Article courtesy of J.D. Roth, read the full article here.
Assuming you want to make a purely financial decision whether to rent or buy, how do you begin? There are a couple of ways to stay objective.
One way to tell whether it’s better to rent or buy is by checking the price-to-rent ratio (or P/R ratio). This number gives you a rough idea whether homes in your area are fairly priced. Figuring a P/R ratio isn’t tough. All you do is:
- Find two similar houses (or condos or apartments), one for sale and one for rent.
- Divide the sale price of the one place by the annual rent for the other. The resulting number is the P/R ratio.
Say, for example, you find a $200,000 house for sale in a nice neighborhood. You find a similar house on the next block renting for $1,000 per month (which works out to $12,000 per year). Dividing $200,000 by $12,000, you get a P/R ratio of 16.7.
But what does this number mean? Writing in The New York Times, David Leonhardt says, “A rent ratio above 20 means that the monthly costs of ownership will exceed the cost of renting.” That’s a little opaque, but what Leonhardt means is that the higher the P/R ratio, the more it makes sense to rent — and the less it makes sense to buy.
During the housing bubble, the national P/R ratio came close to 20 (and went far above that in some cities). In other words, you could rent a $200,000 house for $10,000 a year (or just over $800 per month), which is a pretty good deal.
The normal range nationwide is between 10 and 14 (meaning it would cost between $1,200 and $1,600 to rent a $200,000 house). During the 1990s, just before the housing bubble, the national P/R ratio was usually between 14 and 15 (about $1,100 to $1,200 to rent a $200,000 house).
Price-to-rent ratio data isn’t widely available. If you search long enough, you can find some recent-ish info on the internet, but for hard numbers about your area, you’ll probably have to contact a real-estate agent.
Another way to gauge the cost of housing is to compare it to your family’s income. From 1984 to 2000, median home prices were about 2.8 times the median yearly family income. (In other words, the typical house cost about three times what a family earned in a year.) During the early 1970s, home prices were about 2.3 times median family income. During the housing bubble, this ratio jumped to 4.2.
These numbers don’t mean much on their own, but they can give you some sort of idea of whether housing is overpriced in your area. Plus, it seems safe to assume based on past figures that most families can comfortably afford a home that costs about 2.5x their annual income. (So, if your family makes $80,000 a year, you can afford our theoretical $200,000 house.)
The New York Times has a great rent vs. buy calculator that can help you decide which is best for you. Just plug in the numbers for your situation, and the calculator tells you how long it would take you to break even if you bought a house.
Discussions of homeownership should be grounded in reality. Buying a home isn’t some magical financial panacea. You can waste just as much (or more!) as if you were renting, and you lose a lot of the flexibility and freedom you might otherwise enjoy. If you want to buy a home, do so. But don’t let anyone persuade you that you’re throwing your money away by renting.