Unless you know the future, buying a new home can feel like a gamble.
You’re betting you’ll have the money to pay the mortgage every month for decades. You’re also betting you can afford the taxes, the insurance premiums, and the home maintenance.
If something goes wrong and you can’t pay, your lender could kick you out and sell your home to someone else. Or, if you couldn’t afford to fix a major problem, your home could lose value or become unsafe.
Renting a home seems a lot less risky.
Renting vs. Buying: A Comparison
You should listen to these fears, to a point. Home ownership is a big responsibility. You shouldn’t buy a home without first considering all the costs.
But for most people, home ownership costs less than renting in the long run. In the short term, though, you may see only the costs of buying a home: Down payments, lender’s fees, a home inspection, appraisals, closing costs — these fees create hurdles to home ownership.
Clearing these hurdles will be worth the effort if you keep the home long enough to capitalize on your investment.
How long does that take? The answer depends on your break-even point.
Finding Your Break-Even Point
In every home transaction, there’s a break-even point. Before you reach the break-even point, it will make more financial sense to rent. After the break-even point, you’ll save more by buying, and your savings can grow with each passing year.
To determine your break-even point, compare your buying costs to rent prices for a comparable home in your area.
Let’s look at an example: a $200,000 home financed at 4 percent interest for 30 years with a 10 percent down payment. With such a home your monthly payment would be about $860. We’ll add $100 for insurance, $100 for taxes, and $60 for repairs to get your payment up to $1,100.
Let’s compare this purchase to a similar home rented for $1,500 a month.
|Time in Home||Renting Costs||Buying Costs|
|After Year 1||$18,000||$35,200|
|After Year 2||$36,000||$48,400|
|After Year 3||$54,000||$61,600|
|After Year 4||$72,000||$74,800|
|After Year 5||$90,000||$88,000|
|After Year 6||$108,000||$101,200|
|After Year 7||$126,000||$114,400|
As you can see, after the fifth year in this example, you’d start to save money by owning the home. Before the fifth year, you’d save by renting.
We’ve kept things simple for this example on purpose. In reality, your rent would probably increase a couple of times within seven years, making the total rent cost even higher. Likewise, in the buyer’s cost column, you may need to consider a big home repair or a property tax increase.
Break-even points vary. Depending on the rent amounts in your area or the amount of your down payment, you could break even as soon as the second year. In other cases, it may take 10 years to break even.
If you’re not sure you plan to stay in the area for long, it’ll be worth your time to determine your break-even point before buying.
A Bigger Benefit of Buying vs. Renting
Homeownership eventually pays off in most markets if you’re planning to stay in the home indefinitely. But so far we’ve talked about only out-of-pocket costs.
In addition to saving money in the long run when you buy, you can also amplify the power of the money you’re spending because a home is an investment:
- Property Value: Historically, real estate prices increase over time. The value of your home should increase along with the overall market. If you keep the home for 40 years, it could be worth significantly more than you paid for it. Selling the home could help fund your retirement.
- Benefits of Ownership: As a homeowner, you can live rent-free, or you can charge someone else rent to live in your home. When you’ve paid off the mortgage these benefits will kick into overdrive because you’d no longer be making a house payment.
When you rent, your monthly rent payments create these same benefits for someone else: your landlord.
Initial Costs of Buying a Home
As you’re deciding whether to buy a home, consider the up-front costs. They seem intimidating, but paying them can lead to more financial stability in the future if you stay in the home long enough to cash in.
Your mortgage lender will probably require you to spend some of your own money along with the money you’re borrowing to buy your home. Lenders call your portion a down payment.
A subsidized loan may require only 3.5 percent of the home’s price as a down payment. For a $200,000 home, 3.5 percent would equal $7,000. A conventional loan may require 10 to 20 percent down. Veterans can usually get a loan with no money down.
Paying a down payment requires money out of your pocket, but the money applies directly to your home purchase, meaning you can borrow less.
There are other ways to come up with a down payment, or ways to finance a higher percentage, but you’ll end up paying for it down the road at some point.
Expect to pay a loan origination fee of at least 1 percent of your loan amount. Additionally, your lender may charge to appraise the value of your new home. Appraising the home makes sure your loan doesn’t exceed the value of your home.
Unlike your down payment, these costs will not go toward your home’s purchase.
Then, there’s the biggest lending fee of all: your interest charges. The interest you pay gets added to each month’s house payment. The higher your interest rate, the more you’ll pay. You can lower your interest charges by paying off the home early.
