Is it better to rent or buy? How to know when renting a home makes sense
I've been a homeowner for 24 of the last 25 years. Based on this, you might think I'm an advocate of homeownership over renting. That's not the case. The older I get, the more I appreciate there's no correct answer in the perennial “is it better to rent or buy?” debate. Sometimes buying a home makes the most sense. Sometimes renting is the smarter choice.
In an editorial in the June 2007 issue of Kiplinger's Personal Finance, Knight Kiplinger wrote, “It often costs less to rent. The annual cost of owning a property, be it a house or a condo, is usually greater than the cost of renting, after taxes.” I agree.
Today, let's look at a handful of ways to evaluate the rent versus buy decision from a financial perspective.
The Price-to-Rent Ratio
One way to tell whether it's better to rent or buy is by calculating the price-to-rent ratio (or P/R ratio). This number gives you a rough idea whether homes in your area are fairly priced. Figuring a P/R ratio is simple. 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. But 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 well exceed the cost of renting.” That's a little opaque, I know. Leonhardt is saying that the higher the P/R ratio, the more it makes sense to rent — and the less it makes sense to buy.
The normal P/R ratio 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). During last decade's housing bubble, national price-to-rent ratios rose to 22.73 (in 2005) then to 24.50 (in 2007) before the market collapsed. As most folks were rushing to buy homes, the numbers said they ought to be renting.
Based on this info, I'd argue that:
- When price-to-rent ratios are under 12, it's generally better to buy than to rent.
- When price-to-rent ratios are between 12 and 15, the financial decision is murky.
- When price-to-rent ratios climb above 15, you're probably better off renting.
Nationwide numbers don't tell the full story, of course. While the national price-to-rent ratio might be around 20, the actual numbers in your city could be very different.
Price-to-Rent Ratios for U.S. Cities
In the past, I've struggled to find current price-to-rent ration figures. Recently, however, I learned that Zillow has a dedicated page for researching housing data. From here, you can download tons of different tables related to home sales and rental prices, including monthly price-to-rent info from October 2010 until today. If you're looking to relocate, this is a fantastic resource for finding where your housing dollars will go farthest!
For kicks, I wasted ninety minutes playing with price-to-rent ratios using Zillow data. (What can I say? I'm a nerd!) I downloaded their list of median home prices and median monthly rents, then calculated the P/R ratio for 48 major metro areas. (For a variety of reasons, this is a somewhat arbitrary selection of cities.) Here's my list of price-to-rent ratios in the United States as of January 2018.
If you're moving to Scranton for your new job at Dunder Mifflin Paper Company, it's likely you'll want to purchase a home. But if you're headed to the Bay Area, your best bet is going to be to rent.
I'm somewhat skeptical that these numbers are accurate — they do come from a site eager to create homebuyers, after all — but it's tough to find better info. As far as I'm aware, there's no reliable source that generates these stats on a regular basis. (I personally believe numbers from articles like this are more accurate. However, that article is also eighteen months out of date and doesn't explain its methodology.)
Please note that city-wide price-to-rent ratios only really matter if you're moving from another town. Otherwise, what actually matters are price-to-rent ratios for the specific properties you're thinking of buying or renting.
Home Price vs. Household Income
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 may not 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 a $200,000 house.)
According to the most recent numbers from the U.S. Census Bureau, the median household income in the United States was $57,617 at the end of 2016. (Average household income is greater — $73,207 — but that number is skewed by high earners, which is why I prefer to use the median.)
Using the current U.S. median home price of $232,700, we can see that home prices are currently running at about 4.04 times the typical household income. This ratio isn't quite as high as it was during the housing bubble, but it's still pretty steep. Based on this, renting is likely to make the most sense right now in many parts of the country.
My Favorite “Rent or Buy?” Calculator
Finally, I want to share what might be my favorite way to compare the costs of renting against the costs of buying.
The New York Times has a great rent vs. buy calculator that can help you decide which is best for you. Just plug in the numbers for your situation, and the calculator tells you how long it would take you to break even if you bought a house. This calculator is an amazing tool. Although it lives behind a soft paywall (which can be circumvented using incognito mode in your browser), it's well worth using if you're trying to make a decision about whether to rent or buy.
For fun, I ran the numbers for my own situation. Last summer, Kim and I purchased our current home for $442,000. When you figure all of the remodeling we've done, our actual cost will be closer to $600,000. (Holy cats!) Based on our situation, the NY Times calculator says that we'd be better off renting if we could find a similar property for less than $2767 per month.
Scanning current listings, there are three nearby rental homes similar to ours (more than 1200 square feet, more than an acre of land). They're fetching $2900 to $3000 per month. So, it sounds like buying or renting a property like ours in Portland is a toss-up at the moment. (If I run the numbers using our home's actual purchase price — $442,000 — I'd have to be able to rent for less than $2100 for that to be the smarter option.)
The Bottom Line
Deciding whether to rent or to buy is a complicated financial and emotional decision. I believe it's a shame when folks who are unprepared get driven into the housing market due to misplaced notions of imagined benefits. Homeownership is not a panacea. Renting is not universal folly.
Part of the problem is the vast Real-Estate Industrial Complex, each piece of which has a vested interest in convincing consumers that bigger is better. (As I mentioned in my recent article on the history of homeownership in the U.S., the real estate industry is a relatively recent invention, barely 100 years old. But in that hundred years, it's grown into a powerful force in our economy.)
The housing industry does its best to propagate certain myths about homeownership, myths like:
- If you rent, you're throwing your money away. (This is false. As with all financial choices, there are opportunity costs whether you choose to rent or choose to buy.)
- Owning a home is a forced savings plan. (Also false. Yes, it's possible to build equity in a home if you buy it in the right place at the right time and/or you stay put for a while. Most folks don't stay put, however, so they end up paying a whole lot toward interest and very little toward building equity before buying a bigger, “better” place.)
- You should buy as much home as you can afford. (Complete and utter bullshit. You should spend as little as you possibly can. Instead of pushing the upper bounds of your housing budget, as happens in most cases, you should instead be aiming as low as you can go.)
Now, let me be clear. There's no question that buying a house makes sense for some folks, but mainly for non-financial reasons. Owning a home gives you stability (you're not at the mercy of a landlord) and freedom (you can do what you want with the place). Heck, last year I chose to buy an eighty-year-old “country cottage” on the outskirts of Portland, so I completely understand the non-monetary reasons for wanting to own.
But there are also advantages to renting.
For one, you have flexibility; you can move at a moment's notice. For another, you're not responsible when things go wrong. If the shower starts leaking before you leave for your vacation in Duluth, you don't have to worry about it — you call in the landlord.
If you decide to buy a home, do it for the right reasons: because it fits your goals and will make you happy. Don't do it because you think it's a good investment. A mortgage is not a retirement plan — it won't make you rich. Instead, think of it as purchasing a way of life.
If homeownership is a lifestyle you want and can afford, then buy. If not, rent.
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