Should I buy a home or keep renting?

by FIDELITY VIEWPOINTS – 10/03/2018

Consider how long you plan to stay where you are.

Though houses do generally go up in value, they don't always. It can help to think of your home as a place to live not just an investment.

Rent may be less costly after factoring in all of the expenses associated with ownership.

The mortgage interest deduction has changed due to recent tax law changes.

For generations, buying a home was considered the cornerstone of the American dream. However, in recent years, people have been debating whether buying a home is always better than renting. "A lot of financially savvy people are starting to question whether it's economically rational to buy a starter home or to wait and buy that dream house where they'll live 30 years," says Adheesh Sharma, vice president of financial solutions at Fidelity.

There are arguments both for buying and for continuing to rent, depending on a potential homeowner's individual circumstances. To help you understand these variables and evaluate your own situation, here are 5 important questions to consider as you make the buy-or-rent decision. You can also try Fidelity's Rent vs. buy calculator that lets you plug in your own numbers to see the difference that buying or renting might have on your long-term finances.

1. How long are you planning to stay where you are?

Your intended length of stay has a huge impact on whether it makes more sense to buy or rent. The process of buying and selling a home involves many different costs, some of which buyers often overlook—including brokers' fees, appraisal fees, title insurance, and mortgage origination fee. For the purchase of a $200,000 home, these fees cost an additional $2,128, on average. You may be on the hook for some closing costs when you sell the home too. Sellers generally pay the commission for their real estate agent and the buyer's—it amounts to about 6% of the sales price though that has, on average, fallen closer to 5% in recent years.

The longer you remain in a house, the more time you have to spread out these costs. If you sell within a few years, the value of your house might not have appreciated enough to offset these fees. Other expenses associated with homeownership should also be considered, including the cost of homeowners insurance plus other types of insurance that may be necessary for the area. There's also the cost of maintenance or improvements to the property.

What's more, you almost certainly would use a mortgage to buy the house. A mortgage is a loan that you must pay back, and that can add risk.

To reduce your risk, it's important to stay in a house long enough to reduce your debt and to allow for meaningful price appreciation. "If you're planning to stay less than 3 years, it's likely that buying a home will prove to be a financially questionable decision," says Sharma. Aside from absorbing the closing costs of buying and selling a home, you will also pay capital gains taxes on the sale if you hold it for less than 2 years.

2. Do house prices always go up?

Before the collapse of the real estate market that began in 2007, many people assumed that home prices always rise each year. But that is not the case. The bursting of the housing bubble showed that home prices can suffer major declines. The median home price in the United States dropped nearly 13% between 2007 and 2009, falling from $247,900 to $216,700. In some overheated markets, such as Las Vegas and Miami, prices declined as much as 62% and 51% from the peak.

Before buying a home, consider how your finances would fare if your house's value increased slowly or not at all. With 3% annual price appreciation, a $250,000 house would be worth more than $337,000 in 10 years. With a 1% annual price increase, the same house's value would grow to just $276,000 over the same time period. And that’s before accounting for inflation. In real terms, if the rate of inflation is 3% and your home appreciates in value by 1%, you'd be losing purchasing power. As an investment, it wouldn't be a great deal.

House prices, both indexes and individual homes, historically experience smaller average annual fluctuations than the stock market, but this seeming lack of volatility could mask other risks. First, housing price indexes aren't a good indicator of the growth potential for your house. The reason: Indexes represent a collection of homes in a broad region, whereas actual house prices depend on a host of individual circumstances related to the local market environment and the condition of the home in question.

Second, over the long term, putting too much of your savings into a single, leveraged investment (your house) could actually be more risky than investing in a diversified investment portfolio of stocks and bonds. If you buy more house than you need, the large mortgage payments might not leave anything left over to save for unexpected emergencies (like medical expenses), your retirement, or for college tuition (if you have kids). "Buyers who are focused solely on the idea of a house as an investment, need to understand that it can be very risky," says Sharma.

