On the life decision scale, buying a home is often closer to marriage than it is to the purchase of a car. Buying a home can be one of the best decisions you make or something you bitterly curse forevermore.
And like marriage, buying a home is unique to the individual, requires you to try to predict your life for the next few decades, and depends on too many factors to summarize in one article.
But fortunately, with housing there are five fairly simple numbers we can look at, to help figure out when buying a home is clearly a bad financial idea. I’ve rank-ordered them, starting with…
1.Buying a home as a percentage of your income
The first and most important metric to check before buying a home is whether you can afford it. Duh, right? But believe it or not, too many people mess this up. Instead of thoughtfully considering what they can afford when buying a home, they go with whatever their banker tells them they’re approved for. Or blindly buy something comparable to a friend or rival. Big mistake! HUGE!
When buying a home, what you’ll mostly see online and from bankers is a rule of thumb to keep your housing costs below 30% of your gross income — basically, what your employer reports on your W-2.
For context, about half of renters and a third of homeowners with a mortgage fail to get to 30% or less when buying a home. But please don’t use “Tommy’s mom let him spend 50% of his earnings on a condo” as an excuse to overspend — remember, WAY too many people are pretty darn awful with their money. That’s why the majority of folks who receive Social Security depend on it (vs. income from savings) as their primary source of income.
When buying a home value your financial independence, get as far under 30% as possible. Under 20% is a tough goal in many housing markets, but if you can achieve that with a 30-year fixed mortgage, you’re probably in really good shape unless your income takes an unexpected hit.
What should you be saving? At a bare bones minimum, 10% of your gross income (ideally not including principal payments on your mortgage). A gold star if you can get to 20%. Using that $50,000 a year income, 10% puts you at $416 a month and 20% puts you at $833 a month.
If you’re buying a house that has you saving less than 10%, you’re either paying too much for the house or you need to reassess other expenses like transportation, vacations, food, child care, etc. Alternatively, you can think about how you can increase your income without proportionally increasing your expenses. That could include sharing the house with a renter.
Rules of thumb necessarily abstract away from your personal situation. A single person in their 20’s is treated the same as a couple in their 40’s with three kids. And there will always be compelling-sounding, I’m-a-special-flower excuses to put off saving till tomorrow. Regardless, though, living below your means should be an always-on phenomenon and the 10% savings minimum holds. That’s even more so the longer you wait.
While your housing costs as a percentage of your income helps you figure out if you’re spending too much on buying a home, it doesn’t tell you whether you should be renting or buying.
The price-to-rent ratio helps here.
When buying a home, simply take the price of the house you’re looking at and divide it by what you could rent it for on an annual basis. A qualified Realtor can provide these numbers for you and walk you through it.
Basicly, if a house costs $200,000 to buy and you could rent it for $12,000 annually ($1,000 a month), the price-to-rent ratio is 16.7.
I used this example because monetarily that 16.7 figure is roughly the indifference point between renting and buying. When you get much lower than 16.7, buying becomes more attractive. When you get much higher than 16.7, renting becomes more attractive.
Don’t get too carried away with the decimal places, though. There are many more financial and non-financial factors to consider, so 18.2 doesn’t mean an automatic rent and 13.7 isn’t an automatic buy. But at some point, the numbers get compelling. For instance, at 10 times rent, I’d be very tilted toward buying a home. At 25 times rent, I’d advise renting, rather than buying a home.
What might surprise you is the variability of the price-to-rent ratio, both across the nation and within metropolitan areas.
SmartAsset recently compiled the ratio by U.S. city. San Francisco tops the list at an otherworldly average of 45.9, over seven times higher than Detroit at 6.3.
If you live in high price-to-rent cities like San Francisco, New York, or my home area of Washington, DC, extreme caution is warranted if you choose to buy. Fortunately, even in these areas, there’s a lot of variabilities. In these “sellers’ markets,” you may use bargain hunting tactics — trolling less desirable areas, foreclosures, extreme patience — just to get to a somewhat reasonable price. Again, when buying a home, a proficient Realtor can be a great help in this instance. Or you may be better off renting. Nothing wrong with that… and don’t let anyone socially pressure you otherwise.
3.) Size of your down payment
“Mortgage” is just a fancy name for debt — usually buying a home will be the largest debt we’ll take on in our lives. Fortunately, the larger the down payment, the less scary that debt becomes – for both you and your lender.
