Determining whether to rent or buy a home, apartment, or other dwelling is often a tough choice to make.
As we discussed, housing costs are huge (between 31-39% of spending, on average). And you want to keep yourself out of trouble, should you hit some monetary speed bumps.
Despite what a local realtor or mortgage broker might tell you, it is not always “a good time to buy”.
In fact, there are absolute horrible times to buy. Had you bought a home in the early 2000’s, up through 2007, you’re probably still under-water, and had you lost your job, you might even have been foreclosed upon.
Before you even begin to think about buying a home, you want to make sure:
- You’re going to be there for at least 5, but preferably 7+ years (which requires you to have stable income and an emergency savings fund to keep making mortgage payments)
- You are able to put a minimum of 20% on a down payment, to avoid PMI payments
- You’re buying a home for the right reasons – not some bad advice like “you should buy a home for a mortgage tax deduction“
- You understand that a home is not an investment – with repair, maintenance, property tax payments, and mortgage interest – a home can be money a losing proposition
- You’re not buying a home for emotional reasons, i.e. “we want to start a life together”, “it’s so cute, I absolutely love it!”
- You understand that home ownership as the American dream is a mirage
If you meet all of that criteria, then it’s not automatic that you should buy a home, even if national home prices are depressed. Each local real estate market should be considered separately by looking at house and rent price data to determine if it’s a good time to rent or buy. A good starting point in that analysis is to calculate the local price to rent ratio.
What is Price to Rent Ratio?
Price to rent ratio (aka price-rent ratio) is a formula that compares the price of buying to the price of renting in a given geographic locale.
It will give you objective quantitative data as to whether it might be a great or horrible time to buy in a given geography. It can also give you comparative data on neighboring communities, to determine what the best place to buy a home might be.
It won’t tell you everything, but it’s a great starting point to you making a more informed decision on whether to buy or rent.
How to Calculate Price to Rent Ratio
Doing a price to rent ratio calculation is quite simple.
First, find the median or mean home sales price for a given area. Local realtor boards or news media usually publish this information.
Then, find the average rental price for comparable homes/apartments for that same area.
Then:
Price to Rent Ratio = Average sales price/(Average Rental Price * 12)
What is a Good Price to Rent Ratio?
As a general rule of thumb:
- Price to rent ratio of 1 to 15 = typically better to buy than rent
- Price to rent ratio of 16 to 20 = getting in to risky buy territory
- Price to rent ratio of 21 or more = much better to rent than buy
If you can find historical data for your geography to compare the current price to rent ratio versus historical price to rent ratio, that will give you an even better idea of whether or not it is a good time to buy.
Other Rent Vs Buy Resources:
I’d also recommend taking a look at the following resources to give you a more complete picture on whether or not it is a better time to buy or rent in your area:
Trulia Rent Vs. Buy Index: Interactive and up-to-date maps that factors in personal variables.
St. Louis Fed Home Price Indices: If you scroll down, you can find historical home price indices for most major U.S. metros.
Historical Average Price to Rent Ratios: CNN lists out the historical price to rent ratios in many major markets from 1989 to 2003. The current ratio is out of date, but the historical ratios should provide some added context for you.
Zillow Price to Rent Comparisons: a way to look up price to rent ratios in many major and mid market cities.
Zillow: estimates home prices and rent on every house in their database. Sometimes these are off, I can attest, but still a good starting point.
Price to Rent Ratio Discussion:
- What is the price to rent ratio in your area at the moment (& where do you live)?
- Have you looked at this ratio before buying or renting? If not, do you wish you had?
- What other data have you looked at before determining whether you should rent or buy a home?
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I like the price to rent ratio. I had never heard of that before. I’m a big proponent of buying homes, but I realize that it’s not right for everyone. Your stipulations in order to buy a house are dead on.
Great article!
The best calculator I found was at Michael Bluejay’s site.
http://michaelbluejay.com/house/rentvsbuy.html
Great advice! Especially the part about staying in one place for 7+ years. At a young age mobility is very important. There’s so much opportunity and stuff going on in your 20’s that it’s advantageous to stay mobile.
It strikes me that the cities with high price to rent ratio have homes that are appreciating faster than national averages. How should we take that into account?
It seems that in London, these estimates are way off, and I do believe it has to do with quick appreciation… but how can property values go so far up when rent is more or less capped?