3. Are you throwing away money on rent?

A common argument in favor of home buying is that owners are building equity in a valuable asset that can boost their long-term net worth. By contrast, paying a landlord rent each month and paying for renters insurance seems like spending, rather than saving. But buyers who focus simply on the monthly mortgage payment versus monthly rent might overlook some additional, hidden costs of ownership.

You need to budget for the cost of property taxes, insurance, and regular maintenance (including your time and effort as a homeowner). Many specialists recommend budgeting at least 1% of the value of your home each year to cover routine maintenance. There are also potential unforeseen expenses, such as replacing a heating system or a roof. And if you don't save enough for a 20% down payment, you'll probably have to make mortgage insurance payments, which add even more to the cost of owning a home. Also, if you’re buying a condominium or a single-family home in a planned development, you will most likely have homeowner or maintenance fees to consider.

Buyers hoping a home will improve their net worth should also make sure they are actually building equity in that asset. A low credit score could force you to pay a higher interest rate, and therefore pay more in interest, meaning that your house might need to appreciate in value more quickly than is realistic to have any hope of building up equity.

4. How much will you save on taxes?

Many buyers assume that the additional costs of homeownership will be offset by tax savings generated by the mortgage interest deduction. Before you start counting on those savings, consider the following factors.

Recent tax law changes have lowered the cap on the amount of mortgage interest that can be deducted. Before the tax laws, homeowners could deduct interest on $1,000,000 of debt on a primary or secondary home. Now, for mortgages taken out after the new laws went into effect, deductibility is limited to the interest on up to $750,000 of debt on a primary or secondary home.

Interest paid on home equity loans or lines of credit is still deductible—provided that the money is used for substantial improvements to the home and that the total home equity debt plus mortgage is under the $750,000 cap.

Homeowners must itemize their tax deductions in order to receive the benefit. The median sales price of existing homes in July 2018 was $269,600. For new homes it was $328,700. With the median house price in the United States around $200,000 and mortgage interest rates below 5%, the interest deduction for many homeowners may be less than the $24,000 standard deduction for married couples who file taxes jointly, Sharma points out.4 This means that you might not be able to even utilize the mortgage deduction if your overall itemized deductions are less than the standard deduction for your situation.

Even if you purchase an expensive house and expect to have a large monthly mortgage payment, there's another consideration: Your tax benefit may decrease each year. A typical mortgage amortization schedule dedicates the majority of the monthly payment to interest in the first several years of the loan. Over time, more and more of each monthly payment is applied toward the loan’s principal—meaning you pay less interest and receive a smaller deduction.

5. Are you comparing apples to apples?

Making an accurate comparison between the financial impact of renting and buying starts by factoring in the complete costs of homeownership—not just mortgage versus rent payments—as well as an accurate assessment of how owning would affect your taxes.

Rather than simply focusing on monthly or annual costs of the buy versus rent decision, consider which option would have a greater positive impact on your overall wealth at the end of your stay. For example, let’s say your total costs of ownership were $2,000 a month and you could rent a similar property for $1,800 a month. You might consider how that additional $200 a month could grow if you were to invest it in a diversified portfolio and compare it with all the home equity you will build up during the same time through your mortgage payments.

A quick rent vs. buy comparison could be done using the price-to-rent ratio. Price-to-rent ratio is calculated by dividing the home value by the annual rent amount. Generally speaking, if the price-to- rent ratio is less than 20, buying might be a better option. On the other hand, if the ratio is greater than 20, renting might be better. Needless to say, any ratio or comparison is meaningful only if you are comparing similar properties.

However, the price-to-rent ratio is just a rule of thumb. Use Fidelity’s calculator to begin testing your own scenarios. That way, whether you decide to buy or to keep renting, you can be more confident that your choice is financially sound.

It's also important to weigh the differences between the properties you're considering. For example, you might be thinking about renting a 3-bedroom apartment in a multi-unit building in the city or buying a new, single-family home with a yard. Your decision should take into account the non-monetary benefits each property offers, such as how important outdoor space or proximity to downtown is to you.