July 3, 2017

Should I Buy a House? Pros and Cons

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Is owning a house right for you? It depends on your mindset, financial situation, and future goals. We help you figure out if you're ready to buy.

Once you know these factors, you can decide what's right.

Read on to learn what to consider when buying or renting.

Buy Now or Keep Renting?

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Renting doesn't always mean throwing money out the window. For some, renting is the right choice. It depends on the circumstances.

Real estate may provide a good return on your investment. It may bring a loss too. Just look back at the housing crisis in 2008. No one predicted the loss millions of Americans would take.

In a perfect world, you'd know if buying or renting was right for you. Ideally, you should buy a home and have money left for investments. Many homeowners sink most of their money into their home, though. This means they must forgo traditional investments. Being at the mercy of the real estate market isn't ideal. But we don't live in a perfect world either.

Luckily, your return on investment isn't the only factor. Unless you can predict the future, you must consider the factors below. Honest answers can help you put the pieces together. Looking at the big picture can help you make the right decision.

First, ask yourself the following questions.

Questions You Should Consider

  1. Do you have enough money saved?
    You need a lot of money to buy a house. It's not just for the down payment either. There are also closing costs. You'll want liquid savings too.

    Do you have money for a down payment? Traditionally 20% of the purchase price is ideal. You can put down less. If you do, you'll pay for mortgage insurance. This makes your mortgage payment higher. Can you afford the higher payment? Do you want to throw money at insurance premiums for several years? You'll never recoup the costs of PMI, so give it careful thought.

    Don't forget closing costs. You'll need at least 3-5% of your loan amount in closing costs. You pay them in cash at the closing. On a $200,000 loan, you could owe as much as $10,000 in closing costs.

    Do you have an emergency fund? Owning a home means you need more money saved. What if something goes wrong with the house? There's no landlord to handle the issues. It's up to you. Use your salary as a benchmark. Try saving at least 3-6 months of your salary before buying a home.

  2. Are you in debt?
    Debt lowers your chance of taking out a mortgage. Lenders look at your debt ratio. This is your gross monthly income compared to your monthly debts. The lower your DTI, the higher your chance of approval.

    For example, conventional loans require a maximum 28/36 debt ratio. 28% of your income can cover your mortgage payment. 36% of your income can cover your total monthly debts.

    Even if you can get a mortgage, you must prioritize your finances. Do you have a lot of credit card debt? Do you have student loans? Taking on a mortgage puts these debts on the back burner. You'll likely make minimum payments. Do you want these debts lingering for many years?

    Prioritizing your finances helps you decide between renting and buying. Paying your credit card debt down first may be ideal. You might be able to afford more home and won't overpay on interest charges for the next few years.

  3. What are your plans?
    Owning a home means stability. It also makes it harder to move on a whim. Consider your plans for the near future.

    Do you have a steady job? If it's a new job, you might not know. If it's a job you've held for years, you'll have a better idea. Does your company relocate employees? Do you see a promotion occurring soon? These factors can affect your ability to stay put.

    Are you involved in the community? Setting down roots often means you'll stay put longer.

    Do you like moving around? Some people just like moving. If that's you, renting may be a better option. Buying and selling a home is costly. We discuss how long you should live in a home you buy below.

  4. Are you ready to sacrifice your lifestyle?
    Owning a home often means sacrifice. Consider the potential mortgage payment. Can you comfortably afford it? If not, what would you have to give up? Consider the implications of giving it up. If it's a big sacrifice, you may regret owning a home.

    Not sure what you spend? Track your spending for a few months. Keep track of every penny. Then categorize your spending. Dining out, shopping sprees, salon trips, fast food, and coffee stops are some of the most common lifestyle splurges. Of course, you'll have your own categories as well.

    Once you know where you overspend, try living without those things for a few weeks. How does it feel? If it bothers you too much, you might be better off renting.

  5. Do you know the true cost of owning a home?
    Owning a home means more than paying principal and interest on your mortgage. You'll pay real estate taxes and homeowner's insurance too. You may also have homeowner's association dues. This is just the start.

    Maintaining a home costs money. Utilities, yard work, and furnishings cost money. These are the everyday expenses. You should account for unexpected repairs as well. Estimating around 3% of the price of your home for annual maintenance usually suffices.

