How to Buy a House home
Learn the basics
1.	The Basics
2.	How much home can you afford?
3.	The Down Payment
4.	The Loan
-	Assuming a Loan
-	Owner Financing
5.	Qualifying for a loan
6.	Understand Closing Costs
Do the groundwork
7.	Get your finances in order
8.	Check Your Credit Report
-	Repair bad credit
-	Establish Credit if you don't have any
The Process
10.	Find a Lender
11.	Evaluate the bank's offer
12.	Start looking at houses
13.	Get the Disclosure
14.	Make an offer / Sign a Contract
15.	Have the House Inspected
16.	Problems on the Inspection?
17.	Renegotiate the terms
18.	Appraisal, Survey, & Insurance
19.	Appraisal went through?
20.	Closing!

After the purchase

Avoding scams

More about Mortgages

How much loan can you get?

Figuring your monthly pmt.

15- vs. 30-year loans

Prepaying your mortgage

How to figure mortgage interest

Private Mortgage Insurance

Paying Points

If you won't live long enough to pay off the mortgage

Other Topics

Renting vs. Buying: Which is better?

Paying cash vs. getting a loan

The Debt Ratio

Tax breaks are actually welfare for the rich

Other

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Renting vs. Buying

Which is better?

In most cases, it's better to buy a home than to rent. But not in every case. Comparing buying to renting is actually a fairly complicated endeavor. Fortunately we can give you some quick rules of thumb. You should usually buy instead of rent except when:

• You intend to move within a few years
• Your rent is very low (~ 2/3 or less of what your total monthly payments would be for buying a house, including taxes & insurance)
• You don't expect to live more than another 15 years

If you choose to rent instead of buy, you should save and invest religiously.

Building equity vs. "throwing your money away"

A big myth is that it's better to buy because by owning you're not "throwing your money away on rent". But when you buy a home you will still throw money away on things that don't build any equity. These include:

• Closing costs
• Interest on your mortgage
• Property taxes
• Property Insurance
• Private Mortgage Insurance (if your down payment is less than 20%)
• Maintenance

In fact, these "throwaway" expenses are more than you'd likely spend on rent. If the only financial advantage to buying a home were building equity, it wouldn't be enough to offset these expenses, and it would be better to rent. The reason that buying is usually better than renting is not because you avoid throwing money away, it's because:

• You lock in your monthly payment for 15 or 30 years. (If you kept renting you'd pay more each year.)
• Your house gets more valuable over time.

Freezing your monthly payments is where the real benefit is. Were it not for this, for many people it would make more sense to rent. This is the gem that makes home-buying worthwhile.

There are a couple of other advantages to buying:

• You can stop making payments when the loan is paid off.

This is a big advantage, but it doesn't get your costs down to zero. You will still pay for taxes, insurance, and maintenance even after your loan is paid off. On a home worth $180,000 that could be around $525/mo. Sure, that's better than the $1000/mo. you could be spending on rent, but it's not free.

• You can deduct mortgage interest on your income taxes.

For most people this advantage is pretty small, so we won't consider it in our analysis below. You can certainly include it in your own analysis if you want to be complete.

Here's an overview of buying vs. renting:

