For many people, buying a home is a huge life event and financial milestone. But how should you determine whether to keep renting or take the plunge and purchase a house? The short answer: If you’re able to afford the down payment on a home that is likely to appreciate, and you plan to hang onto the property for at least five years, you should go for it.
The long answer is that it depends on a range of factors including your finances, your future plans, and your priorities. Here, we’ll outline the steps you should follow to figure out if buying a home is right for you.
Step 1: Assess your finances
The most important first step in the rent/buy decision is, of course, determining whether you can afford to buy a home. Before going any further, take a look at the following numbers:
You should only consider purchasing a home if you already have three to six months’ worth of expenses saved in an emergency fund. An emergency fund is one of the fundamental building blocks of good financial health, and it should come before any other investments, including buying property. We think it’s wise to keep your emergency fund in an FDIC-insured account like the Wealthfront Cash Account, which allows you to earn interest without taking any market risk.
Although you can purchase a home with a down payment that’s as little as 3% of the purchase price in some cases, doing so means taking on more debt. Unless there’s a very compelling reason to take the plunge before you have a 20% down payment, it’s generally a good idea to wait until you have more cash to offset the amount you have to borrow. Twenty percent might sound like a lot, but it will save you money on interest and private mortgage insurance (or PMI, which on average can cost between 0.58% and 1.86% of what you’ve borrowed each year), and put you on more secure financial footing as a homeowner. Plus, don’t forget you’ll also need enough cash on hand to cover closing costs, which typically are between 3% and 6% of the purchase price.
Debt-to-income (DTI) ratio
Mortgage lenders look at your “front-end” and “back-end” DTI when deciding whether to work with you. To calculate your front-end DTI, divide your projected monthly housing expenses (mortgage plus taxes plus insurance) by your monthly gross income; for the back-end, divide all of your monthly expenses (including projected housing, loan, and credit card payments) by your monthly gross income. Most lenders are looking for a front-end DTI below 28% and a back-end below 36%. If you’re not there yet, you should wait to buy until you’re in a stronger financial position.
The higher your credit score, the better your chances of getting approved for a mortgage with a lower interest rate. Even a single percentage point matters a lot when you’re taking out a mortgage. On a $400,000 mortgage, for example, the difference between a 4% and 5% interest rate would cost you $68,000 over 30 years. It’s worth doing whatever you can to boost your score before calling the mortgage broker, even if that means holding off longer on buying a home. To improve your credit score, try to use less than 30% of your available credit and pay off your entire credit card bill on time each month. You’ll also want to avoid cancelling old credit cards, even if you don’t use them anymore.
If you’ve been saving up to buy a home in a taxable investment account, you can liquidate some or all of that account to make a down payment (just make sure you’re prepared to pay taxes on any realized gains). In general, we think you should leave your retirement accounts alone. Making a withdrawal means you’ll likely face fees, early withdrawal penalties, and taxes, not to mention forfeit compound growth on your retirement savings.
Step 2: Think about your five-year plan
Let’s assume you’re in great financial shape to buy a home. Next, you should step back and think about your future. Specifically, you should consider where you want to be in five years. If the answer has a definitive geographic location tied to it, then buying a home is a good option. But if you aren’t quite sure where you’ll be living in the next few years, you might be better off renting until your five-year plan comes into focus. Not only does renting offer you more flexibility to move wherever you want, but it’s also typically cheaper than buying in the short term.
You should only buy a home if you plan to be in it for at least five years. Generally, that’s the time it takes for your house to appreciate enough to make up for the transaction costs you’ll pay. When you buy your home, you’ll pay fees known as closing costs which can total between 2% and 5% of your home’s purchase price. You’ll also pay fees when you sell. A real estate agent will charge you 5% or 6% of your home’s value to sell it, and you’ll pay additional taxes and fees that can easily total 2% to 4% of the sale price. Between buying and selling your home, you could pay as much as 15% of your home’s value in transaction costs and fees, which is why it’s wise to buy a home you can see yourself staying in for at least five years.
You should also know that, because of the way mortgages are amortized, it can take years of mortgage payments before your payments are more principal (paying down the loan) than interest (what you pay your lender). For example, let’s say you take out a $300,000, 30-year fixed rate mortgage at a 2.75% interest rate. When you make your first $1,224.72 payment, $687.50 of your payment would go toward interest, and just $537.22 would go to paying down your principal. It would take nearly five years for your payments to become more principal than interest.
Step 3: Scope out your location
You’ve probably heard the saying “location, location, location” when it comes to real estate. Location matters when you’re deciding whether to rent or buy, so you’ll need to get very familiar with the housing market you’re targeting.
First, you’ll need to gather some data. Think about the type of home you want — size, amenities, style, etc. — and then research what it costs to rent and buy comparable homes in your area. Sites like Zillow and Redfin can help you figure out what’s available in your local housing market.
Step 4: Ask yourself: how much do you want to buy?
Buying a home is a big financial decision, but we think it’s important to acknowledge that it can have huge psychological benefits, too. A home isn’t just a thing you own — it’s a place you live your life. We believe the most significant benefits to owning a home are not financial, which means the case for buying a home can’t always be rationalized by a financial model. If the numbers don’t point to a clear path forward, it’s okay to make the decision based on emotional factors.
Renting vs. buying isn’t one-size-fits-all
At the end of the day, the decision to rent or buy a home is a personal one. Buying a home isn’t always a good investment and renting isn’t always “throwing money away.” It’s all about choosing what’s right for you and your individual situation. If you’re starting to think about homeownership and want more support thinking things through, we encourage you to check out Wealthfront’s home planning guide.
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The Wealthfront Team believes everyone deserves access to sophisticated financial advice. The team includes Certified Financial Planners (CFPs), Chartered Financial Analysts (CFAs), a Certified Public Accountant (CPA), and individuals with Series 7 and Series 66 registrations from FINRA. Collectively, the Wealthfront Team has decades of experience helping people build secure and rewarding financial lives. View all posts by The Wealthfront Team