The housing market is going crazy right now and since I’m not a fan of making rash decisions that will affect your life for many years, I thought it would be a good time for some timeless advice.
When you search for mortgage information, there are plenty of ideas floating around the internet. Here are a few:
“Renting is just throwing your money away.”
“Buying your home locks up money that could’ve been invested.”
“You should pay off your home as quickly as possible.”
“If you do buy, don’t pay off your home early. It’s better to invest the money.”
These are difficult topics that require slightly complex [but not overly-complex] answers.
Let’s dive into theses topics, and decide what’s best for you. This is a packed guide for anyone who is considering buying a home, so I’m going to attempt to cover pretty much everything.
Buying Vs. Renting
Should you buy or rent? Well, the answer is dependent upon your situation, the current market and there is no one-size-fits-all answer to this.
I have no problem with people preferring buying or renting. The problem is, so many people think buying is always better…and there is an influx of bloggers, and people with nothing else to do, who have decided that buying isn’t always better. And they want everyone to know. So they’re trying to make it look like buying is always a terrible idea.
Obviously if you see an article title that swings in one direction and against the other, it’s biased and they will only use examples that help their side. That being said, I acknowledge that it’s impossible to write an article that equally applies to everyone, but I’ll try my best to be unbiased.
So, again, should you buy or rent? It’s really not an easy decision. In fact, if anyone tells you one is always better than the other, just smile and nod. And then find someone else to give you advice…
Part of the problem with this issue is when people think it’s only a financial decision.
It’s not.
It’s not always about saving every single dollar. It may mean more to you to have the freedom of renting. Or it may mean more to you to have your own home.
While this guide is mostly focused on the financial aspect, remember, it’s not always about the money.
Here’s the Usual Story
Picture this.
You are a newlywed and you want a house. Actually, you want a home, not a house.
You have always heard that it makes more sense to buy than to rent. After all, this is your home and renting is just throwing money away, right?
So, you find a real estate agent and start searching for your “dream starter home” (an oxymoron, I know).
Maybe you have always heard that you rent a house, but you buy a home.
You think buying is the only obvious option for you.
Then one night you get curious and start searching the internet to make sure you are making a wise decision.
Your world is shattered.
You begin to see article after article on why you shouldn’t buy a home and why you should be renting.
Ok, maybe it’s not that dramatic. Maybe your world isn’t exactly “shattered,” but it does make you stop and think.
Let me go ahead and clam your nerves. There is a time to rent. There is a time to buy.
There is also a time to build. Every situation is different and unique.
When the Answer is Obvious
There are a few times when the answer it obvious.
If you plan to move soon… rent.
If rent is extremely expensive in your area and it’s much cheaper to buy… buy.
If you want a very specific home that you plan to live in for the rest of your life… build.
As far as the rest of the time (read: most of the time), it’s not black and white.
When the Answer is Not Obvious
What happens when there is not an obvious solution?
You will have to do some homework.
You will need to look at the pros and cons of your specific situation. You may even have to run some numbers. I know, it sounds scary! But you will be just fine… I promise.
We’ll look at some of the general pros and cons of buying vs. renting in a moment.
It’s not always easy, but it’s much easier than the “professionals” make it seem to make your decision.
Don’t let someone talk you into a decision that they profit from.
For example, a real estate agent may not be the best person to ask about whether your should be buying or renting.
On the other hand, if your brother-in-law has an empty house for rent, you may not want to ask him for the advice either.
Let’s see what makes the most sense for you…
Buying Vs. Renting Compared
Since this is such a difficult topic, let’s actually break down the pros and cons.
The Pros of Buying
- You will eventually stop making mortgage payments.
- You will keep the same monthly payment on a fixed loan.
- You can remodel, add-on, customize, paint, etc.
- You [eventually] actually own your home.
- You could gain equity if the house appreciates in value.
- You can have pets without deposits or permission.
- You can use mortgage interest as a tax deduction.
The Pros of Renting
- You usually have a lower upfront cost.
- You can change locations fairly easily.
- You don’t have to worry about maintenance.
- You don’t have the debt of a mortgage.
The Cons of Buying
- You’re taking on a substantial amount of debt with a mortgage.
- You’re responsible for maintenance and making repairs.
- You’re not easily able to pack up and move when you want.
- You’re responsible for closing costs and a down payment.
- Your credit can be negatively impacted if you can’t pay your loan.
The Cons of Renting
- Your rent price can increase, sometimes without notice.
- You’re not building equity, you are simply spending rent money.
- You’re not eligible for tax deductions and incentives.