Now that you've covered the basics, you should look at the opportunity cost of buying a home. We discuss this next.

Opportunity Cost

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Opportunity cost is the value of the opportunity you give up. In this case, you opt to buy a home rather than rent.

For example, you put money down on a home. What if you rented and invested that money? You may make a greater return on your investment. The return on the invested money is your opportunity cost. It's money you gave up to buy the home.

Consider these things when choosing between buying and renting:

  • The difference between the cost of renting and your potential mortgage payment
  • The amount of your down payment
  • The amount of interest you'd pay over a set period, say 5 years

These are the largest measurements of opportunity cost.

For example, if your mortgage payment is higher than your rent, you have an opportunity cost. What would you have made if you invested the extra money?

The same principal applies to your down payment money. Let' say you put down 20% on a $200,000 home. That's $40,000. What could you have made if you invested that money? It's your opportunity cost.

Lastly, don't forget about interest. Not the rate, but the money you pay over the life of the loan. Your mortgage disclosures tell you the total interest you'll pay. Look at the total interest over a few years. If you rented, you wouldn't pay interest. You could use this money elsewhere. It's now your opportunity cost.

Opportunity cost may be harder to judge in some cases. You can't predict your return on investment in stocks or bonds. What if you had a loss? These are just benchmark considerations you should keep in mind.

In the end, you'll look at the big picture - all factors considered.

Why Buy Now?

So now you've asked yourself the important questions and measured your opportunity cost. Measure them alongside these compelling reasons to buy now.

  • You can build equity and have an emergency fund.
    Buying a home is a long-term investment. It doesn't give an instant return. You build equity with each mortgage payment you make. Your amortization table shows you the exact amount of principal and interest paid each month. Each principal payment increases your equity.

    Amortization Schedule: A table showing how each monthly payment affects your loan. You'll see how regular payments decrease the principal over time.

    Don't focus strictly on your ROI, though. You also build a somewhat liquid savings account. Your equity is like a secure savings account. Once you owe less than 80% of the home's value, you can tap into the equity.

    Tapping into your home's equity requires a home equity line of credit. It works much like a credit card. You have an available balance. You can use as little or as much as you have available. When you pay back the principal, you can reuse it. You can also let it accumulate as equity.

  • You receive tax benefits.
    Your tax liability doesn't decrease when you rent. It may when you own a home, though. Rent doesn't carry interest. Mortgages do. In many cases, you can deduct the mortgage interest on your taxes.

    You must live in the home as your primary residence. The interest should be on a 1st mortgage too. Interest on home equity loans is sometimes deductible. It depends on the reason you use the mortgage. Funds used for home improvement may be tax deductible.

    Keep in mind, though, that you don't receive a dollar-for-dollar credit. Instead, you receive a portion of what you paid back in taxes. Your tax advisor can give you the details for your situation.

  • You can make your house a home.
    Owning a home means you can do what you want to it. There's no landlord calling the shots. You can make many changes without anyone's approval.

    Paint, cosmetic changes, and even new appliances are your decision. You can rearrange and remodel as much as you like.

    Even if you own a home, the city may need to approve any structural change. Renting means you can't do any of these things, though. You must live in the home as it is in most cases.

Why Rent

Renting is sometimes the better choice for people. Whether you aren't ready emotionally or financially, there are some good reasons to rent.

  • You aren't staying in the area long.
    Most people agree you should stay in a home for at least 5 years to make it worth your while. You usually make back what you paid for the home within 5 years. Not the entire principal, but the costs involved in a home purchase.

    We discussed closing costs above. They could total as much as 5% of your purchase price. You won't get them back if you sell the home. If you stay at least 5 years, you should recoup these costs in appreciation and decreased principal.

    It also takes a few years before you start paying down the principal. You'll notice a large fraction of your initial payments cover the interest. As you slowly pay the principal down, you pay less interest. You then pay more principal than interest.

    If you sell the home before you recoup these costs, you may lose money on the deal. Your opportunity cost increases even more in this case.

  • You have bad credit.
    Getting a mortgage if you have bad credit isn't impossible. But it can be expensive. Sometimes renting is the better option. Renting gives you time to fix your credit. You might not need that expensive mortgage then.

