Should You Rent or Buy? How to Decide

Buying a home--for the first time or for a retirement relocation--has never been more complicated and vexing. It’s no longer a slam dunk that property ownership will reward you over time.

Most American property owners have been chastened by the 2008 meltdown, where home values dropped in most areas--and in some places, prices haven’t fully recovered. Furthermore, some places are far more expensive than others. Residential real estate prices locally vary nearly as much as the stock market, and are influenced by regional and national economic changes.

As a result, deciding whether to buy or rent needs requires careful thought and analysis. Here’s what to consider.

Will Your Home Price Appreciate? You can take considerable investment risk in a property. Remember, unlike a stock or bond, a home requires ongoing maintenance, such as a new roof or furnace, paint, and carpet--and that maintenance can be costly. In addition, property is taxed every year. And finally, the physical structure depreciates constantly.

In addition to ongoing costs, home prices can be all over the board depending on location. According to home-price data compiled by Robert Shiller, the Yale economics professor who wrote the classic Irrational Exuberance and won the Nobel Prize in Economics, residential prices since 1980 have roughly mirrored building costs and population growth. In addition, real estate prices tend to move in the opposite direction of interest rates. Generally when mortgage rates drop, home sales--and prices--go up.

But this trend doesn’t always hold. Around 1990, home prices started to soar as building costs and interest rates fell; then, home prices in most places hit a wall in 2006 and crashed. Prices have generally rebounded since 2010, although now prices are driven more by regional differences: The property-scarce West and East Coasts are doing much better than the wide-open Midwest.

Local home prices also tend to follow job growth. Where there’s strong employment creation, home prices rise. That’s why Texas housing prices are doing better than Michigan.

Ideally, part of the should-you-buy-or-rent decision should be based on the appreciation potential of the home, which depends on the long-term growth of the economy in which your home is situated. That's easier said than done.

Running the Rent vs. Buy Formula Rather than trying to forecast the future economics of an area, it's better to tally up all the costs of owning a home in an area to see if it makes sense. Renters don't directly pay for property tax, maintenance, or financing expenses, but they may be hit with rent increases when landlords pass along those costs.

You also have to take into account the tax benefits of property ownership. You can deduct property tax and mortgage interest as a percentage of your taxable income. But these tax breaks are available only to taxpayers who itemize expenses on their federal tax returns, so that’s a key consideration in making this move.

It's easy to start crunching the numbers with any number of "rent versus buy" calculators online, if only to get a ballpark to see if the decision could make sense. One user-friendly tool is at bankrate.com. The tool includes questions that will help guide your decision, including:

1. Do you have access to a large amount of cash for a down payment?
2. Can you pay cash for the entire purchase?
3. If you don't have the cash, how much will it cost you to borrow?

How you answer these questions will help you out of the gate on your decision. If you have a substantial amount of cash to pay for the entire purchase, of course, you needn’t worry about financing, but you will have more of your own money at risk.

Those with little or no down payment have to see what kinds of loans they will qualify for and submit to credit checks. Borrowers with high credit scores and down payments generally get lower mortgage rates.

You also need to consider how much other debt you’re carrying--credit cards, installment loans, medical debt. High-debt households may have less desirable mortgage options to choose from.

Since buying versus renting is a multilayered decision, you also need to consider:

How long you plan to stay in the home. If you're a short-termer, renting may be a better option, although you'll need some idea of the rate of rent increases in markets you're eyeing. The longer you stay in a home, the greater chance you'll recoup your investment if you buy, all other things being equal.

What the potential home price appreciation may be over your time horizon. Look at local home prices over the past 10 years, including the recession years. Did the area get hammered during the housing bust? Is it vulnerable to local/national economic swings? Are prices on the rise? Will your investment translate into building equity?

How much maintenance is involved in the property you're considering. A townhouse, condo or apartment usually doesn't entail much exterior maintenance, but homeowner associations may ding you with monthly fees or special assessments. If you're buying a "fixer upper," or a home that will eventually need expensive repairs, consider that, as well. That could tip you toward renting--unless you have the cash to cover the additional maintenance costs.