- You’re not usually allowed to customize the house.
- You’re typically struck with extra fees if you have pets.
- You’re never 100% financially free if you are paying rent.
Both Sides of the Argument
Many will argue that you should find cheap rent, then invest the money you would have put into buying a home. That’s not a bad idea.
They will say that a mortgage is simply renting money from a bank. That’s basically true.
Others will argue that you should buy, because renting is throwing your money away. There is truth there as well.
Both options make sense for different reasons, so you have to figure out what makes sense for you.
More Than One Reason to Buy a House
This article is debating between buying and renting for your personal home.
Owning rental property is a different story.
Rental property is an investment and [hopefully] it creates cashflow.
If you finance rental property, it’s important to have the right financing and the right house, but there is no argument that rental property is an investment.
In fact, rental property is usually what people are referring to when they talk about investing in real estate.
It All Comes Down to This
Ultimately, you have to run the numbers and calculate the cost.
Things like taxes, insurance, maintenance, deposits, down payments and other variables should all be included in your calculation.
Figure out what is right for you.
There are literally thousands of articles all over the internet that are trying to convince you one option is better than the other.
The problem with those articles is nobody knows your specific situation.
It’s really as simple as weighing your own personal pros and cons. You should never make a large purchase or investment without going over these 6 steps…
- Sleep on it.
- Talk it over with your spouse.
- Fully inspect what you’re buying.
- Make sure you can still sleep at night after buying it.
- Pray about it.
- Count all costs.
Finally, this entire debate is really between renting and having a mortgage. Paying cash for a home saves you all of the interest. As long as you can get a good deal, it’s a great idea to buy a home, in full, with cash.
Sure, some people say that there are better ways to invest that money, but if you do the research and the work, you will be making a fine investment. You’ll also free up a lot of future cashflow
So let’s continue on to some practical ways to help you make this decision. Let’s make this tangible. There’s a formula you can use to determine whether it makes more sense financially to buy or rent. I emphasize “financially” in the previous sentence, because you still have to look at what makes sense practically (i.e. moving often, your preferences, special circumstances, etc.) and then there are emotions that can trump financially logical decisions as well.
Now for the formula: it’s called the price-to-rent ratio.
Price-to-Rent Ratio
To calculate price-to-rent, you divide the average price of a home by the average annual rent in the area. Since $300,000 is a good country-wide average price for a fairly decent home (a mansion in some places and a smaller home in others), we’ll use it as an example:
Price: $300,000
Rent: $1,500 per month = $18,000 per year
Price-to-Rent Ratio = $300,000/$18,000 = 16.6
Now I’ll explain what you do with “16.6.” Investopedia breaks it down like this:
- Price-to-rent ratio of 1 to 15 = Much better to buy than rent
- Price-to-rent ratio of 16 to 20 = Typically better to rent than buy
- Price-to-rent ratio of 21 or more = Much better to rent than buy
In our example, the choice would be up to you, but at least you would know you’re making a financially wise decision either way. For example, where I’m from, this ratio comes out to “10,” so it would make way more sense to buy than to rent there. But I’m from the South, so it’s very different from much of the country. I’ve noticed that it seems to be better to buy in the South and the Mid-West, and it’s usually better to rent on the coasts and in much of the North. Maybe it’s just me, but this seems to hold true.
It’s a good idea to run this ratio with several different numbers to get a strong idea of which option is better.
There’s even a calculator you can use to streamline this process and I highly recommend using this calculator.
If you account for everything, often you’ll find the ratio comes out similar, if not exactly the same. In that case, if you don’t want the responsibility and headache of home maintenance, rent. If you want to do whatever you want to every part of your home, buy. Of course, there are other factors, but this is assuming you’ve already went through the basic reasons to do either one.
Many people still swear that buying is always the best option. However, renting is becoming a more favored option among millennials. Afford Anything published a very popular article that favors renting, if you would like to see that side. It’s a very in-depth and informative article; however, some of it is a little over the top (perhaps to prove a point) in renting’s favor.
For example, the article explains how the “mortgages end, renting is forever” idea isn’t true, because of the extra things you pay for when you own your home, even after it’s paid off. I see where they’re coming from, but the example is a bit extreme. It gives an example of the life-long expenses you might incur with a $300,000 mortgage after it’s paid off, which are $1,581/month in their example. I happen to own a home worth close to that, and our monthly expenses, taking everything in the article into account, would be around $300/month after it’s paid off, so I think it goes a bit on the extreme of the renting side.
Remember, there is no one-size-fits-all answer.
