MONEY buying a home

When You’re Better Off Renting A Home Than Buying One

141017_REA_RentingOverBuying
Dennis MacDonald—Alamy Phoenix, Arizona.

Today it typically costs less to buy a place than rent one, but exceptions exist. Your situation may be one of them.

It remains cheaper to buy than rent in every one of the country’s 100 largest metro areas, according to new Trulia research. In fact, homeownership nationwide has actually become a sweeter deal, coming in on average 38% cheaper than renting today, compared with 35% one year ago, thanks to falling mortgage rates and rents rising faster than prices.

Just how much cheaper it is to buy than rent varies by area, coming in at 17% cheaper in Honolulu and 63% in Detroit (find the data for all 100 metro areas here). But those figures were calculated assuming the buyer used a traditional 30-year fixed rate mortgage with a 20% down payment. Yet there may be good reasons for financing a home purchase other ways, particularly if you’re a first-time buyer without savings or equity from another home. Or maybe you want to pay all cash in hopes of beating out other bidders in a competitive environment. Are you still better off in most cities buying than renting if you use these non-traditional payment options?

The Pros and Cons of Different Types of Mortgages

Let’s look at how the different payment options play out for a $250,000 home that the owner sells after seven years. To keep things simple, let’s start out ignoring closing costs, home price appreciation, tax benefits, and many other things we do account for when we add these scenarios to our full Rent Versus Buy model, below.

  1. A traditional 20% down, 30-year fixed-rate loan on a $250,000 home would carry a $990 monthly mortgage payment, including principal and interest. After seven years, the unpaid loan balance is $173,291, leaving equity of $76,709.
  2. All cash is just what it sounds like. You pay $250,000 upfront and that’s all equity at the end.
  3. For a 15-year fixed-rate loan, you still put 20% down. The average mortgage rate on a 15-year fixed-rate loan is almost a full point below that of the 30-year fixed rate. But the shorter term means a higher monthly payment of $1,428. The payoff is that the 15-year loan builds equity much faster: $130,507 after seven years.
  4. A 10% down payment loan with private mortgage insurance requires less money upfront. But the higher initial loan balance means a larger monthly payment plus a mortgage insurance premium of $133 per month. Furthermore, the lower down payment and higher loan balance leave equity of only $55,048 after seven years.
  5. A 3.5% Federal Housing Administration (FHA) loan calls for a down payment of only $8,750 but requires upfront and ongoing mortgage insurance premiums. The higher initial loan balance means equity of just $38,748 after seven years. That’s about half what you’d have with a traditional 20% down, 30-year loan.
Understanding the Financing Options
For a $250,000 home Traditional 20% down, 30-year fixed All cash 15-year fixed, 20% down 10% down, private mortgage insurance 3.5% down FHA
Down payment $50,000 $250,000 $50,000 $25,000 $8,750
Monthly payment (incl. mortgage insurance) $990 $1,428 $1,247 $1,441
Equity at 7 years (no appreciation) $76,709 $250,000 $130,507 $55,048 $38,748
Note: Monthly payment is principal, interest, and mortgage insurance premium. Mortgage rates for the traditional 20% down 30-year fixed (4.30%), 15-year fixed (3.48%), and FHA (4.00%) loans are from the Mortgage Bankers Association for the week ending October 3. We use the same rate for a 10% down payment loan as the traditional 20% down payment rate, based on current rate quotes. Monthly payment includes mortgage insurance calculated for the first year of the loan. For FHA loans, the insurance premium falls over time but remains on the loan; the FHA upfront premium is rolled into the loan balance. For the 10% down loan, we assume insurance gets taken off when equity reaches 20%. All dollar amounts are rounded to the nearest dollar.

When deciding whether buying still beats renting with each of these financing options, the math gets complicated. For starters, the benefits of each option depend on how you would invest your money if you weren’t buying a home – that’s the “opportunity cost.” In addition, other factors, such as whether you itemize your tax deductions, also affect the relative benefits. Our Rent Versus Buy model factors all this in. So let’s see the results.

When Buying Is an Even Better Deal – And a Bad Idea

Remember that buying is 38% cheaper than renting nationally under our baseline model of a 20% down payment 30-year loan, tax deductions at 25%, and staying in the home seven years. Under all five of these non-traditional financing options, buying still beats renting. The gap is widest for the 15-year loan, where it’s 43% cheaper to buy. It’s narrowest for the 3.5% FHA loan, where buying is 25% cheaper.

mortgage type graphic

 

The 15-year loan ends up costing the least versus renting thanks to faster equity build-up and more of the mortgage payment going to principal rather than interest. Surprisingly, all-cash is a worse deal than a traditional 20% down, 30-year mortgage, although that hinges on our assumption about what you could earn if you didn’t tie up your money in an all-cash payment. (Geeks: we’re assuming a 3.5% nominal discount rate.) In addition, if you pay all cash, you lose the tax benefit of deducting mortgage interest. If you assume tax deductions aren’t itemized, there’s no tax benefit of getting a mortgage, which makes all-cash a better deal than a traditional 20% down, 30-year fixed rate mortgage.

The biggest shift is with the 3.5% down FHA loan, which makes buying only 25% cheaper than renting. In one of the 100 largest metros, Honolulu, buying with a 3.5% FHA loan is actually more expensive than renting. And, with this loan, buying beats renting only by 10% or less in San Francisco, New York, Los Angeles, and several other California metros.

Going further, it’s not hard to come up with realistic scenarios where buying costs more than renting in many local markets. For a millennial with little savings and no Bank of Mom and Dad, an FHA loan might be the only option. If our hypothetical twentysomething is not in a tax bracket that makes itemizing worthwhile and only stays put five years (those young people are restless), buying ends up costing more than renting in 27 of the 100 largest metros. Those 27 include not only pricey coastal markets, but also in markets like Phoenix, Las Vegas, and Colorado Springs. On the expensive coasts, it’s not even close. For instance, in this scenario, buying costs 30% more than renting in Orange County. Thus while an FHA loan might be within reach for many first-timers, in many costly parts of the country, it doesn’t make buying cheaper than renting. Our interactive map shows this for all the 100 largest metros:

 

blogpost map no 2

So, to buy or to rent? Falling mortgage rates and rising rents mean that buying looks even better versus renting than one year ago, especially in California. But buying is not for everyone. If you live in a market that’s a close call, and you plan to stay less than seven years, don’t itemize your tax deductions, or need an FHA loan, buying might not be the clear-cut winner, and could end up costing far more than renting.

To see the full post, including rent vs. buy figures for the 100 largest metros as well as methodology details, click here.

To read more from Jed Kolko of Trulia, click here.

Related:

MONEY 101: Should I rent or buy?
MONEY 101: What mortgage is right for me?

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