When potential first-time home buyers consider making the transition to homeownership, they often weigh whether it makes more financial sense to continue renting or buying.
Given today’s changing housing market, this decision is more complex. According to Zillow’s Observed Rent Index, rent prices rose 9.6% in October from a year ago, down from a peak of 17% earlier this year, but still well on the way to above traditional standards.
Meanwhile, in the buy market, annual house prices are up 13% from a year ago, according to First American Data & Analytics’ preliminary October house price index.
As annual house price growth nationwide has slowed from a peak of nearly 21% in March, mortgage rates have more than doubled from a year ago, which has had a significant impact. on affordability.
Changing housing market conditions and an uncertain outlook are creating a difficult headache for potential first-time home buyers considering whether to rent or buy.
Break down the cost of ownership
It is important to take a close look at the monthly cost of renting or owning. The cost of rent is relatively simple: it is the amount of rent paid by the tenant each month. Cost of ownership, on the other hand, is more complicated and includes taxes, repairs, home insurance, and monthly mortgage principal and interest payments.
Consider a hypothetical first-time home buyer who takes out a 30-year average fixed-rate mortgage in October of just over 6.9%, with a 5% down payment on a house at the sale price of 25th percentile. We use the 25th percentile because first-time home buyers are much more likely to buy a lower priced home.
After factoring in the total monthly cost of homeownership and comparing it to the median rent by market, renting was better than owning for potential first-time buyers in 47 of the top 50 U.S. markets. The three exceptions were Birmingham, Ala., Memphis, Tenn., and Pittsburgh, Pennsylvania.
However, this calculation leaves out the main financial advantage of owning over renting – the accumulation of equity.
The heritage effect of home ownership
For first-time home buyers, finding the money for a down payment is usually the biggest hurdle to home ownership. However, once the home is purchased, the appreciation helps build home equity, an important benefit that renting does not provide.
The rebalancing of the housing market makes it difficult to predict the pace of appreciation in the top 50 markets. However, the historical average annual rate of house price appreciation between 1988 and 2019 was 3.8%. When factoring this conservative valuation advantage into our rent-to-own analysis, it was cheaper to rent in just 20 of the major markets. The chart below compares, by market, the rental cost to the cost of ownership adjusted for the average annual rate of house price appreciation.
If a first-time home buyer put down a 5% down payment on a $205,000 house (the 25th percentile house price) with a mortgage rate of 6.9%, the buyer would pay approximately $1,283 per month in principal and interest, plus approximately $662 in taxes, repairs, private mortgage insurance and homeowner’s insurance costs. This brings the buyer’s total monthly cost of ownership to $1,945.
Taking into account the national historical rate of appreciation, 3.8%, this equates to a capital benefit of approximately $651 per month, reducing the total monthly cost to $1,294. Compared to the median monthly cost of rent in Chicago, $1,356, it makes slightly more financial sense to buy rather than rent once adjusted for appreciation.
Will the dynamic of rent versus purchase change?
The future of mortgage rates is uncertain, but if they rise, it will mean higher monthly payments for the same loan amount. House price appreciation will vary widely across markets over the coming year, but further moderation is likely. Nevertheless, this analysis demonstrates that the long-term wealth effect of home equity remains a powerful factor in the homeownership decision.
Odeta Kushi is Deputy Chief Economist at First American. This article is not intended as investment advice.
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