The decision on whether to rent or buy a home is a difficult one. There are many factors at play, and not all are financial. When my wife and I bought our home, we had to think hard about our motives. Was it a good financial decision? Were we blinded by our emotions?
Emotions can lead you to make some of the worst financial decisions ever. That's why I love methodologies that set emotions aside and make you take an objective look at things. The metric below is one of those approaches that can help you make an informed decision.
Before I continue, let me deflate some of you right now. I meet with a lot of people who are not ready to buy a home (or second, third, or fourth home) but think they are. Don't even think about buying a home if:
- You don’t have an emergency fund saved up. This should be at least 6 months of household expenses.
- You don’t have money for a down payment. 20% is ideal, but there are certain scenarios where less than that is acceptable.
- You can’t afford to take on more debt (See my article on How Much Debt Is Too Much?)
- You don’t plan on living there for at least 5 years.
- Your income is unreliable. It’s one thing to get kicked out of a rental if you can’t pay, it’s another to have your house foreclosed on.
- Your primary motivation is one of the following:
“A home is a good investment.” It’s not.
“All my friends are doing it.” Your friends’ situations are different from your own. Plus, you could have dumb friends.
“We need one to start our family.” Your baby won’t know whether you own your house/apartment or if you’re leasing it. I promise.
What Is It?
Assuming none of the above apply to you, a great tool to use in your decision is the price-to-rent (P/R) ratio. This ratio is often used in economics to look at trends in the housing market. It can also be useful on a personal level to determine how expensive it is to buy versus rent in your area. It’s a simple three-step calculation. All the data you need can be found on Zillow Data.
- Look up the median home sale price for a given area.
- Look up the median rental cost for the same area. For the purposes of this calculation, you’ll need an annual number, so multiply that monthly cost by 12.
How to Use It
So, how do you interpret this number? A high ratio suggests that the cost of ownership will likely be higher than the cost to rent, meaning that it would be better to rent than to buy. The converse is true for a low P/R ratio. A good rule of thumb for interpreting the resulting ratio is:
- If the ratio is under 13 – it’s typically much better to buy than to rent
- If the ratio is between 13 and 16 – the decision could go either way depending on various factors
- If the ratio is above 16 – it’s typically better to rent than to buy
The numbers above can be a helpful guideline, but the situation may differ depending on the area in which you look.
Right before the housing bubble burst in 2007, the average price-to-rent ratio was 24.5! This means that the vast majority of people should have been renting, but most were buying. In hindsight, this was one of many indicators that should have been a warning sign.
Here’s an example calculation for the areas around where I live (using the March 31, 2018 numbers from Zillow):
This would tell you that LaGrange would be a good place to look for buying opportunities. Conversely, Prospect is an area that renting would likely be better than buying. For Eastern Louisville and Crestwood, the decision would be a bit of a toss-up.
The price-to-rent ratio is also a great tool to use when contemplating a move to a new city. The Get Rich Slowly blog has a great overview of these ratios among different US cities. When you move to a new city, you have the disadvantage of not knowing the area well. The P/R ratio gives you a leg up in your search. You can see which areas are overpriced, as well as areas with good buying opportunities.
The decision to buy or rent is a difficult and complex decision. There are many different important factors to consider. The price-to-rent ratio is one tool of many that you can use to aid your decision.