That’s why lenders require you to pay private mortgage insurance (PMI) of as much as 1.5% of your original loan amount per year until your skin in the game (i.e. equity) reaches 20%. Make sure you understand what time of mortgage you have though. Recent changes on some types of mortgages do not allow the PMI to drop off after you reach your 20%. You would have to refinance the loan which is an additional expense.
Not paying that extra fee alone is reason enough to do a 20% down payment. But also remember when you are buying a home that you’re committing to 360 months of payments, so saving up 20% of the price of the house helps ensure you have the discipline to see it through, is a check against buying a home beyond your means, and is just a smart, conservative thing to do.
In fact, in an ideal scenario, you have 30% socked away before buying a home — 20% for the down payment and 10% as a cushion against unexpected expenses. A leaking roof or an unexpected electrical problem can eat into that cushion quickly. Having the proper home warranty can help reduce how much you need in an emergency fund.
On a $200,000 house, that means saving $40,000 for a down payment and an additional $20,000 as a cushion beyond your regular emergency fund.
If you think a 20% down payment plus a 10% emergency cushion is too onerous, consider that in the early 1900’s, down payments of 50% were commonplace. That’s $100,000 on a $200,000 house.
I’ll end this section with one real-world consideration that muddies the waters a bit. Folks who have a hard time saving for a down payment probably are poor savers in general. Those are also people who are often saved in retirement by the home equity they’ve built up for decades.
What this means from a practical standpoint for folks who have a hard time saving is that if you limit your housing costs when buying a home to a low percentage of your income and ensure that your price-to-rent ratio is also low, it may make sense for you to buy with a lower-than-recommended down payment. You’ll want to make darn sure that you have a good 10% emergency cushion in any case, though. It doesn’t do any good to “buy” a house only to have the bank take it back from you in a few years.
4.) What’s the least amount of time you’re committed to staying in the house?
The longer you stay in a house, the more advantageous buying a home is versus renting.
If you stay the full term, you’re locking in your mortgage payment against 30 years’ worth of inflation.
Meanwhile, every time you sell a house, you’re paying something on the order of 6% of the house price to real estate agents and then another 2% to 5% in closing costs. Not to mention any moving costs and potential double mortgage payments during the transition.
All-in, we’re talking something in the neighborhood of 10%, so $20,000 on a $200,000 house. That’s roughly as much as a late-model used car, five to 10 fantastic vacations, or maxing out your 401(k) for a year.
Also, on a 30-year fixed mortgage, you’re mostly paying interest in the early years. When you get a new mortgage or refinance, you reset the timeline.
For these reasons, a lot of people use five years as the minimum you’d want to stay when buying a home. That’s not an awful rule of thumb, but I’d likely push for an even longer time period when buying a home.
Let’s say a couple I’m friends with is interested in buying a home. Let’s say further that they know for a fact they are going to sell the house in five years — either because it’s a starter home or otherwise. Unless the price-to-rent ratio is amazingly low, I’d ask them to really think about whether the costs, risks, and pain of buying a home are worth it versus just saving up more money to buy when they’re ready to fully commit.
At 7 years, I get much more bullish on buying a home.
There is an exception and a caveat, though.
The exception: If you are willing and able to rent out your house to cover your mortgage, insurance, taxes, homeowner fees, maintenance, and any property management costs, it could make sense to buy at five years or even fewer.
Here’s one a lot of people don’t consider before buying a home. For obvious reasons, lenders give lower interest rates to people who have a strong history of paying back what they owe. On a mortgage, the difference can currently be as much as 1.5%.
On a $200,000 house with 20% down, that means someone with a credit score of 740 or higher (850 maximum) could save about $140 a month versus someone with a low-but-approvable credit score. $140 a month may or may not sound like a lot to you, but that’s a whopping $50,000 discount over the life of a 30-year mortgage.
For that reason, it may make sense to delay a home purchase until you can get your credit score to 740 or above. On a more game theory note, if you’ve had poor credit in the past, you may want to prove to yourself that you can handle a mortgage before buying a home. Living with foreclosure constantly hanging over your head isn’t the American Dream.
Could you come out ahead buying a home that costs you 50% of your gross income, that’s 30 times a comparable annual rent, and that sports a 5% down payment? Absolutely. And you could win a million-dollar game of Russian roulette, too.
But I wouldn’t advise it.
Getting safely on the right side of each of the five numbers we’ve discussed above — especially the first two — will get you far in disaster-proofing your buying a home.