	Renting	Owning
What You Pay For	Rent (and possibly renter's insurance)	Once * Down Payment * Closing Costs For 15-30 years * Mortgage Payment  (principal + interest) Forever * Taxes * Insurance * Maintenance
What You Can Deduct on your Taxes (in the U.S.) (footnote)	Nothing	* Interest on mortgage, and property taxes (only if you itemize on Schedule A instead of taking the Standard Deduction) * If it's rental property, you can also deduct insurance and maintenance, whether or not you itemize. If it's a duplex and you live in half and rent the other half, you can deduct half of these costs. * When you sell your home, you don't have to pay any taxes on the gain, in most cases. Whoa!
How you can build an investment	Take the money you would have spent on a down payment for a house and on high monthly mortgage payments, and invest in something else instead, such as a socially-responsible mutual fund.	Your house is your investment. When you buy your house, your stake in the house is equal to your down payment. (If you put 10% down, you own 10% of the house when you start.) As you make monthly mortgage payments for 15-30 years, you'll gradually own more and more of the house. Also, the house will get more valuable over time. (Figure at least 3%/year.) Once you've paid your house off in 15-30 years, you no longer have to make a monthly mortgage payment. All you'll have to pay is taxes, insurance and maintenance. Besides that, you live for free.
How you could screw up this investment	Fail to invest your extra money somewhere else. In that case, you have no investment.	Possible mistakes include: Paying more than the house is worth Paying more than you can afford (in which case you could lose the house by failing to make payments) Paying too much interest, by getting an ARM mortgage with unfavorable terms, or failing to refinance a FRM when rates drop. Note that even before you finish paying off your loan you own a substantial portion of your house, but that value is locked into the house so it's not cash in your pocket. To convert your investment to cash, you must either sell the house (and start over with another one), or borrow against your existing home and invest the cash in something else (a second house, a business, a socially-responsible mutual fund, etc.). If you don't do one of these two things, you'll never see any real money from your investment. The best you will do is to not have to make monthly payments any more when the house is paid off, which will take 15 to 30 years. If that's all you want, then fine. But you do have extra financial power locked into your home, which does nothing for you unless you tap into it.
Pros	* Simple * Start investing right away, without having to save for a down payment * Easier to move if you decide to relocate * No cost or effort spent on maintenance * If your rent is low enough, this could be a better investment than house-buying.	* Pride and comfort in owning your own home. * Ability to customize the home exactly how you want. * Money that you pay towards the principal on your loan each month increases the % of your home that you own. In effect, you're paying yourself. * Mortgage payment stays the same over 30 years. If you were a renter, your rent would definitely go up. * If you itemize deductions, you can deduct the interest you pay on your mortgage. * You leverage your investment by buying the home with (mostly) the bank's money. You might put only 10% down, but your whole house (all 100%) of it appreciates every year. If you put $10k down on a $100k house, the whole $100k appreciates, not just the $10k you put down. * When (if) you sell your home, you don't have to pay any income tax on the gain. Whoa!

Comparing buying vs. renting

Below we'll explain in detail how to compare the financial aspects of renting vs. buying. If it's too daunting for you then you can always look for a rent-vs.-buy calculator on the web, though I haven't seen any that seem especially accurate. (For example, many seem to assume that every penny you spend on interest is deductible, which is not really true because they're not accounting for the fact that you get around $7000 of automatic deduction anyway even if you don't itemize, so the benefit from itemizing is a lot more limited than they're letting on.) Also, the results from these calculators will be only as good as the numbers you put into them; the default values for things like the appreciation rate or your savings/investment return rate could be drastically different from reality. Unfortunately, detailing all the values that go into a calculator could be the subject of a small book, and is beyond the scope of this web page, though we do provide a fair amount of background material below.

Anyway, to get started on our rent vs. buy comparison, let's see a summary of your expenses for renting vs. buying.

Total Expenses when Renting vs. Buying
Renting	Buying
Rent	Down Payment   +Closing Costs   +Mortgage Payments   +Taxes   +Insurance   +Maintenance ------------------------------    Total Cash Out ------------------------------     Equity built from down payment   +Equity built through mortgage payments   +Equity built through appreciation ----------------------------------------------------------     Total Assets ---------------------------------------------------------- Total Expenses = Cash Out - Total Assets

With renting it's pretty easy -- all you pay for is rent. But with buying you have a bunch of expenses, and on the other hand you have some benefits that must be weighed against those expenses. That's why the comparison is not so simple.

 

Let's start building a complete example, building it one step at a time. Let's say you're currently paying $1000/mo. in rent. You're thinking of buying a $180k home. How do you compare the two?

