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The Ultimate Guide to Housing and Real Estate: Renting vs. Buying a Home

Article Contents:

Housing plays a significant role in your financial plan

Coming as a shock to no one—where you choose to live and how much you pay for your housing can have a significant impact on your finances. Housing is often the most considerable expense you will incur, and it takes a lot of crunching numbers, research, and serious budgeting to make a final decision. Whether you choose to rent or buy a home doesn’t just affect your budget and how much money you have leftover at the end of the month. It also impacts your financial plan, your lifestyle, your investments, and your savings

It’s common to hear of people purchasing a home as an investment, and so they can put down roots—even though it may not be the correct financial decision for their situation. On the opposite hand, many people continue to rent due to the flexibility it offers, ignoring the fact that they would accrue a larger net worth over time if they purchased a home instead. 

In North America, we’re continually hearing that being a homeowner will solve our problems, that it’s the key to happiness or financial success, and that it’s an integral piece to the American dream. 

However, owning a home isn’t always better than renting, and renting isn’t as simple as everyone makes it out to be. It’s important that you consider the pros and cons of each situation to figure out whether renting or owning is best for you.

The ins and outs of renting your home

Whether you’re renting your first apartment or considering your next one, it’s essential to analyze what percentage of your income will go to rent. Spending too much of your paycheck on monthly rental payments could negatively impact your finances. You could risk coming up short when it comes to covering other expenses, paying off debt, or working towards your financial goals.

How much should you pay for rent? 

The 20% rule is a popular guideline to determine what percentage of your income should be allocated for rent. In simple terms, this means that your monthly housing costs should not go above 20% of your gross monthly income (the sum of all forms of earnings before any deductions or taxes). 

Let’s say you earn a monthly salary of $8,333. You would multiply that by the recommended rent-to-income ratio of 0.20 (20%), to learn that your affordable rent would be $1,666. By only paying this affordable rent amount, you can reallocate additional money into your desired savings and investing accounts. 

🏡 Rule: Do not spend more than 20% of your monthly gross income on rent payments.

The 20% rule is a common practice for those committed to being financially stable. It’s also a guideline that many landlords follow when determining if a potential tenant can afford the rent. Some financial experts recommend allocating 25% of your net income (the sum of all forms of earnings after any deductions or taxes) instead, which is comparable to 20% of gross income. 

The pros and cons of renting

Pros of renting

Some benefits of renting include: 

  • Your monthly, home-related expenses tend to be more predictable, and you’ll know exactly how much you’re going to spend on housing each month. 

  • Most often, the landlord or superintendent handles the bulk of your home’s maintenance and repair needs. 

  • Renting is a more flexible option. If your job changes or you want to move to a new neighborhood, it’s merely a matter of notifying your landlord. 

  • The startup cost of renting is almost always the more affordable option. Aside from an application fee or security deposit, you won’t be responsible for a down payment, closing costs, and other up-front fees that occur when buying a home.

As we mentioned above, renting your home allows you to have the flexibility of moving year after year to find a rent price that works for your budget. It also gives you a place to call home until you can save up enough for a down payment on a house (if that’s your goal). This flexibility could come at a price, though.

Cons of renting

Renting is not without its faults: 

  • Most often, you’re not permitted to make any updates or customizations to the property.

  • You have to deal with a landlord and their rules for the home. 

  • You face unpredictable rent increases each time your lease is up for renewal unless your apartment is rent-controlled.

However, the biggest negative of renting is that you won’t be building equity. According to Apartment Guide’s 2020 Annual Rent Report, the average monthly rent for a one-bedroom apartment in 2020 is $1,617. Throughout a one-year lease, your rent payments would total $19,404. And while you may get your security deposit back, you will never see returns on your monthly rent.

When you purchase instead, the money you pay into your mortgage likely will come back to you in part or in full when you sell the home. 

When does it make sense to rent?

Homeownership isn’t for everyone. For some people renting might even make more sense for their financial circumstances. 

If you don’t know what your long-term plans are (you might go back to school, take a job promotion in another country, your job situation isn’t stable, etc.), and aren’t quite ready to settle down, renting is the best choice. 

Renting may also make sense for you if you cannot afford the monthly carrying costs of homeownership. Unlike homeowners, renters have no maintenance costs or repair bills, nor do they have to pay property taxes. You’re also avoiding the requirement of a sizable down payment—typically around 20% of the property’s value. 

What to consider before buying a home

For many American’s, owning a home can provide a sense of pride and freedom that can’t be matched by renting. When you own your own home, you aren’t required to follow a landlord’s rules, and your monthly housing costs are building equity. 

