Many Millennials are considering purchasing a house. And if you are looking to buy a home, you should consider first if renting a little longer is best for your situation and goals.
When evaluating whether to continue renting or buying a home, the usual debate goes like this: Buying allows for equity appreciation and tax advantages, but renting is generally cheaper and can carry less risk. As a renter, you could be investing the extra money not used toward a mortgage, property taxes, and home expenses in a diversified portfolio. Both points are equally valid.
But for most people, home ownership is much more than a money issue; it can be a significant goal you have set to achieve. And thus, emotions can run high. The reality is that purchasing a home isn't always better than renting. And renting doesn't always provide every convenience you may believe it does.
There are vital points to consider when deciding between renting or buying, and each has advantages and disadvantages. Those items are:
Can you afford the home?
Does owning a home fit into your ideal life?
Will you live in the house long enough to take advantage of homeownership benefits?
Buying a home is one of the most significant financial moves ever. You should be aware of many issues, including how the costs of purchasing and owning a home will impact your overall financial planning goals. In addition to this blog, I provide this checklist to help you organize your thoughts surrounding your home purchase. Download the list here.
First, Determine If You Can Afford a Home
Before deciding whether to rent or buy, you must know the answer to one crucial question: "Can I afford to purchase a home?" The answer depends on your situation. Some key areas to consider include:
Your current savings and cashflow
Your credit score score
Your debt-to-income ratio
What is Your Current Savings and Cashflow?
Savings are the first step. Before you go into debt, you must ensure the basics are covered. First, an emergency fund must cover at least three to six months of your essential living expenses. You need to have this fund intact before purchasing the home, and it needs to still be there after the purchase (aka, purchasing a home is not a reason to use your emergency fund). This emergency fund should reflect your future expenses when accounting for the new house. The emergency fund isn't just to cover unexpected costs – it's to provide for you if you lose your source of income. Without an emergency fund, you may need to take on credit card debt, take out a loan, or sell investments. These options harm your financial wellness, so having an emergency fund with three to six months of living expenses is critical.
The next big savings goal is the down payment. It's possible to get a mortgage with as little as 3.5% down (or even 0% in some instances). But such a small down payment requires an additional monthly cost – private mortgage insurance (PMI). A down payment to cover the standard 20% down will save you the cost of PMI and save you money in interest over the life of the mortgage. But for some folks, this 20% down payment can be a heavy lift. If you choose to have a less than 20% down payment, carefully review your pro forma budget, which helps you understand how your expenses will fit within your income and goals.
Is Your Credit Score Healthy?
The better your credit score, the lower the interest rate you'll pay, which means the less you'll spend in interest over the life of the loan. For example, the difference between a 3% interest rate and a 4% interest rate on a 30-year $500,000 mortgage is slightly more than $100,000. One percentage point difference may not seem like a lot, but it is. Attaining the best rate possible in a rising interest rate environment is crucial. Building a good credit score and delaying a home purchase long enough to improve your financial situation can mean saving tens of thousands of dollars over the life of your mortgage.
What is Your Debt-to-Income Ratio?
Debt-to-income is the percentage of your monthly income that goes towards debt payments. Lenders use it to determine your trustworthiness and reliability as a borrower. In other words, if 30% of your monthly income goes towards credit card payments and car notes, your debt-to-income (DTI) ratio would be 30%. Lenders want to see as low of a DTI ratio as possible. Your DTI should be around 25-35% or lower when trying to get a mortgage.
But if you're a business-minded entrepreneur, you may approach home ownership differently. If you're starting your business without a partner that has consistent W-2 income, it can be challenging to qualify for a mortgage. You generally need two years of solid financials if self-employed and receiving 1099 income. You may also not want to sacrifice extra cash for a down payment. Carefully consider using this extra cash to get your business off the ground. Remember, owning a home typically carries additional risks over renting. As an entrepreneur, you are already taking a significant risk starting a business. So carefully consider your financial resiliency.
Does Owning a Home Fit into Your Ideal Life?
Outside of the financials, you need to consider your feelings and life. Do you enjoy renting because of the flexibility and the convenience? Do you feel you'll be stuck in one location once you buy a home? How does owning a home fit into your ideal life?
Answering questions like these is one of the best ways to get to the root of your decision. Always ask yourself the "why" behind wanting—or not wanting—to buy or rent. When it comes to a lifestyle decision like the difference between buying and renting, finances are only one factor to consider.
Two Important Items to Consider
You don't plan to move anytime soon – The general rule of thumb is that if you plan to live somewhere longer than five years, it can make sense financially to buy. Choosing to move sooner than five years can cost you money as you won't have built up any equity in the home, and closing costs will not have amortized over a long-term mortgage.
The tax benefits are beneficial to you – There are several deductible home expenses. If you are married and filing jointly, you can deduct up to $750,000 of mortgage interest if the property is your primary residence. Depending on your situation, you may also deduct up to $10,000 of state and local property taxes. Depending on your income level, you may also be able to deduct PMI. If you are self-employed, you can deduct expenses such as repairs, utilities, mortgage interest, real estate taxes, and more per the percentage of the home the office space occupies.
The Takeaway
As you can probably tell, there's no one-size-fits-all answer here. The decision between renting and buying is more than running the numbers and seeing which option is most cost-effective. We all know decisions require personal reflection. A financial planner can help you discover some of the more profound reasons behind wanting to rent or buy and ultimately help you make the right decision that aligns with your goals and values.
Do you need help strategizing your home purchase goal? Feel free to place a commitment-free 30-minute meeting on my calendar. We can discuss your goals and begin best optimizing your financial plan in that meeting.
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