Rent Vs. Mortgage: How Close Should They Be?

Deciding between renting and buying a home can be challenging, especially in competitive markets. There are several factors to consider when choosing between renting and buying, such as cost, freedom over your space, and financial security. In this context, it is essential to understand how close rent should be to a mortgage. While renting might be more suitable for those seeking short-term savings or planning to stay in an area for a short period, buying a home can be a valuable long-term investment.

How close should rent be to a mortgage?

Renting vs. buying a home: the pros and cons

Deciding between renting and buying a home can be a challenging decision, especially in competitive markets. Both options have their own set of pros and cons, and there is no one-size-fits-all answer. Here are some factors to consider when weighing the pros and cons of renting versus buying a home:

Financial Considerations

Cost is a significant factor when choosing between renting and buying. In general, renting might be more suitable for someone who is concerned about short-term savings or is not ready to commit to a particular location. Renting is often associated with lower upfront costs, as you typically don't have to worry about a large down payment or closing costs. Additionally, maintenance and repairs are the responsibility of the landlord, which can save you money in the short term. According to Olsen, in most places, rent is less expensive than a mortgage on a monthly basis, even when comparing similar homes. However, it's important to note that rents have been increasing, and in some metros, the difference between renting and owning with a mortgage has narrowed significantly.

On the other hand, buying a home can be a valuable long-term investment. While it may require a substantial down payment and closing costs, homeowners can build equity over time and grow their overall wealth. Making mortgage payments can be considered "forced savings" as you build ownership in your home. Additionally, homeowners can benefit from tax deductions to lower their federal tax bill, such as deducting the interest paid on mortgage debt. However, as a homeowner, you will be responsible for all maintenance and repair costs, which can add up quickly.

Flexibility and Mobility

Renting provides flexibility and mobility, making it ideal for those who like to move around or are just starting their careers. Lease agreements are typically shorter, allowing for more freedom to relocate without the burden of selling or renting out a property. In contrast, buying a home provides more stability and control over your living situation. As a homeowner, you have more freedom to modify and improve your home without the restrictions of a landlord. However, it becomes more challenging to move, especially if you're facing financial difficulties or defaulting on your mortgage.

Privacy and Space

When you rent, you may have to deal with issues like thin walls, loud neighbors, or a landlord who may restrict certain activities. On the other hand, owning a home provides more privacy and freedom to create a space that suits your preferences and lifestyle.

Job Security and Financial Stability

Before considering buying a home, it's crucial to assess your financial situation and job security. Lenders will review your employment history and income stability to determine your ability to secure a home loan and make consistent mortgage payments. If you're facing financial challenges or uncertainty about your job, renting may be a more suitable option until you achieve greater financial stability.

The cost of renting out your home

Renting out your home can be a smart financial move, but it requires careful calculation of costs. Firstly, you must consider the mortgage, maintenance, and homeowners' association dues. You should charge enough rent to cover these monthly outlays. If you are renting the house furnished, you must ensure that your insurance covers the personal possessions you leave behind. Alternatively, if you are renting the house unfurnished, you will need to factor in the costs of moving and storing your items.

There are also tax implications to consider. In most places, you will not be eligible for tax exemptions, and your taxes may increase. You can reduce your cost basis each year, and this amount will be a loss against income from the rental, or it can be used against your ordinary income. However, when you sell, your basis will be lower, and you will be taxed on the difference between your basis and the sale price.

Additionally, you will need to market your property to attract tenants. This may involve paying for advertisements, online listings, and real estate agent fees. You will also need to pay for background and credit checks on prospective tenants, and you may need to hire a real estate attorney to ensure you have a solid rental agreement in place.

Finally, you should be prepared for your property to sit vacant for some time. Good tenants can be challenging to find, and even if you find new tenants right after the previous ones move out, there will likely be a few days of vacancy. During this time, you will still need to cover the property's mortgage and utility costs.

How to set the right rent price

Setting the right rent price is a challenging task, and there are many factors to consider. Firstly, it is essential to understand the local market and comparable properties in the area. The rent price should be competitive and in line with similar rental properties in the neighbourhood. Overpricing compared to similar options may lead to potential tenants choosing other properties. The rental market has its seasons, and it is important to be aware of these swings. For example, in college towns, rents tend to peak before the semester starts and drop during breaks.

The location of the property is a significant factor in determining the rent price. Desirable neighbourhoods that are safe, have access to good schools, public transport, and family-friendly amenities are in high demand and can command higher rents. The size of the rental also matters, with larger units typically fetching higher rents. However, smaller properties may sometimes attract a higher price per square foot, depending on the specific market demands.

