Monday, February 06, 2006

"To buy or not to buy...that is the question"

For the sake of simplicity, I am going to apply my rationale to the California housing market. I know that property values have gone up many places, but I think California as a whole probably has the worst affordability problem. California is where I live, it is where I work in the mortgage business, and you can apply the fundamentals that I will talk about to any area of the country. Now let's get moving!

In this first segment, I want to look at the 'core' arguments people use for 'owning' versus renting. The 4 main points I hear as to why owning is better than renting are (in no particular order):

1. Tax benefit
2. Appreciation
3. Pride of ownership
4. Stability

Before we get going, I want to say that I have absolutely nothing against owning or renting. I just think the choice should be based on math and finances, and not emotion and 'hype'. That said...let's start looking at things.

To look at this rent vs. own decision, we need to look as if we were buying TODAY, not yesterday, not in 2003, and not in 1997. To do this, let's use a 'median' priced type home for California. I will use a price of $550,000. If you live in CA, you know this isn't going to get you something that great. It will be a 1-2 bedroom condo, or an older, smaller, SFR, that isn't in a 'prime' area. Yes, there are always, exceptions, but I think this is a fair assessment.

Since most people do not have the 110k to put down, and about half of your first time homebuyers put no money down, I will use 100% financing in this example. I will assume 'good' credit with a 700+ FICO score. I know 100% financing isn't preferred, but let's face it, many of the financial decisions made during this real estate boom aren't preferred, just very popular. To get a 30yr fixed on this house, we will use a 6.25% 30yr fixed first, and a 9% fixed 2nd. I will use a LOW tax rate of 1% even though 1.25% is more realistic for most areas in California. I will use a flat $75 a month for insurance.

$440,000 at 6.25% = $2,709.16
$110,000 at 9.00% = $885.08
Property Tax 1.0% = $458.33
Monthly Insurance = $ 75.00

Total payment = $4,127.57 **note: if this happens to be a condo or PUD, add HOA fees. Add Mello Roos as well

I know about what a 1 bedroom condo rents for, and I also know what a smaller 1000-1200 sqft house rents for that falls into this price range. You are looking at rents that most likely fall in the $1200 to $1800 a month range for a place like this. I know several friends that rent million dollar plus homes in the $2500 - $3500 range. So I feel comfortable with these amounts. Again, I know that most people do NOT get a 30yr fixed or a fixed 2nd, but if you are getting an interest-only loan, then you are just 'renting' from the bank, and banking on the appreciation you hope the property generates. You get a tax deduction, but 'spending a dollar to save 40 cents' isn't necessairly the best plan either. Maybe some of the tax pros can chime in on what they see with regards to the actual write-offs for real estate. I have heard from several people that their 'tax break' wasn't all it was cracked up to be. It was nice, but they were expecting much more.

That said, how many people can really afford to spend $4000 a month on their mortgage?? Let's use the higher debt-to-income ratios of the subprime market at 55% for a full doc loan. Let's give this person the benefit of the doubt, and assume they have zero debt and zero car payments. I'm trying to err on the side of 'lower' than actual costs to show how much money you should really be making. Using the $4,127.57 payment with no other debt, at a 55% debt ratio, you would need to make $7,504.67 per month or $90,056.07 per year. If we throw in a car payment or a little credit card debt, and round the monthly debt payment off at $4600 a month, we would need to make $100,363.63 per year to 'afford' this house. Again, let's not forget that this is with 55% of our income going to DEBT...this is before taxes, food, gas, furniture, savings, health insurance, dental, disability insurance, entertainment, vacations, movies, fun, etc.

Makes you wonder if there is REALLY enough money left over to do anything else after 55% of your income is going to debt payment. Add another 25% to taxes, and you already have 80 cents of every dollar you make spent!! As you can see by this CAR data, most people in California make about half that amount. So it is possible for a couple to 'afford' this median priced home. But let's not forget that I am using a 55% debt ratio and assuming very little debt, and using low estimates for property taxes and no HOA's. I'm also assuming it is not a fixer upper, and move in ready.

Don't you wonder why for the longest time (decades) that banks wanted people to spend no more than 28-33% of their gross income on housing? Now it is commonly accepted to use 40-43% or even higher in subprime. I won't even get into 'stated' income loans right now. If you can't qualify at a 55% debt ratio, then should you really be buying?

Know that we have a good ballpark of what is costs to 'own' ($4100-$4200 a month), and we know what it costs to rent...$1200-$1800 a 'median' priced home, which looks like the better option for 'most' people TODAY? With the median income in CA only 53k, how many people can really spend $4000 a month on their mortgage for the LONG TERM?!??

I know that pride of ownership is a nice feeling. I know that getting 10-20k back on taxes is nice (rough number crunching there), I know that reading the OC register and watching the news and hearing about escalating property values is REALLY nice. But what happens IF that appreciation happens to slow, stop, or heaven forbid, go the other way?? I'm not saying it will happen, but can you at least admit that it COULD happen? What is the plan if everything doesn't go as planned? What happens to that pride of ownership if you can't sell your house for 5-6% more than what you paid for it to break even?