However, while purchasing a home is often the first step towards building long-term wealth, you must understand all the pros and cons before you take the plunge into homeownership.  

How much home can you afford? 

If you’ve decided that buying a home is right for you, the first step is to determine what you can afford. Understanding your financial limits will help you to focus your home search on properties within your price range, even before you apply for a mortgage. 

Affordability is determined based on a key rule that many personal finance experts agree with:

🏡 Rule: You should not take out a mortgage with a balance that is more than three times your annual household income or that results in monthly payments of more than 30% of your monthly income.

Don’t forget that if you have other debts, you have to consider them in addition to your monthly mortgage payment to determine how much you can actually afford. 

In most cases, a target affordable mortgage payment is built using calculations for principal, interest, and property taxes on a mortgage valued at three times your annual household income at market rates.

In high-interest rate environments or high property tax locations when buying a home that is 3x your annual household income would result in higher monthly payments, the alternative condition of 30% of monthly gross income would become the limiting factor.

Many factors can impact the overall cost of your mortgage. You should not back yourself into a corner and take on a mortgage you can’t afford. The top three factors that contribute the most to American’s struggling with a mortgage they cannot afford include:

  • A mortgage interest rate above the market rate.
  • Private Mortgage Insurance (PMI) payments.
  • Purchasing a home or taking out a mortgage that is greater than three times their annual household income.

Always keep in mind that your situation will ultimately dictate what you can genuinely afford, so be sure to refer to your financial plan for guidance. 

Down payments: how much should you pay?

Your down payment is a percentage of the purchase price that you pay up-front when you close your home loan. It plays a significant role in the home-buying process, as lenders often look at it as your investment in the home. 

Not only will it affect how much you’ll need to borrow, but it can also influence your mortgage’s interest rate. Putting at least 20% down on a home will increase your chances of getting approved for a mortgage at a decent rate, and will allow you to avoid the cost of PMI.

If your down payment is lower than 20%, your lender may require you to purchase PMI since they’re lending you more money to buy the home and increasing their potential risk of loss if the loan should go into default. Keep in mind that PMI will increase your monthly payments.

Be sure to truly consider what a higher or lower down payment means for you and your financial health. Is it worth it for you to pay PMI every month to gain the benefits of homeownership? Or would it make more sense for you to save for a sizable down payment and avoid PMI all together—even if that means waiting longer to buy a home?

Different types of mortgages: what’s right for you?

You can choose from several types of mortgage loans. Each has its own eligibility factors and down payment requirements. Keep in mind that mortgage lenders often differ in fees, closing costs, and the interest rate they’re able to give you. Be sure to shop around and get several quotes before making a final decision on brokers or lenders you’re willing to work with. 

Don’t forget to ask the potential lender about the down payment and any PMI you’d be required to pay as this will impact both your upfront and long-term costs as well. 

FHA loans

The Federal Housing Administration backs these loans. They require as little as 3.5% for a down payment and allow for credit scores to be as low as 500. However, they do require that you pay a premium for mortgage insurance over the time-span of the loan. 

Fixed-rate loans

The original and by far the most popular type of loan, a fixed-rate mortgage can come in 5-year, 10-year, 15-year, 20-year, 30-year, 40-year, and even 50-year timeframes—all of which are completely amortized. They come with fewer fees than FHA loans, but they also have more stringent credit requirements. Down payment requirements can vary, anywhere between 3% and 20%. 

 

VA loans

A VA loan is insured by the Department of Veterans Affairs and is only available to members of the military, veterans, and, in some instances, to spouses of these individuals. Depending on whether the discharge was honorable or dishonorable, these loans require no down payment or mortgage insurance. If you’re interested in learning more, check out these tips on how to get a VA loan.  

USDA loans

Guaranteed by the U.S. Department of Agriculture, USDA loans are only available to purchase properties that are located in designated rural areas of the country. They require no down payment, but you’ll have to pay mortgage insurance premiums. 

Other costs to consider when buying a home 

Your mortgage payment is only one small(ish) slice of the overall cost of owning a home. Beyond that, there are many others that you’ll need to budget for if you plan to buy, not rent. 

Here are the rest of the costs you’ll need to know about to ensure you’re financially prepared to be a homeowner. 

Mortgage interest rates

If you do choose to go down the path of homeownership, you’ll quickly become familiar with the concept of mortgage interest rates and what they mean for you. 