How affordable the area is in general. Some markets are always pricey, such as most of the West Coast, Northeast, and high-end neighborhoods throughout the country. You may find bargains elsewhere.

What the tax benefits are. You can't deduct your residential rent payments directly from your taxes. As noted earlier, write-offs on your federal return only work if you itemize expenses. But keep in mind tax benefits don't trump the other considerations. If you don't have the money to buy in a particular market--or if you don't itemize expenses--tax breaks may not add up in the total calculation. Those with median incomes (around $50,000) reap no federal tax benefits in 75% of U.S. cities, according to HelloWallet, a Morningstar-owned company.

Some Important Caveats Since the rent versus buy decision involves so many separate math problems, many online calculators may not be up to the task. They may not be able to tell you if the tax benefits are worth it in your case, notes Aron Szapiro, consumer finance expert with HelloWallet.

“Most people will itemize for a few years after buying, but the delta [difference] between the savings realized with their itemized return--and the savings they would have gotten filing with the standard deduction--is small and likely to shrink over time.”

If you're just starting to run the numbers on the rent versus buy question, it's useful to check out a metric that shows the relative relationship between renting and buying--the "price to rent ratio."

Basically, this number compares the total costs of buying (finance, taxes, tax breaks, insurances, closing, etc.) to renting costs (including renter’s insurance). The boiled-down formula is average list price of homes in an area divided by average rents (times 12).

You have to be careful using this ratio, though, because it doesn’t tell you everything you need to know about this decision, Szapiro adds.

“The p/r ratio can help estimate the likely point at which the benefits of ownership outstrip the costs of ownership (compared to renting), but there is nothing in the ratio that includes finance costs, taxes, tax breaks, or insurance,” Szapiro notes.

“For example, in the District of Columbia, the property tax rate is 0.85%, but in Takoma Park, Md.--just across the border--it is about 1.35%. The p/r ratio can easily be the same in both. I think individuals need to actually look at the rental market to see what homes that would meet their needs might rent for.”

Even if the numbers suggest buying is a more prudent course, Szapiro suggests you take a long-term view if you want to hold onto a property. “Historically housing has not appreciated not much more than the rate of inflation,” Szapiro says. “Homes are a depreciating asset and prices will probably slow down.”

Still, the idea prevails in the American consumer psyche that it’s nearly always better to own than rent, even when economic logic dictates otherwise.

Szapiro has done research that shows that some 40 million homeowners bought homes during periods when it was better to rent than buy. That’s roughly half of the number who own homes today. Why? Because for generations the cultural meme was that homes never went down in value. The last crash disproved that notion in a big way.

What’s clear is that higher-income households--those earning more than $100,000 annually--are in a position to gain more on an aftertax basis from the first 10 years of homeownership in nearly every market, mostly due to the tax code, Szapiro found.

Yet those tax savings will vary widely depending upon where you live. High-income homeowners in the expensive Los Angeles area (who write off their home expenses), will reap about $35,000 in tax savings, compared to around $1,000 in Las Vegas.

Sometimes, though, the sheer expense of a home in certain markets makes renting an easy decision unless you have the cash. According to Local Market Monitor, a real estate information service, p/r ratios can vary dramatically. At the high end is San Francisco at 44, Seattle at 26, and New York at 25, meaning that renting has an edge in these markets. Buying would make more sense in Atlanta (15) or Ft. Lauderdale (16).

All told, making the right homeownership decision shouldn’t be done blindly or simply because you feel more comfortable buying. Take the time to run the numbers. Hopefully economic logic will win over emotion.

John F. Wasik is a freelance columnist for Morningstar.com and author of 14 books, including "Keynes's Way to Wealth: Timeless Lessons from the Great Economist." The views expressed in this article do not necessarily reflect the views of Morningstar.com.