Housing Affordability

Housing is one of the most important topics in personal finance as buying a home is typically the largest purchase that you will make in your lifetime. In this article we’ll discuss the pros and cons of renting versus buying, provide a calculator to determine if renting or buying makes the most sense based on your local housing market, and discuss the best mortgage option for you if you decide to buy. By reviewing the pros and cons of renting compared to buying as well as using the calculator below I hope you can make a more informed housing decision and improve your personal finances.

Renting vs. Buying?

To start with let’s look at the largest pros and cons of homeownership compared to renting.

The biggest pros for homeownership:

  • Building wealth through home price appreciation and paying down the principle in your mortgage loan. It almost doesn’t need to be said, but you will build wealth as you pay down the principal as well as through home price appreciation. While home price appreciation is not guaranteed over shorter time periods, over the long-term U.S. home prices tend to appreciate at a higher rate than inflation. The below chart shows the percent change in U.S. home prices and CPI since 1988, with U.S. home prices appreciating at an average of 3.8% per year compared to inflation of 2.6% per year during that time frame.

FRED

Source: Federal Reserve Bank of St. Louis

  • Inflation hedge. By locking in your housing costs for the period of your mortgage, you benefit from higher inflation. For example, if your income increases by 2% per year over 10 years, your housing costs would fall by 18% relative to your income. If your income increases by 5% per year for 10 years, your housing costs would fall by 39% relative to your income. Additionally, higher inflation should lead to higher asset prices including real estate, although the correlation has not been very strong over the past 30 years.
  • Sense of pride in homeownership. The intangible benefits of homeownership are difficult to quantify. They can include the pride of homeownership, the joys of working on home improvement projects as well as greater day-to-day enjoyment stemming from major renovations.

The biggest cons for homeownership:

  • Reduced financial flexibility. As a homeowner, your financial flexibility is reduced as your housing expenses are fixed for the life of your mortgage, typically 30 years. Additionally, your liquidity is substantially reduced as a result of needing to put down a large down payment. You could always sell your home if necessary, but that entails large transaction costs of typically around 6% of the sale price.
  • Typically increases the correlation of your wealth and income. Unless you work 100% remotely, buying a home in an area near where you work will further concentrate your wealth and income in a particular geographic region. For example, if you lived and worked in New York City during the financial crisis, you experienced substantial home price declines, investment losses due to declining equity markets, and potential income losses due to the substantial number of layoffs in that region. While this is clearly an extreme example, unfortunately, we are also seeing many similar examples play out as a result of the COVID-19 epidemic. This correlation is a hidden risk that most people don’t consider when buying a home.
  • Responsible for maintenance costs, property taxes, and homeowners insurance. As the homeowner, you are explicitly responsible for a number of expenses that renters don’t have to pay for such as maintenance and repairs, water utilities, property taxes, and homeowner’s insurance. While homeowners explicitly pay these costs, renters ultimately pay these costs as rents are set to account for property tax, homeowners insurance, and maintenance and repairs.

The biggest pros of renting:

  • Increased financial flexibility. If buying a home reduces your financial flexibility, renting clearly increases your financial flexibility as you don’t need to put down a large down payment and you have greater optionality to reduce your living expenses by finding a cheaper place to rent in your local area or moving to a lower-cost location. Additionally, if you can keep your rent much lower than your mortgage payment would be, you can invest the difference and build wealth accordingly. Also by renting you can reduce the correlation between your wealth and income.
  • Don’t need to explicitly pay for repairs/insurance/taxes. While a landlord pays for maintenance as well as insurance and taxes, the renter ultimately incurs those costs indirectly over time. Landlords will set rent to pay for these costs, which many people don’t realize. Nevertheless, as a renter, you don’t have large unexpected costs coming up such as replacing a boiler or repairing a roof.

The biggest cons of renting:

  • Lose from higher inflation. Housing costs are not fixed, so typically renters lose out when inflation increases, as higher inflation leads to higher rents. Also, renters don’t benefit from home price appreciation, which also typically increases with inflation as noted above. As a renter, you would hope for lower inflation locally. On the other hand, when you rent, you typically don’t benefit from higher inflation as your higher income likely translates into higher rents in your local area. In higher-cost areas, we’ve seen rental inflation substantially outpace increases in income.
  • Not building wealth. While buying a home can lead to serious wealth building as described above, renting clearly does not have those direct benefits. I noted above how renters can benefit from not having to put down a large down payment and
  • Dealing with landlords. We’ve probably all dealt with challenging landlord situations, so I’ll keep this brief, but as a renter, you clearly have much less control over your housing space and may need to deal with difficult landlords. Unfortunately, this is nearly impossible to know upfront and it’s difficult to quantify the peace of mind from owning a home and not needing to deal with a landlord.

Housing affordability differs substantially across the U.S.

To make the comparison between renting and buying meaningful we need to compare the Price/Rent ratio in your local area. The price/ratio compares the median home price in an area to the median rent in that area. Housing affordability varies substantially across the U.S, and this metric is a useful indicator to gauge the relative attractiveness of renting compared to buying for a particular location. For example, the price/rent ratio was at 5 in Detroit compared to 53 in San Francisco. This implies that buying a house in San Francisco is 10x more expensive relative to local rents than buying a house in Detroit! Ratios between 1-15 indicate that buying is more attractive in that market, a ratio of 16-20 indicates that there is not a substantial difference between renting and buying, and a ratio above 21 indicates that renting is more favorable.

price rent ratio

Rent vs. Buy Calculator

Calculator Instructions

Enter ages as whole numbers.