In layman’s terms, your interest rate is a percentage of your total loan balance and is essentially the lender’s compensation for allowing you to borrow money to purchase your home. It’s an extra amount that you’re required to pay every month, in addition to your principal payment, until your loan is paid off. 

The interest rate that you receive on your loan will have a direct impact on the size of your mortgage payment—higher interest rates mean higher mortgage payments. Mortgage interest rates can waver depending on the overall state of the economy, as well as the condition of your finances. 

Mortgage rates decrease when… Mortgage rates increase when…
The stock market falters.  The stock market is strong. 
There are dips in foreign markets. Foreign markets are strong and stable. 
Inflation slows.  Inflation is up. 
Unemployment is high.  Unemployment is low. 

As mentioned above, market and economic factors are not the only things considered when lenders are deciding on a possible mortgage interest rate. It also depends largely on your financial situation. Lenders will consider: 

  • Your credit score
  • Your repayment history and any collections, bankruptcies, etc. 
  • Your level of existing debt. 
  • Your income and employment history. 
  • The size of your down payment.
  • Your assets. 
  • Location of the property. 
  • The type of loan, the term, and its amount.

Overall, the riskier you are as a borrower, the higher your rate will be. 

When you begin the process of applying for a mortgage, you’ll notice that banks and lenders typically offer two types of loans:

1. Fixed-rate loan

With a fixed-rate loan, the interest rate is locked in and will never change. In turn, your monthly payment will remain the same for the life of the loan. Mortgage loans typically have a repayment life-span of 30 years, but shorter lengths of 10, 15, or 20 years are also an option. Keep in mind that while shorter loans will have higher monthly payments, they’re typically offset by lower interest rates. 

2. Adjustable-rate/variable-rate/hybrid loan

With an adjustable-rate mortgage (ARM), the interest rate isn’t locked in—therefore, the monthly payment will change over the life of the loan. Most ARMs have limits on how much the interest rate is permitted to fluctuate, as well as how often it can be changed. 

Keep in mind that while mortgage rates don’t directly impact home prices, they do heavily influence the supply. As mortgage rates rise, existing homeowners are less likely to list their homes for sale, driving up demand (and prices) for homes already on the market. On the other hand, when rates are low, homeowners are much more comfortable selling their properties. This, in turn, shifts the market to be in the buyer’s favor, meaning more options and negotiating power. 

Property taxes

As a homeowner, you’ll be required to pay property taxes—a tax set by the township, city, or county in which your home is located. Property taxes generate the revenue that states require to keep themselves up and running, while also providing necessary services to their residences. They fund schools, fire departments, and libraries, and can be a significant source of funding for your city or county.

This tax payment—assessed according to the value of your home—can easily total $500 to $1,000 or more a month. Sometimes, even more. You can choose to pay them as part of your monthly mortgage payment or in annual or semi-annual payments made directly to your local tax authority. 

Private mortgage insurance 

PMI is a policy that essentially protects your lender should you default on repaying your loan. It covers all or a portion of your remaining mortgage and is often required if your down payment is lower than 20%. 

Similar to any other type of insurance policy, you’re essentially paying a premium to cover damages should you find yourself unable to pay off your loan. Lenders consider that this is more likely to happen if you have less of an ownership stake in the home. 

There are both advantages and disadvantages to PMI:   

Pros Cons
May make it easier to qualify for a mortgage as it
lowers the risk you present to a lender. 
Increases your monthly loan payment. 
Allows you to make a smaller down payment.  May increase your closing costs. 
  Does not protect you if you fall behind on payments. 

HOA and condo fees

If you purchase a residence within a homeowners’ association (HOA) or a condominium association, you’ll be required to pay a monthly or quarterly fee. This charge covers costs for things that benefit the entire neighborhood or building, such as garbage collection, repaving the parking lot, or revamping common areas.

Homeowners’ insurance

Banks and other lenders often require you to have homeowners’ insurance before issuing you a loan. Bear in mind that premiums can and often do, rise annually, and do not cover “acts of God.” This means that you’ll need to purchase even more coverage against disasters such as floods, hurricanes, and earthquakes. Even water damage from heavy storms is rarely covered in a basic homeowner’s policy. 

Basic maintenance 

Unexpected maintenance—such as fixing a leaky faucet, patching a loose shingle, or paying for HVAC repairs—typically produces the highest bills. The best thing you as a future homeowner can do is to focus on padding your emergency savings. 

Some financial experts suggest budgeting about 1% or 2% of your mortgage balance as a yearly maintenance and repair fund, but the amount you decide to save depends on the age, condition, and actual size of your home. 