First we figure the payments on the loan. A $180k house with 5% down ($9k) means a $171k loan. At 6% interest over 30 years your monthly payments would be $1025. (See figuring your monthly payment.) The following table shows how much we'd spend over 30 years for renting vs. buying. In simplest terms here's how it looks for buying vs. renting:

Amount spent when renting vs. buying	Renting	Buying
Spent over 30 years	$360,000 ($1000 x 12 x 30)	$369,000 ($1025x 12 x 30)

So far it costs $9,000 more to own the house. But we also paid closing costs when we bought our house. Closing costs vary widely but let's assume 3% of the purchase price ($5400), and that you roll them into the mortgage.

Including closing costs	Renting	Buying
Spent over 30 years	$360,000 ($1000 x 12 x 30)	$381,000 ($1058x 12 x 30)

Wee also made a 5% down payment, and we should account for that:

Including the down payment	Renting	Buying
Spent over 30 years	$360,000 ($1000 x 12 x 30)	$381,000 ($1058x 12 x 30)
Plus Down Payment		$9000
Total Spent	$360,000	$390,000

Now it costs $30,000 more to own the house. But we're not done with our expenses for owning the house....

Taxes, Insurance, and Maintenance

Let's add in estimated taxes, insurance, and maintenance costs:

• Taxes & Insurance: $3600/yr. (est. 3% of purchase price)
• Private Mortgage Insurance: $1411/yr. for 5 years
• Maintenance: $1800/yr. (est. 1% of purchase price)

Renters might want to get renter's insurance too, but we're not including it because:

• Most renters don't have it.
• You have to pay for insurance when you own a home, when you rent you don't.
• The cost of renter's insurance compared to homeowner's insurance is tiny.

Anyway, let's see how things look once we factor in taxes and insurance.

Factoring in Taxes & Insurance	Renting	Buying
Spent over 30 years	$360,000 ($1000 x 12 x 30)	$381,000 ($1058x 12 x 30)
Plus down payment	0	$9,000
Plus taxes & insurance	0	$108,000 ($3600 x 30)
Plus private mortgage insurance	0	$7,055 ($1411 x 5)
Plus maintenance	0	$54,000 ($1800 x 30)
Total spent	$360,000	$559,055

Whoa! Once we add in taxes, insurance, and maintenance, buying the house costs a lot more. But what we're failing to consider is that all the money from renting is thrown away, while when you buy only some of it is thrown away. So now let's balance that out by looking at how much equity we've built.

Building Equity

When you rent, 100% of the money you spend is thrown away. When you buy, only some of that money is thrown away. Homeowners will still "throw away" money spent on taxes, insurance, interest, and maintenance. However, money you spend paying back the principal of the loan is value you get to keep. So is the money you spent on the down payment.

Building Equity	Renting	Buying
Spent over 30 years	$360,000 ($1000 x 12 x 30)	$381,000 ($1058x 12 x 30)
Plus down payment	0	$9,000
Plus taxes & insurance	0	$108,000 ($3600 x 30)
Plus private mortgage insurance	0	$7,055 ($1411 x 5)
Plus maintenance	0	$54,000 ($1800 x 30)
Total spent	$360,000	$559,055
Less equity we've built from down payment + mortgage payments	0	$180,000
Net loss	$360,000	$379,055

Buying still looks like a worse deal, but we're not done with our analysis yet, so sit tight. In the meantime, let's discuss equity.

It might seem that the equity you've built is somewhat mythical. After all, after paying off your house, you don't suddenly have $180k in cash to spend. If you want to continue living in your house, it seems that your equity is tied up in the house, and therefore useless. You might wonder if building that equity really did you any good.

Yes, it did, and here's why. If you hadn't bought the house, then you would still be renting, right? In thirty years, you'd still be faced with paying $1000/mo. for rent. You'd have to come up with that $1000/mo. from scratch each month, working to earn it. But if you'd bought the house, you could sell it for $180k and you could use that money to pay the rent with for several years. You really did build equity by buying, even if you don't sell, because the alternative is that you'd have to keep paying rent, and that you'd have to come up with that rent money from scratch each month.