Your real estate agent will receive a sales commission that’s already included in the sales price. A typical commission is 6 percent of the home’s selling price.
After the home’s sale, your agent will split the commission with the seller’s agent. If only the seller has an agent, the seller’s agent could claim the entire commission. If neither party has an agent, there’s no commission. The seller will keep that money or will lower the sales price which means you keep it.
A Realtor may also ask you for earnest money. This is a mini-down payment which tells the seller you’re serious about buying the home. Earnest money can range from $500 to a couple thousand dollars. Ultimately it goes toward the purchase of the home.
Before finalizing your purchase, get the home inspected from the roof to the basement and everywhere in between. If the home has structural or safety issues you’ll want to know before buying it.
The cost of a home inspection can vary among markets, and it will depend in part on the size of your home. An inspection will cost around $500.
You’ll need to work with an attorney to finalize your home purchase. Paying the attorney for his or her time and for other legal fees such as researching the home’s deed will add a few thousand dollars known as closing costs.
Sometimes the buyer and the seller split closing costs. You’ll have to work this out when you enter a contract to purchase the home. As a buyer, you should expect to pay some if not all of the costs. It’s possible to finance closing costs in with the mortgage loan, but doing so adds to your debt.
Ongoing Expenses of Homeownership
Once you’ve closed on the home and started making payments, the costs of home ownership start to balance out. As the years go on, you’ll pass the break-even point. Owning the home will make more and more sense.
But you’ll still have costs to manage:
Most counties and cities charge property taxes based on the value of your home. New homeowners often add this cost to their monthly house payments by using an escrow account managed by the mortgage company.
The taxes you pay support:
- Public Safety: Your community’s police, fire, and emergency medical personnel likely get paid through your property taxes.
- Public Education: Even if you don’t have kids in your area’s public schools, we all benefit from a better educated society.
- Public Parks: Your area parks and street maintenance make your neighborhood more livable and can add to your property values.
Your homeowner’s insurance premiums can also be added to your monthly house payments.
Getting insurance is a no-brainer when you own a house. For a couple thousand dollars a year you can buy protection to replace your entire home or fix major damages from storms or fires.
As a homeowner, you can’t call the landlord when the AC breaks down or the sink won’t drain.
To prepare for a major repair, you should start a savings account and set aside $100 a month or so. You could also borrow money for home repairs, but paying outright gives you more control.
Some homeowners use home warranties to control repair costs, especially for appliances and major systems. But warranty contracts can be confusing and frustrating. If the seller throws in a warranty, that’s great. But check it out closely so you’ll know exactly what to expect.
For a major repair, renovation, or addition, consider a home equity loan. Equity loans give you access to the value within your home without you having to sell the home. Give yourself a few years to build equity before considering this kind of borrowing.
As the homeowner you’re also responsible for maintaining the home, inside and out:
- Lawn Care: Will you hire a lawn care company? Even if you don’t, you’ll have to buy your own mower and other equipment.
- Pest Control: In warmer climates, paying a professional pest control company could be a good idea.
- Professional Cleaning: You can save money by cleaning the house yourself, but if you don’t have time, a professional service can help. Some homeowners call in the pros once or twice a year to get everything sanitized and sparkling.
How Much Should You Spend on a House?
All housing-associated costs — the mortgage, the taxes, and insurance, the maintenance and repairs — will be higher when you buy a bigger or more valuable house.
The location of your home will determine your home’s value, but the size of your home and lot will also impact the price.
As you shop, look for a home large enough to meet your needs within your price range. Conventional wisdom says you shouldn’t pay more than 25 percent of your monthly budget on housing costs.
You may need to adjust this general rule depending on the reality of your life:
- Other Major Debt: If you have a lot of extra student loan debt, or if you pay child support or private school tuition, you may need to spend less on housing.
- Few Other Commitments: Someone with very few bills may be able to dedicate more money to housing.
- Goal-Based Investing: If you’re determined to buy a home in a specific area because you expect increases in market value, you may be willing to spend more.
Finding a home within your budget will increase your ability to keep, maintain, and improve your property which will help your investment pay off.
Bottom Line: A Home and an Asset
Home ownership isn’t for everyone. Temporary residents should almost always rent. If you’re not sure how long you’ll live in a city, find your break-even point so you can get a better idea about the costs of renting vs. buying.
But if you plan to live in the area for the foreseeable future, buying a home can make your monthly housing money go a lot farther. As the years pass and you continue to make payments, you’ll be moving closer to owning the home outright.
When you get there, you’ll have a home of your own and a big financial asset to build on in the future.