Now, since this guide is about mortgages mostly, let’s move on to the different types of loans if you do get a mortgage.
Types of Mortgages
Let’s say you’ve decided to buy. What are the types of loans and which is best?
There are two basic types of loans. Let’s cover those first:
- Fixed Rate Mortgage – This is exactly what it sounds like. The interest rate is fixed for the duration of the loan. Nine times out of ten, this is going to be your best bet. It generally comes with the least amount of risk and the best rates over the long haul.
- Adjustable Rate Mortgage (ARM) – Unlike a fixed rate mortgage, an adjustable rate mortgage’s rate changes over time. It generally starts out lower than the average market rate, but it can go much higher than the market rate within a few years. There is a cap on how high an ARM’s interest rate can go. For example, a six-point cap means that if you start with a 3% interest rate, it can’t go above 9%, but 9% is a whole bunch of percent!
Again, it’s almost always best to go with a fixed rate loan. Sure, the interest rate may go down in the future, but over the long haul, there’s a much better chance of it going up. And if you think interest rates are too high right now, just wait. Or you can refinance later. But they will go down eventually if they’re really high.
Now let’s talk about a few of your options:
- Conventional Loans – This is the most basic of all mortgages. Conventional loans are not insured or guaranteed by the federal government. It’s just you borrowing money from a bank and paying it back. The interest rates are usually pretty good, but this option does require a larger down payment than most of the options below.
- FHA (Federal Housing Administration) Loans – The rates are generally higher for an FHA loan, but you can get them with a very low down-payment. That translates to: “If you can’t wait until you’ve saved up enough money for a down-payment, and you really want your home right now, regardless of home much it will cost you, get an FHA loan.”
- VA (US Department of Veterans Affairs) Loans – These are the loans offered to our Armed Forces. I qualify for a VA loan, but I have never taken one out. Though they will often finance up to 100% (yes, no down-payment), the interest and fees are generally much higher than conventional loans.
- Balloon Loans – Balloon loans offer a fixed rate (generally low) for a period of time, with lower monthly payments than most other types of loans, but at the end of the period, the entire balance is due. Generally this type of loan is either for investors, or people looking to refinance before the end of the period.
- USDA/RHS Loans – These loans are for people in rural areas, offered by the RHS (Rural Housing Service). This could be a good option for someone who is buying a farm, for example. There are many guidelines and specifics to getting approved for this loan. Having a degree in agriculture can actually help you qualify for this loan. You can see all the specifics on the US Department of Agriculture’s website.
There are other types of loans, such as interest-only ARMs and Jumbo loans, but these types of loans are very uncommon, since the housing bubble many years ago. These types of loans are also generally a bad idea.
Private Mortgage Insurance (PMI)
Private Mortgage Insurance (PMI) is generally required if you have less than 20% equity in your home. For example, if you buy a $100,000 house (mortgage for 100k and appraises for 100k), and you put 15% down (85k remaining balance – 15% equity), you would be required to pay PMI until you paid the house down to $80,000 (20% equity).
PMI is for conventional loans, whereas VA loans require no PMI, and FHA loans have their own insurance and fees for this purpose. But when you’re taking out a conventional loan from a bank, they don’t have the government or the VA backing anything, so they have to take precautions against you possibly not paying your mortgage.
PMI is generally 0.25% – 2% of your mortgage balance, per year. And once you hit 20% equity, you can contact your lender and have the PMI removed. Though the lender should do this automatically, you’ll want to make sure it happens. They will give you a statement in the beginning stages of the loan that will layout how much, and how long, you have to pay until you hit the 20% equity mark.
How Amortization Works (And Why 30 Year Loans are Evil)
Amortization is “the paying off of debt with a fixed repayment schedule in regular installments over a period of time”, according to Investopedia. Basically, it’s a schedule that shows you your payment, broken down by principle, interest, and any applicable taxes or insurance in escrow.
This is a very important schedule. If you understand it, it can save you some money.
With a fixed rate mortgage, you pay more principle and less interest as the loan matures. That means that making extra payments makes a much bigger difference in the beginning of the loan.
Thirty years is a long time to pay for a house. Opt for a 15 year mortgage or even a 10, but you probably already know that. If you can’t afford to take out a mortgage shorter than 30 years, you can’t afford that house. Sorry if that hurts your feelings, but at least it doesn’t hurt your wallet.
If you currently have a 30 year mortgage, and you can’t refinance, that’s ok! You can pay a little extra on a 30 year loan to pay it off quicker. Let’s look at how much extra you would have to pay to pay it off early – it’s not much.
