to buy a starter home in Tyler, Texas is in order for home ownership to make financial sense, you need to see yourself living in the home for at least four years. For many young couples and families, it is very difficult to envision life four years from now with changing jobs and family dynamics but time in the home is (from a financial perspective) the most significant factor in the buying versus renting debate.

Now that you have read 1,100 words on the financial trade offs between buying a renting, please remember the non-financial aspects to the decision. Renting offers peace of mind on large repairs but renting also requires dealing with a landlord or property management company. Owning your own home provides a sense of stability but also demands more attention and care. Ask yourself where you see yourself in four years, don’t overlook the fees and costs of buying and selling a home, don’t overlook the monthly interest paid to the bank in the early years, and don’t overlook the non-financial considerations for your and your family. In the end, what feels like a large decision is just another step in life. Enjoy the journey and don’t forget to learn something along the way.

 

Thanks for reading — Thomas Neuhoff