To Buy or Not to Buy
Is renting or buying a house the better option? For decades, becoming a homeowner was synonymous with “making it” here in America. Today, the US Homeownership rate has dropped to its lowest level in 50 years indicating that “making it” may not mean the same thing to everyone. While there can be many factors that contribute to this statistic, the question of buying or renting is a decision that isn’t as easy as it once was…
Similar to an investment strategy, the question of buying or renting is a highly personal one. Over the past few months, many of our clients have asked us to help them decide between buying or continuing to rent. This question becomes even more important if you live in an expensive city where your monthly rent or mortgage payment could equal over half of your take home pay. If you’re in the market to buy a house, we want to arm you with the knowledge you need to make an informed decision. A recent survey showed that 63% of millennial homeowners regret their first home purchase! We don’t want you to be part of this statistic, so we’ll lay out both the macro and micro arguments to help you make the decision whether buying or renting is best for you right now.
To begin, it’s important to briefly understand the context of the housing market at this very moment -- because timing is (almost) everything. First, like most markets, the housing market is cyclical - meaning it goes up and down over time. The period between the highest high and lowest low marks one cycle. The best time to invest in real estate is at the beginning of a cycle when interest rates are low, housing prices have fallen and incomes are growing. As the cycle nears its end, interest rates are climbing and housing prices have crept up for several years, making it more difficult to buy. It’s been ten years since both the housing market and the US stock market rebounded from the Great Recession. Although we can’t predict the future, it’s safe to say that we are in the later stages of a cycle that began a decade ago.
In addition to considering the current state of the housing market cycle, the answer of whether you should buy or rent depends on your current lifestyle, your job security, and how long you plan on living in your new home. If you have inconsistent earnings, a not-so-good credit score, a job that could relocate you, or you have a dream to spend a year traveling around the world - then it probably isn’t the right time to buy a house. Alternatively, if you’ve decided that the city or town you live in is one you want to put roots down in, where rent is pricey, and you have sufficient savings beyond your emergency and retirement funds, then it could be a good idea to consider buying.
Let’s first discuss all the reasons why you should continue renting.
REASONS FOR RENTING
Flexibility and freedom: Imagine a big life event - like going back to grad school, moving for a job, getting married, starting a family - that may require you to pack up and move to another city. Moving only a year or two into paying down your mortgage could cost you tens of thousands more than renting. You may be saving for the day when you can pack up and take off traveling around the world for a year. Studies have shown the millennial generation now values travel more than they value owning a home. If you’re a renter vs an owner, it is much easier to break a lease or wait until a year-long lease expires than it is to sell a house.
Avoiding the costs of homeownership: Apartment owners escape much of the costs associated with homeownership. If you buy a house, in the first year you’ll have to fork up a hefty downpayment (20% of the value) plus closing costs. In the first year and every year thereafter, you’ll pay mortgage interest, annual property taxes and any costs needed to maintain your home...which can all add up. The median home price in California today is $525,000. If you were buying a home in California and put 20% down, you’d have to have $105,000 saved for the down payment. If you don't save enough for a 20% down payment (which is what Mana recommends), your lender will likely require you to make mortgage insurance payments (also known as Private Mortgage Insurance or PMI) or you might be considering mortgage protection insurance, making your monthly payments even more costly. As a renter, you call your landlord who will pay for a plumber if your sink springs a leak or if your showerhead needs to be replaced. And if you live in a gated community or condo complex, the owner - not you - is on the hook for things like Homeowner’s Association dues.
More money to invest for your future self: How much could that $105,000 grow if invested over the next twenty, thirty, or forty years? Without a big downpayment to save for, you could put away more for your future - like in retirement. Unlike our parents, most of us can’t count on a pension or the guaranteed income of Social Security to rely on for retirement funds. If you are 40 or younger, your personal retirement savings are likely to be all you have to live on. If you save and invest more for retirement instead of using your money for a home down payment, there is a good chance you would receive a better return on your investment. In fact, according to recent research from Florida Atlantic University, renting and reinvesting the savings from renting, on average, will outperform owning and building home equity, in terms of wealth creation, for the first time since 2010.