And yes, in 30 years the house will actually be worth more than the $180k we paid for it. Hang on, that's next.

Appreciation

Appreciation means that an asset gets more valuable over time. Real estate generally appreciates; a house bought today is worth more a year from now.

The general rate of inflation is about 3%, and I think it's safe to assume that real estate appreciation will be about the same. Many people consider real estate to appreciate a lot faster than inflation, but I don't think you can count on that:

• From 1976-95, houses didn't appreciate faster than inflation. The huge surge in appreciation happened only recently, from 1995-2006, and that was a fluke. It likely won't happen again any time soon. From here on out, we can probably expect only modest appreciation.
• It's not feasible for houses to appreciate faster than inflation for the long term. If people's salaries go up about 3% a year, but houes appreciate 7% a year, it won't be long before nobody can afford to buy a house.

The U.S. average for real estate appreciation from 1963-2006 was 6.3%. (U.S. Census PDF) This is bigger than the typical 3% general inflation rate, but there are three caveats:

1. The general inflation rate in the 70's and much of the 80's was much higher. The average inflation from 1976-95 was around 5.4%, almost as high as the rate of real estate appreciation.
2. The 6.3% figure above includes the fluke period from 1995-06 when real estate prices surged, which will probably not happen again for a looong time.
3. Part of the home price increase was probably because homes got bigger. From 1950-2005, the average home size doubled. Factoring that in, that makes the rate of appreciation 5.2% after accounting for size increases. (Figuring that we saw an increase in home size of 2*(43/55)=1.56 for 1963-06, making the effective 2006 price not $246k but rather $246k / 1.56.)

For all these reasons, I wouldn't count on appreciation being any higher than the general rate of inflation.

Anyway, let's factor in appreciation into our calculations, assuming 3%/year.

Appreciation	Renting	Buying
Spent over 30 years	$360,000 ($1000 x 12 x 30)	$381,000 ($1058x 12 x 30)
Plus down payment	0	$9,000
Plus taxes & insurance	0	$108,000 ($3600 x 30)
Plus private mortgage insurance	0	$7,055 ($1411 x 5)
Plus maintenance	0	$54,000 ($1800 x 30)
Total spent	$360,000	$559,055
Less equity we've built from down payment + mortgage payments	0	$180,000
Less equity built from appreciation	0	$256,907
Net loss	$360,000	$122,148

Now we're talkin'! Once we consider paid equity and appreciation, buying turns out to be a better deal. We've spent a lot less and we own a home. But we're not done yet.

Inflation

In this next step we'll account for the fact that rent, taxes, insurance, and maintenance cost more over time, and that any house we buy is worth more over time. But notice one thing that's not affected by inflation: Your mortgage payment. This is one of the main benefits of buying a home: your mortgage payment never increases. Your taxes, insurance, and maintenance go up, but the amount you pay the bank each month does not. This compares favorably with rent, since rent goes up all the time.

Inflation rates are hard to predict, so let's just use a rate of 3% for our expenses (rent, taxes, insurance, maintenance, and home value).

Factoring in inflation	Renting	Buying
Spent over 30 years	$570,905 ($1000 x 12 x 30, increasing 3%/year)	$381,000 ($1058x 12 x 30)
Plus down payment		$9,000
Plus taxes & insurance	0	$171,271 ($3600 x 30, increasing 3%/yr.)
Plus private mortgage insurance	0	$7,055 ($1411 x 5)
Plus maintenance	0	$85,636 ($1800 x 30, increasing 3%/yr.)
Total spent	$570,905	$653,962
Less equity we've built from down payment + mortgage payments	0	$180,000
Less equity built from apprecitaion	0	$256,907
Total that we're really out	$570,905	$217,055

Buying is still a way better deal. We spent less, and we own a house.

