My friends and I have had this conversation countless times. I’ve seen this reasoning from everyone, from a Wall Street Investment Banker to a Cashier at the local Fast Food restaurant. It’s very common to think this way, regardless of background or income.
Why would anyone want to throw away money (on rent) when they could buy a house and create wealth (via home equity)?
It’s a very logical question to ask.
But, it’s also very illogical. Making a rent payment is very simple, while buying a home is very complex. What may seem like similar transactions are actually extremely different.
Buying a home can easily create wealth, but it can just as easily destroy it.
If your justification for buying a house is that your current rent payment could cover a similar mortgage payment, I recommend you rethink your decision.
Your Rent Payment is NOT Comparable to a Mortgage Payment
Just because you can afford an $800 rent payment, does NOT mean that you can afford an $800 mortgage payment.
Your $800 rent payment is equivalent to a $400 mortgage payment. If this seems like a drastic difference to you, it’s because owning a home is drastically different from renting a home. I will walk you through the differences between rent payments and mortgage payments below.
If you are paying $800, your initial thought is that you can afford a mortgage payment of $800. If you do some simple math or plug numbers into a mortgage calculator, you’ll find that financing $150,000 will give you a mortgage payment of about $800. You see this and begin looking at houses that cost $150,000;
What About Taxes and Insurance?
Each year, you are required to pay taxes on the property that you own. The amount of this tax depends on where you live. It could range from .2% to 2%. Some homeowners decide to make this payment with their monthly mortgage payment, while other homeowners choose to pay their taxes annually.
In addition to the taxes, you will also have to maintain insurance on your property. Again, you can combine this payment with your taxes (usually referred to as escrow) and your monthly mortgage payment.
It’s always best to look up tax rates in your area, but I estimate 1.25% of the property value for taxes. Insurance will be about .5% on top of that.
After factoring in taxes and insurance, the $150,000 house that you were eyeing is suddenly out of your price range. Now you’re looking at a price of about $115,000. Here’s how I concluded that:
$115,000 financed for 30 years at 5%
- Mortgage Payment: $617
- Taxes: $120
- Insurance: $50
- Approximate Monthly Payment: $787
Your $800 rent payment is now comparable to a $600 mortgage payment.
What About Maintenance Costs?
When you are renting a home or apartment, your landlord is (or should be) a phone call away. If something breaks, they will fix it. If something stops working, they will replace it. Unless you are the one that caused the damage, your landlord covers all maintenance and repair costs. This is one of the rudest awakenings when it comes to buying a home.
Regardless of the age of your house, you can expect something to break or stop working. My house is relatively new (born 1993) and there is always an unexpected expense of some kind. If you want to estimate what this expense could be, there are 2 decent approximations.
What You Can Expect to Pay for Monthly Home Repairs and Maintenance
- 1% of your home’s value
(If you live in a $150,000 home, you can expect to spend $125/month on repairs and maintenance.)
- 25% of your mortgage payment
(If your mortgage payment is $800, you can expect to pay $200/month on repairs and maintenance.)
Neither estimation is perfect, but it’s a place to start. When in doubt, assume it will cost more.
After factoring in monthly home repairs and maintenance, the $115,000 house that you were eyeing is suddenly out of your price range. Now you’re looking at a price of about $95,000. Here’s how I concluded that:
$95,000 financed for 30 years @ 5%
- Monthly Mortgage Payment: $510
- Taxes: $99
- Insurance: $40
- Monthly Maintenance: $128
- Approximate Monthly Payment: $777
(*The taxes and insurance at this point are underestimations)
Your $800 rent payment is now comparable to a $500 mortgage payment.
What About a Down Payment?
Traditionally, mortgages have been 80/20. This means that the lender will finance 80% of the home if you put down 20%. In other words, you would be required to have $20,000 as a down payment if you wish to buy a home priced at $100,000.
If you want to set yourself up for success, I would recommend following this tradition.
If you do not have 20% to put down, there are other financing options available. With a FHA (Federal Housing Administration) loan, you may only be required to put down 3.5%. In order to purchase the same $100,000 house, you only need to put down $3,500.
What About Private Mortgage Insurance?
If you only make a down payment of $3,500 on a $100,000; then your mortgage balance will be $96,500. Since the value of the collateral (house) is so close to the loan amount, you will be required to pay Private Mortgage Insurance (PMI) to insure the lender against default (if you stop paying). You will be required to pay this insurance each month until your Loan-to-Value (LTV) is less than 80%. Therefore, once the balance that you owe drops below $80,000, you will (likely) no longer be required to pay this premium.
In order to stay true to the example in this article, we are looking at homes priced at $95,000. Therefore, a down payment of $3,325 would be required. The PMI that you would have to pay monthly is about $88.
After factoring in a down payment and private mortgage insurance, the $95,000 house that you were eyeing is suddenly out of your price range. Now you’re looking at a price of about $85,000. Here’s how I concluded that:
$85,000 financed for 30 years @ 5%
- Monthly Mortgage Payment: $456
- Taxes: $89
- Insurance: $35
- Monthly Maintenance: $114
- Down Payment: $2,975
- Private Mortgage Insurance: $79
- Approximate Monthly Payment: $773
Your $800 rent payment is now comparable to a $400 mortgage payment.
Buying a house is a HUGE decision. Just because you are comfortable with your rent payment does not mean that you’ll be comfortable with a similar mortgage payment. There are so many costs associated with buying and maintaining a home that you never see while renting a home. Before you take the plunge into home ownership, please consider what I said earlier:
Buying a home can quickly create wealth, but it can destroy it just as quickly.