Can I afford to buy a house? Should I continue to rent? What if I plan to buy and rent it out later?
Three of the most common questions I receive from Driven members.
Living in three of the most expensive cities in America – New York City, Washington DC, and now San Diego – I’ve asked myself these questions as well. The rent we pay in these cities relative to the square footage seems criminal.
“Rent feels like throwing money away. At least with a home I will be building equity.” I hear this all the time.
Most of us are extremely ill-informed when it comes to real estate. How much experience do you have buying a home? I think most people inadequately evaluate and plan for a home purchase. Sold on the American dream for a long time now, many are concerned interest rates are going up and they want to take action before it’s “too late.” This is probably why almost 70% of millennials are unhappy with their real estate decisions.
I want to arm you with resources to ensure you find yourself living the American dream and not stuck in a regrettable real estate nightmare.
What can I afford to buy?
Let’s start with what lenders want to see:
- Maximum household expenses (principal, interest, taxes, insurance) should be below 28% of your gross monthly income.
- Total household debt (add credit cards, car payment, etc) should be below 36% of your gross monthly income.
The reality is that what’s good for the lender may not necessarily be good for the borrower. After all, lenders lend money assuming that at least some people will default, and that the rest will do ‘whatever it takes’ to repay the loan, even if that means significantly curtailing lifestyle. In other words, lending guidelines are based not on fiscal prudence, but the maximum amount of pain the borrower is anticipated to tolerate without causing mass defaults!
We don’t want you experiencing your maximum threshold of pain.
Should I continue to rent?
I want to acknowledge that while buying a home is a huge financial investment, there are certainly other factors that come into play. For example, buying the perfect home to raise your family, with the perfect yard, in the perfect school district, with the perfect commute, etc. In this case, you might not really care if you make or lose money on the home as an investment. The qualitative factors of the real estate could outweigh any financial outcome.
I will move to the readers most interested in the financial aspect. Those trying to determine if it is more appropriate to buy or rent.
One of my favorite concepts is BURL (Buy utility, rent luxury) by Sam at Financial Samurai. A little long, but definitely worth the read.
Sam argues a prudent rule to follow is “to pay no more than 100X the monthly rent as the purchase price.” This is also referred to as the 1% rule.
Everyone living in a coastal city just threw their hands up in disgust, but stay with the idea. Sam reviews a detailed analysis in evaluating a prospective property in the rent vs. buy decision. You can review his entire analysis in the article, but some additional factors to consider are taxes, insurance, maintenance and the opportunity cost of the down payment.
Savvy real estate moguls may correctly point out that the real estate may appreciate by greater than the opportunity cost of the down payment Sam uses, which would more than offset the cost value in the calculation. This is fair, but, you could just as well encounter an unexpected depreciation in value. Simply ask anyone that purchased during the last cycle high. Being conservative with the math seems more advantageous to me.
Even if you don’t necessarily agree with 100x as your barometer, you can now calculate the appreciation you need to realize in order to get a good return on your investment. You’ll likely be surprised at just how often renting is more beneficial.
What if I plan to rent the home later?
You can still start with the 1% rule, just vary it slightly – “Does the monthly rent equal one percent of the purchase price or more?”
In addition to the 1% rule, you can get more detailed in your evaluation when renting. This is my favorite article that outlines the alternative valuation methods. To summarize, Pant explains the cap rate as well as cash on cash return calculations. If you’re thinking of renting, do yourself a favor and read the entire piece.
While the three articles included in this post are terrific resources, a home transaction is likely one of the largest financial decisions you will ever make. If you currently own a home and are interested in renting, or are thinking of buying and wondering what makes the most sense based on your financial goals, reach out to Driven to schedule a free consultation. We can evaluate your personal circumstances and walk you through the pros and cons so that you can make an informed financial decision for you and your family.