In my previous article, Misconception: Renting is for Suckers, I wrote that there comes a point when it makes more sense to rent an apartment than buy a home. For myself, I have a rule of thumb that for every $1 dollar I spend in rent a month I can afford to buy up to $125 in property. Right now I pay $1000 in rent, so using my rule I shouldn’t spend more than $125,000 on a home. This created a surprising amount of controversy; some exclaiming me a heretic, and some accusing me of house-hating. For those of you who wanted to know where that number came from, wait no longer — and I’ve put together a calculator for you to figure out how much you should spend on a home.
But wait… Isn’t buying always better?
For those who view buying a home as an investment, there comes a point when it makes more sense to rent than buy. There are many expenses involved in owning a home that need to be weighed against the cost of renting, such as property taxes, maintenance, repairs, and major expenses such as a new roof or appliances. If you pay too much for a house, your expenses will be greater than your current rent. In essence, your house would be costing you more money!
There are three major benefits of home ownership: equity, reduced taxes and appreciation. These benefits are great, but they run out at some point and don’t automatically make buying a better option. The question is when is buying the better option? What we need to do is figure out at what point the costs and benefits of home ownership become equal or less than renting.
So how much should I pay?
In my last article I wrote that my rule of thumb is for every dollar of rent I spend, I can buy up to $125 in property. That means with my $1,000/mn rent, I should buy a home that costs no more than $125,000. That’s unfortunate for me because it’s nearly impossible to find anything habitable for that price in Northern NJ where I live. Therefore for me renting is the better choice.
But the ratio is different for everyone because it is affected by a number of variables and from what I’ve seen the ratio typically ranges between 100:1 and 190:1. The factors that impact the ratio the most are:
- How much you can spend as down payment. Larger down payment; higher ratio.
- How many itemized deductions you have. More itemized deductions; higher ratio.
- How much property taxes are in your area. Lower property taxes; higher ratio.
- What the current interest rates are. Lower interest rates; higher ratio.
I’ve built a calculator in Excel for you to use that will tell you the most you should spend on a house. You simply open the file, enter in a few variables and use Goal Seek to figure out how much you should spend on a house. You can also look into help to buy a house.
You can also use a mortgage rate calculator to determine your total mortgage payment based on interest and loan amount.
Download the Maximum Home Price Calculator
Plus: Help with Goal Seek
Take a few minutes to download and play with the calculator. If you have questions please post a comment here or email me at chris {at} investorgeeks * com, and I’ll get back to you as soon as I can.
Why tax benefits are overhyped
In my previous article I wrote that tax deductions were flakey, and therefore I didn’t include them in my calculations. That was probably too hasty and I have now included them in my calculator. Tax deductions can result in real savings, but because of the Standard Deduction the benefit you receive from your mortgage and property taxes will vary based on how many other deductions you have in a given year.
When you look at the tax benefits of owning a home you have to look at the extra tax benefit you receive above and beyond the Standard Deduction because you can’t take it if you itemize your expenses. Think of the Standard Deduction as a hole. If you want to save a pile of money, you first have to fill the hole. The more deductions you have, the smaller the hole will be when you include your potential home deductions.
If you cannot itemize any other deductions other than mortgage interest, the standard deduction ($5,000 for single filers) will in essence be deducted from your mortgage interest. So if you’re single and you can deduct $6,000 in mortgage interest and $3,000 in property taxes, you’ll be able to itemize $9,000. But the tricky part is that it’s only going to reduce your taxable income by $4,000 because your standard deduction is now gone. The more deductions you can itemize, the more your taxes will be reduced when you buy a home.
To see just how much your current itemized deductions affect your price ratio take a look at the following table.
| Downpayment | Taxes | Deductions | Price Ratio |
|---|---|---|---|
| $ 20,000 | 2.5% | $ 0 | 118:1 |
| $ 20,000 | 2.5% | $ 2,500 | 125:1 |
| $ 20,000 | 2.5% | $ 5,000 | 132:1 |
In this case, the difference between having no itemized deductions and expenses equal to the standard deduction meant a ratio increase of 12%. Even with a higher down payment and lower taxes, maximizing your deductible expenses could increase the price ratio by 5-10%.
My calculator has built-in support for tax benefits so it does the work for you. Simply enter in the standard deduction that applies to you and how many deductions you can itemize this year, and it will do the rest.
I still won’t bet the farm on appreciation
Many people criticized my last article that I didn’t take appreciation into account, but I’m okay with that. I’ve built appreciation into the calculator if you’d like to include it in your analysis, but I like to sleep well at night, so I want my house to be financially sound on a cash flow basis first so that bull markets are even sweeter. Using leverage may mean huge returns but it can also mean devastating losses. The market right now is in a very weird spot, and it could keep going up or it could fall precipitously. With all bets off on the direction of the market, I’ll err on the conservative side.
You should buy a home… Eventually!!
The reaction to my previous article uncovered something that I had already suspected: people have strongly-held beliefs about home buying. Let me assuage those people now. A home is a place to live, and if you feel strongly about buying a home because you’re looking to start a family or settle down for 10+ years, then I encourage you to buy a home.
However, for those of us who are still young and will likely not keep our next home for more than a few years, then I encourage you to look at buying a home as an investment. And just like any investment, there is an element of timing. The motto is not "buy high, sell low" and likewise we should not buy when home prices are overvalued.
Home buying should be for everyone, but that doesn’t mean it has to happen today. If the numbers work for you then make the leap cause you are leaving money on the table by renting. Otherwise, sit back and relax as your landlord mows your lawn for you and you wait for the right time to buy. The more you can stash away in the bank now, the bigger your down payment will eventually be and the more you can afford to pay for a home.
Wrapping it Up
Buying a home isn’t always the best option. There comes a point when home ownership will actually cost you more money than renting. Given my circumstances I can spend up to $125,000 on a home — unfortunately even condos in my market cost more than that and so for now renting is the best option for me. The amount is different for everyone based on how much they can afford for a down payment, what property taxes are like in their market, and others. Using the Maximum Home Price Calculator you can quickly and easily figure out how much you should be spending on a home and if renting is the best option for you.
References
Misconception: Renting is for Suckers. Chris Welch. InvestorGeeks.
Publication 530: Tax Information for First-Time Homeowners. IRS. http://www.irs.gov/
Your Home as a Tax Shelter. NOLO. http://www.nolo.com/
Is It Better to Buy or Rent? David Leonhardt. New York Times. http://www.nytimes.com