This is the amount you would pay every month (for an 8%, $100,000 loan) to pay off your mortgage early:
- 30 years: $733.76
- 25 years: $771.82
- 20 years: $836.44
- 15 years: $955.65
- 10 years: $1213.28
Did you notice that there is only a $102.68 difference between paying off this loan in 30 years and paying it off in 20 years? That’s 10 years off your mortgage! Here’s a quick infographic showing the difference – for you more visual people:
Figure out your numbers and how much you can save with Dave Ramsey’s free mortgage calculator. And check out this amortization calculator to see how your schedule works. Your bank can provide this as well.
Not only do you pay off your mortgage earlier with a shorter loan, but the interest rate is usually much lower. Why? Simply because the bank is “stuck” or “locked-in” at that interest rate for a shorter period of time
Here’s an example of a basic amortization schedule. You can see the principle and interest for each payment:
Now we’re going to dive deeper into paying off your home early, starting with the most basic question you can ask…
Should You Pay Off Your Home Early?
Let me explain the two schools of thought on this:
- You should pay off your mortgage early, because it will free up your monthly payment for other things (like investing) and help you to become financially free. This is true.
- You should NOT pay off your mortgage early, because you will miss out on interest you could have received from investing that extra money. This is also true.
There you have it, two sides to the argument. And these are not the only two sides, just the most popular. Obviously, which one you choose depends on your financial goals.
This isn’t just about the numbers. Just like how some people prefer the debt snowball to the debt avalanche for emotional or mental reasons, the same applies here.
Here’s the short of it: If you want to be fully financially free of all debt, pay off your mortgage early. If it’s going to kill you to see all of that money going towards your home, instead of gaining interest in an investment, invest the money.
If you do decide to pay off your mortgage early, it should be the last debt you pay off.
Make sure you accomplish these things before you start paying off your mortgage early:
- Pay off the rest of your debt
- Fully fund your emergency fund
- Max out your IRA for the year
You could go a step further and max out your employer retirement account, but that’s personal preference.
How to Destroy Your Mortgage Payments
Ok, so you’ve decided that buying is the way to go, you’re using a mortgage to do it, and you don’t want to be stuck paying on your home for the rest of your life. Good choice. Here’s how to pay off your home early, and quickly:
1. First-Day Strategy
If you take full advantage of this strategy, it’s one of the most powerful ways to make a huge impact on shortening the life of your mortgage without paying extra (literally, you aren’t actually paying extra money).
You simply make your first payment on the day the loan is activated (the day the lender starts charging interest) instead of waiting until your first payment is due, which is usually over a month out.
This works so well, because this way, your entire first payment goes towards principle. Principle payments have the most impact during the early years, especially this first payment.
It will make you sick to see how little of each payment is going to principle in the early years of a mortgage. There could be as little as $20 or $30 each month going to principle on a $1,000 payment. The rest is going towards interest.
If you’re already the proud owner of a mortgage, you can still apply this strategy by simply making one extra full payment. It won’t have quite the same effect as it will on the first day, but you will still knock some serious time off your mortgage.
2. Split-Payment Strategy
You’ve probably heard of it. Some people think it’s magic, but it’s actually a really simple concept.
You simply pay half your payment twice per month, instead of making one full payment.
This works in 2 different ways…
- Paying half-payments every two weeks will cause you to automatically make one extra full payment every year. (26 half-payments per year comes out to a total of 13 full payments instead of the usual 12)
- You will lower the principle balance 26 times per year instead of 12.
You can usually set this up with your bank, but if they won’t do it, you can still take advantage of this strategy by adding a little extra to your principle each month or by making one extra full payment each year.
To figure this out for your mortgage, simply divide the amount of your principle payment (principle only, not escrow or interest) by twelve and add that amount to each month’s payment.
3. The Planned Increase-Payment Strategy
In this strategy, you’ll simply increase your mortgage payment each year, by a certain percent.
This requires discipline, but it’s highly effective. In some cases, it may not require discipline. Some financial institutions actually offer a way to set this up manually, just like you would for an investment account that increases annually, but many don’t offer this service. So expect to have to do it on your own.
The idea behind this method is that you will receive pay increases, and therefore, be able to make slightly larger payments each year. It can be an extremely valuable way to pay off any large loan early.
Hopefully this guide helped you make some decisions. Leave your questions below!
Further Book Reading
- The Total Money Makeover by Dave Ramsey
- Your Money or Your Life by Vicki Robin & Joe Dominguez
- How to Save Money by Bob Lotich