The pros and cons of home ownership

The National Association of Realtors (NAR) reported that the national median existing single-family home price in the second quarter of 2020 was $291,300. Are you prepared to make that type of financial and lifestyle commitment? 

If you’re ready to put down roots and are committed to staying in the same place for five years—or longer—home ownership could be the next step. You also have to be ready for the responsibility of being a homeowner, as it comes with much more financial responsibility than renting. Let’s take a quick look at some of the pros and cons of owning a home below.

Pros of owning a home

Benefits of homeownership include: 

  • Pride of ownership. This is often the number one reason why people want to own their homes. It gives you and your family a sense of stability and security while investing in your future.

  • Over the years, real estate has consistently appreciated in value. If you stay in your home long enough, there’s a very good likelihood you will be able to sell for a profit due to appreciation in the future.

  • Your equity grows as you pay down your mortgage. When you sell, you would likely get back every dollar you paid out and more, assuming you stay in your home long enough.

Cons of owning a home

Homeownership comes with negative factors of its own: 

  • Homeownership requires you to bear all the unexpected expenses. 

  • Owning a home is never risk-free. You may end up purchasing during a time that’s followed by economic decline, which directly affects your home’s value.

  • An expensive buy-in in the form of a down payment. 

  • You’re required to pay several thousand dollars a year in property taxes.

  • Homeownership creates roots, so you want to move, you’ll need to jump through more hoops than you would renting. 

What you should consider before purchasing an investment property

Real estate can be a sound investment if you take the time to educate yourself about the process and the best ways to get great returns. Evaluating the expected income, the expenses, the return, and the rewards and risks that come with the property can help you make the most of your investment.

Here’s what you need to know about investing in real estate to determine if it’s the right choice for you. 

Avoid borrowing to purchase

Many financial experts will warn you not to borrow money to purchase investments. Be sure to consider this before you move forward with a piece of investment real estate. If you can’t afford to pay cash for the home, at the very least, you should be able to afford the mortgage payments, even without the influx of rental income. 

If you can’t afford the mortgage payment without the rental income, it may end up being more of a financial burden, rather than a means of building wealth. 

Consider all your expenses 

Just as if you were purchasing a home for yourself, you need to consider the cost of taxes, utilities, upkeep, and repairs for investment real estate. Be sure to price your rental property accordingly, so that all these fees and other expenses are fully covered. 

Legal considerations

When it comes to rental properties and dealing with tenants, there are a considerable amount of legal obligations that are required of you as the homeowner and the landlord. As you might have guessed, these legal obligations often come with additional costs that you need to be aware of. 

In addition to the costs mentioned and outlined above, you may encounter legal issues with tenants that land you in less than ideal situations. Understanding how local, state, and federal regulations regarding discrimination affect your screening of potential tenants is also a good idea.

Start small 

Some first-time real estate investors begin by purchasing a duplex or a home with a basement apartment. They then live in one unit and rent out the other. This is an excellent way to dip your feet in the water, but keep in mind that you will be living in the same building as your tenant. 

Overall, be realistic with yourself and in your expectations. Similarly to any other investment, rental property won’t produce a large return right away—and picking the wrong property could be a serious hit to your financial plan. 

Making the final decision about renting vs. owning

As you determine whether you should buy or rent a home, you must familiarize yourself with all possible related expenses, and budget carefully before making a final decision. 

Keep in mind that your location will play a significant role in the process as well. A recent report from real estate and property data firm ATTOM Data Solutions shows that buying a home is more affordable than renting in just over half of U.S. markets. Conversely, renting is the more budget-friendly choice in 47% of markets. 

It’s clear that there are arguments for both renting and buying, but the decision is a personal one that should be made after careful consideration of your finances, goals, and needs as a household. Whether you already have enough saved to buy a home or you’re beginning to plan your next steps, be sure to consult your financial plan to ensure you prioritize financial stability. 

Your financial future starts today

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Article Author:
Claudia DoRego

Claudia DoRego

Claudia DoRego is a content marketer, currently working for Loopio, helping to support and maintain their brand’s voice across all channels. She is passionate about content creation and brand management for both tech and finance industries, and can often be found trying out a new recipe in her spare time. You can find Claudia on LinkedIn and Twitter.
Article Author:
Claudia DoRego

Claudia DoRego

Claudia DoRego is a content marketer, currently working for Loopio, helping to support and maintain their brand’s voice across all channels. She is passionate about content creation and brand management for both tech and finance industries, and can often be found trying out a new recipe in her spare time. You can find Claudia on LinkedIn and Twitter.

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