Yes, you have 5-6% transaction costs to buy and sell real estate. If you buy the place for $500k today, you can't sell it for $500k tomorrow and 'break even'. You need to pay 20-30k to get that house sold. So you better hope that you have some appreciation in there. And no, an appraisal doesn't mean that is the 'value' of your house. The real 'value' of your house is what somebody will PAY you for it. Appraisals look at recent sales to guage your value. If the values happen to be declining, your appraisal is a 'lagging indicator' of the market.

So, assume you are looking TODAY at buying vs. renting, where do you stand? Let's answer these questions.

1. Can you afford to put money down? If not, do you have 3-6 months minimum of ALL your living expenses in savings...including your 'new' mortgage payment? If no, they I would consider renting.

2. If you have some money down, can you afford a 30yr fixed rate mortgage payment? You probably need to be making $120,000 a year or more to do this realistically in California.

3. Do you like the house and plan on staying a while. Emphasis on staying a while. If your job isn't set or secure, or you can't find another high paying job quickly, I would suggest renting for a while.

4. Do you realize that property values MIGHT go down? And if so, are you prepared to take a loss or wait it out? Remember, past performance is NO guarantee of future results. Just because property has doubled in many places, doesn't mean it will continue to do so.

Even in today's market that just experienced rapid appreciation the past few years, if you can answer the above questions, and are comfortable with the situation, then by all means, go ahead and buy. If you have the money to put down, are making great money that will continue, can easily afford the home, and plan on staying a while no matter what the market does, then by all means, enjoy your new home.

I'm just here to point out to the people that don't have the savings, the down payment, or the income to 'afford' a house TODAY. I'm here to let them know it is OK to rent! Based on the statistics, I think renting is the smart choice for the 'average' person in California with the 'average' income. I don't think getting an I/O or neg-am loan so that you can 'buy in' today is the best choice. Those loans were designed to help sophisticated people manage their cash flow, not help people that don't make enough money get a house they can 'afford'.

Read some of the stories in the forums. There are people in there with real world stories about how hard it was to 'live' with a mortgage that was only 30% of gross income, and not 55%. There are stories about people with kids, families, and people that experienced 'unplanned' events. Take their word for it, not mine.

I will get into renting more this week. I know renting can be a pain. Moving, it's not your place, etc. We will look at this more later in the week.

I hope this helps people some. I know it is not all inclusive, but it should give many people, lots to think about.

I am going to keep making my posts over here, but I am going to shut down the comments. Go to

If you would like to make a comment. Don't forgot to check out the FORUMS...lots of good activity going on over there already.



Anonymous Anonymous said...

good stuff -- for those of us in the Bay Area with rent control available, there's even more reason to rent -- you pretty much "own" the place

2/06/2006 3:48 PM  
Blogger SoCalMtgGuy said...



The thing that many people forget is that they are NOT buying TODAY!!!!

I have friends that bought a house for 325k that is now worth over 1.2 million. They don't seem to get that it would be different if they had to pay 1.2 mil versus 325k for a place.

Not only would the taxes be about 1100 a month vs. 300 month...the mortgage would be huge!

Glad my post could be of help. Stay tuned as I have more rent vs buy posts coming!


2/06/2006 3:50 PM  
Blogger grim said...

Very nice! Posted a link up to this one for my readers. While your description is Cali-centric, the gist is applicable nationwide.

Northern NJ Real Estate Bubble

2/06/2006 4:04 PM  
Anonymous Anonymous said...

Found your site awhile ago via NNJ Real Estate Bubble, since I am in Northern NJ. I sold my house in 2001 for nearly $900,000 and subsequently sold another house I owned (Florida) in late 2001; I definetly left money on the table (02' to 1st 1/2 05' funny money period) however even the prices I sold them for then will not be met again. The way the buyers financed the purchases had me feeling bad for them, barely 10% down; had to borrow 5 of the 10 etc. I just don't know what goes thru peoples heads. I have almost always been a high earner since my early 20's (I'm 41) and have owned residential and commercial property; the killer of it since I am now renting is all the no money types telling me how I should buy...little do they know I will ("when there is blood in the streets") The fact of the matter is your liability (mortgage) is the banks asset...most just don't get the concept, however I'm certain they will, in time.

2/06/2006 10:05 PM  
Blogger Roadtripboy said...


Great post. I liked how you bring some rationality to the idea of home ownership. It is easy to get caught up in the good ole' "American Dream" and feel that you are just missing out if you don't join the Jones' and buy a home too, even if you can't afford it. I think for too many people, buying a home has become linked too closely with self-worth and people feel like they'll never "make it" and forevermore be "losers" if they don't buy immediately. The irony is that by purchasing when your finances aren't cooperating increases the likelihood that you won't "make it" and end up in foreclosure, bankruptcy, and other nasty financial side-effects.

Buying a home should be less of an emotional decision and much more of a rational one and this post highlights the reasons to buy vs. rent very clearly.

2/07/2006 12:18 AM  
Blogger MANmom said...

SoCal, great post, I recently visited a new home community in SD that had an additional $600 per month in not one but TWO HOA's, CFD, and Mello Roose, How does one who signs up for that mortgage and is stretched thin afford an estra $600 a month? My grandmother always said "you can't save a person from his own stupidity"!

2/07/2006 8:02 AM  

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