The features and upgrades of the property itself can also influence the rent price. Properties with resort-style amenities or proximity to desirable locations may warrant a higher rent. However, it is essential to consider the law of diminishing returns and avoid over-developing the property, as the cost of some improvements may not be recouped if they are disproportionate to comparable properties in the area.

It is also crucial to consider the various expenses associated with renting out a property. These include maintenance, repairs, taxes, insurance, and professional services such as legal and financial advice. A common suggestion is to set the rent high enough so that 50% of it covers these expenses, with the remaining 50% applied to the mortgage.

Additionally, it is important to stay informed about local laws and regulations regarding rent control or stabilization. These laws can limit the amount of rent that can be charged and the rate of increase. Consulting with legal and tax professionals can help ensure compliance and optimize the property's value.

Lastly, it is worth considering the financial circumstances of potential tenants. While renting may be more suitable for those seeking short-term savings or planning to stay in an area for a limited time, buying a home can be a valuable long-term investment. As a result, the rent price should be set at a level that is both profitable and appropriate for the market.

The difference between renting and owning in metros

There are several differences between renting and owning a home in large metros. One of the most significant factors is cost. In general, renting tends to be more affordable than owning a home with a mortgage in large metros. This is because the median rent costs are typically lower than the median housing costs, which include mortgage payments, taxes, and fees. The gap between renting and owning has widened over time, with the difference in monthly costs increasing from $475 in 2022 to $498 in 2023 in the US.

The difference in costs between renting and owning varies across different metros. For example, in 2023, the dollar difference between renting and owning a home with a mortgage was highest in San Francisco, Bridgeport, Connecticut, and New York, with a difference of $1,414, $1,367, and $1,340, respectively. On the other hand, Phoenix, Orlando, Florida, and Palm Bay, Florida, had the narrowest gaps, with median gross rent costs being $90 to $128 less than median housing costs per month.

Another difference between renting and owning in metros is the level of responsibility and maintenance required. When renting, the landlord is typically responsible for maintenance and repairs, whereas homeowners must bear the cost and hassle of upkeep and repairs. Homeowners may also have more freedom to modify and customize their living space, whereas renters may be restricted by landlord rules and regulations.

Financial stability is also a critical factor when deciding between renting and owning in metros. Renting can provide more flexibility and short-term savings, especially for those who cannot afford a down payment or keep up with mortgage rates. In contrast, buying a home can be a valuable long-term investment, allowing homeowners to build equity and benefit from tax deductions. However, it is crucial to ensure financial stability before committing to a mortgage, as missing payments can lead to foreclosure.

Ultimately, the decision between renting and owning in metros depends on various factors, including budget, lifestyle, and financial goals. While renting may offer more flexibility and lower costs in the short term, buying a home can be a wise investment for those seeking long-term stability and wealth accumulation.

Tax implications of renting and buying

When it comes to renting and buying, there are several tax implications to consider. Here are some key points to note:

Renting

If you are renting out a property, the income you receive is typically taxable, and you are required to report this rental income on your tax return. Any expenses incurred to get the property ready for renting and then to maintain it as a rental can be deducted from your rental income. These deductible expenses may include mortgage interest, property tax, operating expenses, depreciation, repairs, insurance, utilities, and maintenance. It is important to maintain good records of these expenses, as they may be subject to audit. Additionally, advance rent, such as receiving rent for the last month of a lease, is taxable in the year it is received. Security deposits, on the other hand, do not need to be reported as rental income if they are intended to be returned to the tenant at the end of the lease.

Buying

When buying a property, there are also tax considerations. If you plan to buy a property and rent it out, you can benefit from tax deductions on expenses such as operating costs and depreciation. Depreciation allows you to reduce your taxable net income by taking a percentage of your cost basis in rental buildings each year. However, if you sell the property, you may be subject to depreciation recapture, where you pay tax on the gain plus the depreciation deductions you claimed. Additionally, if you convert your main residence into a rental property, your tax basis in the property is calculated differently, and there are special rules to determine your tax basis.

Implications for Both

Whether you are renting or buying, it is essential to understand the tax laws and regulations to maximize tax benefits and minimize liabilities. Staying informed about tax changes can help you optimize your tax strategy. Additionally, keeping good records and maintaining a paper trail is crucial for claiming tax benefits and deductions, as you may need to substantiate certain expenses during an audit. Consulting with a tax professional can provide personalized advice and ensure you are compliant with the relevant tax laws.

Frequently asked questions