 

Another windfall: No more monthly payments

It gets even better. The table shows only the first 30 years. But starting in year 31, your house is paid off and you no longer have to make mortgage payments to the bank, while as a renter you'd have to keep paying rent. That saves you $3600/mo. Your costs in year 31 would thus be:

Year 31 out-of-pocket costs	Renting	Buying
Amount spent on rent or mortgage payments	$29,124 ($1000 x 12, adjusted for inflation)	0
Plus taxes & insurance	0	$9,000 ($3600 in year 1, adjusted for inflation)
Plus maintenance	0	$4,369 ($1800 in year 1, adjusted for inflation)
Total spent	$29,124	$13,369

Your equity has bought you the right to not pay rent any more. You'll still have to pay for taxes, insurance, and maintenance, but it will be less than half of what you'd spend on rent.

And it doesn't stop there. Let's say in your retirement years you decide you want to do any of the following:

• Move to another state or country.
• Move to a smaller house.
• Move to a larger house.
• Become a renter again
• Travel extensively, not having a specific home for several years

By owning your home instead of renting you're now in a much better position to do so, because you can simply sell your existing home and use the money to finance any of your other plans. If you'd continued to rent you wouldn't have this equity.

Building equity for renters

Renters can build equity too, just not in a home. You simply invest in something else, such as a mutual fund or your own business. If you can invest $525/mo. and earn 6%/year on it, then after 30 years you'll be in about the same position as the home buyer in our example above, with about $525,000 in equity, before taxes.

Some people do their own math and think that renting and investing the difference is way better than buying, but they're usually missing a couple of things. First, they're neglecting to subtract out the taxes you pay once you sell your investments. This is at least 15%, usually more, depending on the capital gains tax law in effect at the time. By contrast, in most cases you can sell your home without paying any tax at all, since most gain or personal home sales is exempt. Second, they're assuming they can make 10% in the stock market because they saw somewhere that that's the historical return. But 40% of that return is from dividends, and dividends are usually not that easy to reinvest, if they're paid at all. I think assuming 6% is a more reasonable figure.

Another thing you have to consider is that to make this whole "investing the difference" idea work, you have to diligently invest every penny you would have spent towards a house, right away. I doubt most people have the financial discipline to do so. Owning a home is a form of forced savings. However, if you're diligent about always investing the difference, and are disciplined enough not to spend any of it for 30 years, and you're confident that you can earn a decent rate of return, then you can rent instead of buy with little to no financial penalty, and perhaps even a profit.

I made a Google spreadsheet to compare buying vs. renting, which I think is a little more accurate than the typical rent-vs.-buy calculator. To punch in your own numbers, click "Edit this page" at the bottom of the page, log in, then choose File > Copy Spreadsheet.

 

So there you have it: That's how to compare buying vs. renting!

1. Poor people who have to pay rent don't get this break. They can't deduct their rent on their tax returns.
2. Rich people have much more expensive homes, so their tax savings on mortgage interest is phenomenal. This deduction actually winds up COSTING middle-class homeowners, because we're all paying higher standard tax rates as a result of the rich getting a real estate deduction that's worth a lot more to them.

Here is a telling passage from Take the Rich off Welfare:

"The National Housing Institute calculates that [the mortgage interest] deduction cost the Treasury slightly more than $58 billion in 1995, and that half that total -- $29 billion -- went to people with incomes over $100,000. (In comparison, the entire 1995 budget for HUD, the Department of Housing and Urban Development, was $26 billion.) ... [M]iddle-class homeowners think they're the ones getting the deal. If you believe that, you're being had. It's a classic case of being tossed a few scraps from the table. If we simply eliminate all the handouts and boondoggles [like this one], our tax rates would drop so far, so fast, that special little deals like these homeowners' loopholes would seem archaic and silly." [pp. 52-56; emphasis added]

Same deal with the fact that you pay no tax on the gain when you sell your home. Rich people have much more expensive homes, so they're the ones reaping the lion's share of the no-tax-on-the-sale rule. (Actually, rich people do have to pay taxes on gains above $250,000, or $500,000 for married couples, but that's still a LOT of gain that they get tax-free.)

Last update: June 2008