If all these reasons build a strong enough case for you not to buy, then it might make more sense to keep on renting. However, there are just as many compelling reasons why it could be a great idea to buy a house instead of renting. Arm yourself with all the facts from both sides before making a decision.
REASONS FOR BUYING
Home is where the heart is: There can be psychological benefits to feeling that the home you own belongs to you and/or your family. Many homeowners are proud that they can pass down a valuable asset filled with memories to their children someday. For others, owning a home can signify ultimate stability. My childhood was filled with impermanence. After my biological father left us, my mom, sister and I bounced around motels and temporary housing - sometimes spending nights in our van when money ran extremely low. For me, buying a house signified a place to plant roots that never had the chance to be planted before. It was the first step towards my vision for financial freedom, but it doesn’t have to be that way for everyone.
An investment you can live in: Some people think of their home as both an investment for their future and a place that they can call home. If the value of your home increases and amounts to more than you’ve paid in mortgage, interest, taxes, and maintenance over time, you’ve earned a return on your investment.
Ownership: When you pay off your home, it’s yours. If you have the resources to take on a 15-year fixed rate mortgage, you could own your home free and clear in 15 years. You could save tens of thousands of dollars with a 15-year mortgage over a 30-year mortgage. How would it feel to have no monthly mortgage payment after 15 years?
The possibility of a future income source: Let’s say you purchase your home, live in it for five or more years, and then move out because you need more space or you’re moving to a new city. If you don’t need to sell your home just yet, you could explore renting out your home for either the short or long term to create an additional stream of income. Depending on the state of the rental market at that time, you may be able to use that rent to pay most if not all of your mortgage payments. Remember to seek professional tax advice before you make this decision. Once your first home isn’t your primary residence anymore, it will be treated differently when it comes to taxes.
Reduction of your tax bill: If you are a high income earner and want to create more deductions, various tax breaks help offset some of the cost of homeownership. However, some of these lost some of their luster in the Tax Cuts and Jobs Act of 2017 (read the next section for more details).
California specific long term hold + intergenerational benefits: In California, there are several Propositions that exist to provide preferential tax treatment to homeowners. In the late 1970s, hyperinflation was causing home prices to increase so significantly (50-100%+ year over year) that individuals were unable to pay their property tax bills at the higher valuations. Proposition 13 was passed in 1978 and limits the amount that the property tax assessment can increase on an annual basis to 2%. Proposition 8 was passed the same year and allows for reassessment of property values in a declining market. Lastly, Proposition 58 & 193 permit parents and grandparents to pass on property to their kids when they die without a tax reassessment at an unlimited property value assessment for their primary residence and up to $1 million for other real property.
CHANGES TO THE TAX LAW YOU SHOULD CONSIDER BEFORE BUYING A HOUSE
If you’re a high income-earner in a high income tax or property tax state, it’s likely that you’re interested in buying a home because it can help you save on your tax bill. If reducing your tax bill is a major reason why you’re buying, read on to understand how the Tax Cuts and Jobs Act of 2017 (TCJA) may have an impact on any future tax bill.
Less reasons to itemize. Beginning in 2018 the standard deduction went from $6,500 to $12,000 for individuals and from $12,000 to $24,000 for Married Filing Jointly. To take advantage of any home purchase-related deductions, you must itemize on Schedule A and you’ll only make that choice if your itemized deductions exceed the new higher thresholds. Early estimates have shown that only a little over 10% of the 150 million households in the United States will benefit from itemizing their deductions in 2018.
