Though they could fall farther, housing prices are starting to seem reasonable again in many parts of the United States. Mortgage rates are cheap, too. Naturally, that means some GRS readers are beginning to express an interest in buying a home.
But prices are still high in a lot of places — including Washington, D.C., which is where William lives. He recently dropped a line to ask for advice: He'd like to buy a home someday, but prices are too steep. What should he do?
My friends and I all read Get Rich Slowly. We're all saving for retirement through various tax-incentivized accounts, and we all live in the Washington, D.C. area. We all have one question that's becoming more and more important: How on earth can any of us possibly buy a home?
- The one-bedroom house I'm renting with my girlfriend has an asking price of around $300,000, and is pretty small — around 600 square feet. If we wanted to buy it, that'd be a $60,000 downpayment.
- We just looked at a 2-bedroom condo — it was well over $500,000, or a $100,000 downpayment. That's the sort of place we might want eventually, but the prices are ridiculous.
- Before we moved in together, she was living in a studio condo which she could have bought at below market value for only $100,000, which is a $20,000 downpayment. That's the first downpayment where the amount doesn't utterly boggle my mind — and it's for a studio!
Together, my girlfriend and I make about $7,000 each month (after taxes). That may seem like a lot, but it doesn't seem to go far in D.C. If I took five years to save for 2-bedroom downpayment, I'd need to save $1600 a month. Even if I split it in two, that's still $800 per month per person. That's close to our rent payment, and is more money than I lived on throughout college and grad school.
That's also more money than the $1500 we currently save each month, so we'd not only need to go through lifestyle deflation, but we couldn't save for anything else. As near as I can tell, we'd have to put all of our extra dollars towards the project for several years. Is that what's supposed to happen?
Help! How can anyone afford a home with prices like these? Do you know of any good answers? Do the readers?
First things first: When housing prices are high, the smart move is to rent. Though renting fell out of favor during the middle of the past decade, there's no shame in it. In fact, a lot of times, it's the financially sensible move.
Earlier this year, I wrote an article that tried to answer the question, “Does renting make sense?” Because it's directly relevant to William's question, I'm going to quote part of it here.
Renting by the numbers
One way to tell whether it's better to rent or buy is by looking at the price-to-rent ratio (or P/R ratio). This number gives you a rough idea whether homes in your area are fairly priced.
Though it may sound intimidating, figuring a P/R ratio isn't too tough. All you need to do is:
- Find two similar houses (or condos or apartments), one for sale and one for rent.
- Divide the sale price of the one place by the annual rent for the other. The resulting number is the P/R ratio.
For example, say you find a $200,000 house for sale in a nice neighborhood. You find a similar house on the next block for rent for $1,000 per month (which works out to $12,000 per year). Dividing $200,000 by $12,000, you get a P/R ratio of 16.7.
What does this number mean? Writing in The New York Times, David Leonhardt says, “A rent ratio above 20 means that the monthly costs of ownership will exceed the cost of renting.” That's a little opaque, but what Leonhardt means is that the higher the P/R ratio, the more it makes sense to rent — and the less it makes sense to buy.
During the housing bubble, the national P/R ratio came close to 20 (and went far above that in some cities). In other words, you could rent a $200,000 house for $10,000 a year (or just over $800 per month), which is a pretty good deal.
The normal range nationwide is between 10 and 14 (meaning it would cost between $1200 and $1600 to rent a $200,000 house). During the 1990s, just before the housing bubble, the national P/R ratio was usually between 14 and 15 (about $1100 to $1200 to rent a $200,000 house).
Another way to gauge the cost of housing is to compare it to your family's income. From 1984 to 2000, median home prices were about 2.8 times the median yearly family income. (In other words, the typical house cost about three times what a family earned in a year.) During the early 1970s, home prices were about 2.3 times median family income. During the housing bubble, this ratio jumped to 4.2.
These numbers don't mean a whole lot on their own, but they can give you some sort of idea whether housing is overpriced in your area. Plus, it seems safe to assume based on past figures that most families can comfortably afford a home that costs about 2.5x their annual income. (So, if your family makes $80,000 a year, you can afford our theoretical $200,000 house.)
Washington, D.C., in an expensive city. I'm guessing that William and/or his girlfriend are tied to their jobs there, and that the jobs can't be done from elsewhere in the country. This is usually the case.
However, if owning a home is important to you and prices are high, sometimes the best financial decision is to move elsewhere. This is especially true if you have a job you can do from a cheaper part of the country. Geographic arbitrage is a great way to live rich.
In my case, Portland is expensive, and I could write from anywhere. Maybe North Dakota, for example. But my wife's job isn't portable, and she loves the place she works. (Plus, we can afford our home.) So, we'll stick here for now.
Saving for a down payment
Finally, William worries that if he wanted to save for a down payment, it'd take him years. “Is that what's supposed to happen?” he asks. Usually, yes. According to U.S. government data, housing is by far the largest expense in most people's budgets. It can take a decade to save for a down payment!
Sometimes, you can buy a home for very little down. My wife and I bought our first house for something like 3% down (or $3,300) in 1993, for example. But this brings on added complications, not the least of which is private mortgage insurance, which is required if you don't have at least 20% equity in your home.
For most people, the smart way to buy a home is to make a big down payment. And that usually means saving for years at a time. From the stories I've heard, though, this can be treated very much like a debt snowball, where the saver pursues this one goal — a down payment — with fanatical vigor.
Enough theory! What would you do if you were in William's situation? If you've been in a similar spot in the past, what choice did you make? Should he give up on the idea of ever owning a home? Should he be patient and save? Or should he pack his bags and move to North Dakota?
Author: J.D. Roth
In 2006, J.D. founded Get Rich Slowly to document his quest to get out of debt. Over time, he learned how to save and how to invest. Today, he's managed to reach early retirement! He wants to help you master your money — and your life. No scams. No gimmicks. Just smart money advice to help you reach your goals.