Enter dollar amounts without the dollar sign. For example, for $10,000 you would enter 10,000.

Enter percentages as decimals. For example, for 2% enter 0.02.

There are many inputs listed below to be comprehensive. Feel free to leave an input blank.

Input values, click "Calculate" button for results.

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How big of a mortgage should I take out?

So assuming you have decided to buy a house, how much of a mortgage should you take out? Banks will typically allow your monthly mortgage payment (principal, interest, homeowner’s insurance, and property tax) to make up upwards of 28% of your gross income. In other words, you can borrow up to 3.6x your gross income. Spending 28% of your gross income on your mortgage is equivalent to spending 45-50% of your after-tax income on your mortgage payment. This of course doesn’t include other home-related expenses such as utilities and ongoing maintenance and repairs, which would bring your all-in housing costs to well above 50% of your after-tax income. That is way too much leverage to take on in my opinion, unless you have a substantial investment portfolio to rely on for your monthly mortgage payments.

In determining how much you can borrow, I like to focus on after-tax income, as you can’t avoid paying taxes. Taxes are the definition of a non-discretionary expense. Personally, I would target no more than 25% or your after-tax income spent on your monthly mortgage payment. After factoring in utilities and other maintenance and repairs this should bring your all-in housing expense to around 30-35% of your after-tax income. Using these ratios will give you a large enough margin of safety should your income decline, and will allow you to save a substantial portion of your after-tax income. I fully acknowledge that following these guidelines is challenging in many markets including some of the higher-priced cities that are listed in the chart above. The percent of your income that you spend on housing should decline over time even if your income increases at the same rate as inflation, as I described above.

Prior to refinancing we spent around 22% of our after-tax income on our monthly mortgage payment and around 26% after accounting for utilities and expected maintenance and repairs. After refinancing, we’re down to spending 17% of our after-tax income on our monthly mortgage payment and around 22% of our after-tax income when accounting for utilities and expected maintenance. At these ratios, we have enough cushion in our budget to be able to save a substantial amount of our after-tax income. This situation is not feasible for most people, and I appreciate how lucky my wife and I are to be in this situation.

What type of mortgage should I take out?

Lastly, there are many different types of mortgage products available, but the two main types are fixed-rate and adjustable-rate. A fixed-rate mortgage has a fixed interest rate for the life of your mortgage, which is typically 10, 15, or 30 years. As a result of the fixed-rate, your mortgage payments will be the same for the duration of the loan. Fixed-rate mortgages are the most popular product with over 75% of mortgage loans being fixed rate.

The other major type of mortgage is an adjustable-rate mortgage (ARM), where the interest rate will reset every year based on an index, typically LIBOR plus a spread. Most adjustable-rate mortgages will also have a fixed rate feature, where the interest rate will be fixed for a set number of years. For example, a 10/1 ARM will have a fixed interest rate for the first 10 years and then will adjust on an annual basis for the remaining life of the loan. There is also a lifetime cap on the potential interest rate that the ARM can adjust to. For example, the adjustable-rate cap might be 7.5%. Additionally, there are caps on how much the rate can increase in any year, which could be 2%. While ARM’s involve greater uncertainty once the interest rate becomes adjustable, they are also offered at lower interest rates for a fixed period of time. For example, a 30-year fixed mortgage might be offered at 3.25% while a 10/1ARM is offered at 2.625% and a 7/1 ARM is offered at 2.5%. A couple of other key points are the fact that as a homeowner you benefit from higher inflation as discussed above. So even if your ARM does reset higher, that would be due to the fact that interest rates are higher due to stronger economic growth and higher inflation. As a result, you would likely benefit from a higher income and a higher home value. However, I want to be clear that it is not guaranteed that your home will increase in value and that your income is much higher, and that in a worst-case scenario your mortgage payments would increase without an offsetting increase in income.

While most people opt for a fixed-rate mortgage, an ARM may be a better choice for you if the interest rate differential is large enough and depending on other aspects of your financial situation. For example, if you are buying a starter home and only plan to live there for 5-7 years, a 5/1 or 7/1 ARM could make more sense as you would be paying a lower fixed rate for the first 5 or 7 years. An ARM might also make sense if you have the means to pay down your loan faster, do to a high income or substantial savings. For example, my wife and I recently refinanced to a 10/1 ARM at 2.625%, a rate that is at least 0.5% lower than for a traditional 30-year fixed-rate mortgage. Over the next 10 years, we will save at least $38,000 from lower monthly payments by choosing an ARM and will have paid down an additional $17,000 of principle due to the lower interest rate. By applying the monthly savings to our monthly mortgage payments we will have paid off an additional $60,000 of principle over the next 10 years compared to a 30-year fixed-rate mortgage. Additionally, my wife and I plan on paying off the mortgage over the next 10 years.

To summarize, if you plan on staying in your home for more than 10 years and do not anticipate paying off the loan quickly then a traditional 30-year fixed-rate mortgage probably makes the most sense, especially considering that mortgage rates are at historically low levels. On the other hand, if you plan on spending less than 10 years in your home or have the means to pay down the mortgage aggressively than an ARM could be a better product for you. Additionally, if you have enough cash and available liquid assets to aggressively pay off the mortgage than an ARM makes a lot of financial sense. Personally I would not choose an ARM unless the interest rate was at least 0.5% lower than a traditional fixed-rate mortgage, to account for the additional risk of an ARM. As shown below, 30 Year fixed-rate mortgages are effectively at all-time lows, so you may not be able to find a more attractive rate from an ARM product.

primary mortgage market survey


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