If you do choose to itemize, you’ll likely be able to deduct less…
...In mortgage interest - If you itemized your deductions on Schedule A before the TCJA, you could deduct qualifying mortgage interest for home purchases of up to $1,000,000 plus an additional $100,000 for equity debt. The $1mm cap applied to a mortgage on your primary residence in addition to one other home. If you take out a mortgage after December 15, 2017, you are capped at a home price of $750,000 of which you can deduct mortgage interest. The new law also further limits this to “acquisition debt”. You can only deduct the interest payments you make towards your home equity line of credit if you use the funds to “buy, build, or substantially improve your home”. If you live in a city where real estate prices have sky-rocketed - like San Francisco or Seattle - these changes could have a dramatic effect on the amount of mortgage interest you can deduct.
...In State and Local Taxes - Another attractive itemized deduction for those of us living in high income tax or property tax states is the State and Local Taxes deduction (known as SALT). Before the TCJA this deduction was unlimited and included a deduction for the amount of state tax, real estate tax and personal property tax you paid in the previous year. If you live in states like California, New Jersey and New York, this itemized deduction amounted to tens of thousands of dollars for some. Post-TCJA, this deduction is capped at just $10,000, creating much less of an incentive for new homeowners in these states.
...And no more deducting PMI - In 2007 Congress passed a law that allowed Private Mortgage Interest on both your home and vacation home to receive the same treatment as mortgage interest. As of the time of this writing in March of 2019, this deduction has expired and you can no longer deduct the monthly PMI amount- just another reason why Mana recommends putting the full 20% down! As mentioned earlier, if you don’t put 20% down, lenders will typically require you to pay Private Mortgage Interest monthly on top of your monthly mortgage payments.
As you can tell, it’s important to know the devil in the details and seek the help of a financial professional like a CFP® or CPA to fully understand the ramifications of buying a home. Additionally, the New York Times published an incredibly detailed calculator in 2014 for consumers to better understand the numbers behind the decision. Note that the ‘Taxes’ section has not been updated to reflect the new tax law, so you’ll need to factor in the limits to the allowed deductions mentioned above.
BEFORE YOU BUY, EVALUATE YOUR SITUATION
Now that you understand the fundamentals of the “To Buy or Not to Buy” argument, you’ll want to work through your personal situation and evaluate if the numbers makes the most sense for you. If you’re a Mana client, we work with you to arrive at the numbers.
Finally, if you do decide that buying a home is in your future, be sure that you have all or most of the following:
Excellent credit - that means a score of 750 or more. An excellent credit score is essential to getting the best mortgage terms. In other words, better credit will save you money.
A steady income - if you don’t have a reliable source of income, lenders will be less willing to take the risk of lending you money and may penalize you with a higher interest rate loan if you do qualify.
A downpayment of 20% or more - PMI will add extra, non tax-deductible costs to your monthly mortgage payment.
An Emergency Fund of at least 3 months of expenses - Saving for a down payment shouldn’t come at the risk of not having this cushion of cash. If you’re a married couple with only one source of income, then your emergency fund should be closer to 6 months of expenses.
A monthly mortgage payment that’s 30% or less of your take home pay - To minimize regret, your target should be a mortgage payment you can handle. And don’t forget about the continued monthly savings you’ll need for maintenance and repairs which you’ll be responsible for. It’s a good idea to plan to spend anywhere between 1-3% of your home’s purchase price each year in home maintenance and repairs.
A plan to stay in your house for at least 5 years. The upfront costs - inspectors, realtors, closing costs, moving, furnishing - will inevitably equate to more than renting would cost in the first few years of homeownership. However, if you annualize those costs and spread them out over the number of years you stay in a home, the more it makes sense to buy. Plus, the longer you stay, the more your monthly payments will be going to paying down your mortgage debt (instead of paying for interest).
If you’d like to buy a house and meet this criteria, congratulations - you’re well on your way to becoming a homeowner. If not, don’t worry, it may be a wise decision not to buy. Wherever you’re headed, creating a long-term plan, understanding the details and mapping out the steps to get there is a sure path to get you there sooner.