    If you buy, you could spend most of your money on the home. This may leave little money for your other bills. If you can't fix your credit, the bad credit could haunt you for many years.

  • You don't want the responsibility of owning a home yet.
    You don't pay maintenance, taxes, and utilities when you rent. You only have one thing to worry about - paying the rent. The landlord handles everything else. The money doesn't come out of your pocket.

    If you don't have an emergency fund or down payment funds set aside, you can do that while renting. This may give you the opportunity to save for a bigger down payment. This could mean a lower mortgage payment in the future.

How Much Can You (Really) Afford

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Once you decide to buy a home, you have other decisions to make. Among the most important is how much home you can afford. Banks will tell you the maximum amount you qualify for. It may be more than you can afford.

Before taking the full amount, consider what you really can afford.

  • Consider the actual cost of homeownership.
    A prequalification only takes into consideration the principal, interest, taxes, and insurance. You should consider other costs.

    The standard upkeep and sudden repairs are a couple of things. You also have furnishing and home d├ęcor to consider.

    Don't take the prequalification amount at face value. Truly consider how it affects your budget. How much money is left after you pay everything? Don't forget utility bills and other home-related bills.

    Can you afford new furnishings and appliances? Can you keep the house up and fix what breaks? Create a budget just for homeownership so you can see what you really can afford.

    Rule of Thumb: Budget 1% of your home purchase price toward ongoing maintenance. For example, if your house cost $250,000, you should budget $2,500 each year for maintenance. Don't be tempted to use this fund if nothing happens that year. You might be surprised at how much it costs to repair a home. Even a basic roof replacement can cost $6,725 and up.

  • Consider your future plans.
    If you are buying a home, chances are you plan to stay for at least 5 years. But consider your personal goals.

    Are you a 2-income family now? Will it remain that way for the foreseeable future? Many couples start with 2 incomes but go down to 1 after having a baby.

    Do you have big plans for your professional future? Opening a business or changing careers can affect your ability to afford a mortgage. Think ahead to at least the next 3 to 5 years to determine what's right for you.

  • How big is your emergency fund?
    You should have at least 3-6 months of a mortgage payment set aside. You shouldn't need this money for any other purpose. It protects you should you lose your job or have any other issue occur.

    Being able to pay your mortgage for 3-6 months can help you prevent foreclosure. Basing the mortgage you can afford on the size of your emergency fund helps you keep things affordable.

Don't just look at housing expenses either. You should include your consumer debt. Credit cards, auto loans, and student loans play a role in what you can afford. You can't neglect your other debts. Remember the debt ratio we discussed above? That plays a role in what you can afford.

Want to Buy? Watch Out

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If after careful consideration, you still want to buy, consider the following before making the purchase.

  • Your house is not an investment.
    It's a place to live. Investments are stocks and bonds. They sit in a portfolio. Compare the money you put in your home and money invested in stocks or bonds. Is a large majority in the home? Does this mean your portfolio is a majority of real estate investments?

    You might get lucky if you buy low and sell high. Consider it a bonus, though. Don't rely on the gains as income. You never know what may happen.

    Ideally, no more than half of your portfolio should consist of real estate. The other half should include stocks, bonds, and non-risky investments.

  • Don't become house-poor.
    A house-poor person is someone who puts all of their money into their home. They take the largest loan available. Once in the home, the homeowner can no longer afford the costs of daily living. Every penny goes to the home.

    Striking the perfect balance, as we discussed above, helps avoid this from happening.

  • House prices continue to rise.
    The housing crisis brought housing prices crashing down. Luckily, they have come back. The bad news, though, is that they keep rising. No one knows just how much more they'll increase. Don't get caught up in a bidding war or in buying a home you can't afford.

    Stay smart and only buy what you need. Buying a home can be an emotional process. You fall in love with a home and will do whatever necessary to purchase it. This cycles right back to becoming house-poor. Don't do it.

Renting or buying is a personal decision. Some people benefit from renting. Others want the status of being a homeowner. Whether it's a smart decision or not depends on many factors. Lay it all out on the table and consider your options. Only then can you decide what is right for you.

More from CreditDonkey:


How Much to Buy a House


Buying Your First Home


How to Save for a House

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