September 22nd, 2016 6:50 AM by Jackie A. Graves, President
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.
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.
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…
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!
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.
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.
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.
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.
at it another way, here’s your gut check: How much of your gross income are you
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(!).
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.
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.
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.
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.
price-to-rent ratio helps here.
take the price of the house you’re looking at and divide it by what you could
rent it for on an annual basis (Sites like Zillow can
help you get a ballpark estimate quickly).
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.
another way, it would take 16.7 years’ worth of rent to buy the house in cash
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
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.
might surprise you is the variability of the price-to-rent ratio, both across
the nation and within metropolitan areas.
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.
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.
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.
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%.
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.
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
$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.
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.
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.
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
you stay in a house, the more advantageous it is versus renting.
stay the full term, you’re locking in your mortgage payment against 30 years’
worth of inflation.
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
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.
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.
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.
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.
years, I get much more bullish on buying.
is an exception and a caveat, though.
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.
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 worst-case scenarios.
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%.
$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
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
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.
wouldn’t advise it.
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
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