Rent or Buy?

More than two out of every three Americans, a record high, own their own homes. Sandi Cereghino isn't one of them.

Right now Cereghino, 25, who works for a public relations firm in Portland, Ore., is content to rent a one-bedroom apartment in a nearby suburb. But she worries that paying rent isn't the smartest way to spend her money. "Once you make that payment each month, it's gone," says Cereghino. Mortgage payments, on the other hand, would go toward property that she might eventually own free and clear, which is one of her goals.

More than one-third of all renters are saving for a down payment on a house, according to Fannie Mae's 2000 national housing survey, and it's a safe bet that many of them are in their twenties. U.S. Census data show that nearly 37% of adults under 30 have already purchased a home.

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Low mortgage-interest rates are encouraging renters of all ages to buy. And there are plenty of advantages to owning a home, from saving on taxes to building equity to being free to paint your bedroom purple.

But for young people the financial benefits can be overstated. While property taxes and mortgage interest are tax deductible if you itemize, not every dollar of interest and tax will result in a tax break. If you have been taking the standard deduction, you'll benefit only to the extent that your itemized deductions exceed the standard deduction ($4,700 for single filers in 2002 and $7,850 for married couples).

Suppose your mortgage interest and property taxes total $8,500. If you're in the 27% tax bracket in 2002, you might think that means Uncle Sam effectively pays $2,295 of the bill for you via tax savings. But if you're single and have been claiming the standard deduction, you give it up when you start to itemize. If your itemized deductions -- including $1,500 for state income taxes in this example -- total $10,000, the tax savings from buying would be just $1,431. That's about $865 less than a quick, everything-is-deductible calculation would lead you to believe.

But the biggest potential drawback for young people is that they won't stay in a home long enough to recoup the transaction costs involved in buying a house. If you think you'll need to relocate to advance your career, or if you're still unsure about where you want to settle, renting may be the better choice. "You have to ask yourself what else is going on in your life," says Wendy Johnson, who trains teachers of home-buying classes in Duluth, Minn.

How long will I live in the house? In addition to the purchase price, buying a home can cost you as much as 6% in closing costs, including 1% of the loan amount for every point on your mortgage loan plus attorney, appraisal, loan-application and other fees. You're likely to put more money into the house for improvements and repairs. When you sell, there's a different set of costs, including the agent's commission, typically 6%.

Recovering those costs depends on price appreciation, which varies by location. For example, house prices spiked 9.5% nationwide in 2000 but grew only 2.6% in 1996. Long term, house prices tend to rise one to two percentage points above the rate of inflation.

Most experts recommend that you hold on for five to seven years to make purchasing a house or condo worthwhile. Owning property for three years or less virtually guarantees that you will lose money, says Judi Wolfson, a ReMax real estate agent in Warminster, Pa.

Uncertainty about where she wants to settle is one reason that Cereghino is undecided about buying a home. As long as she continues to rent, she says, "I can move wherever I want once my lease is up."

Can I take on additional debt? When lenders evaluate you for a mortgage, they prefer that no more than 40% of your gross income go toward paying off debt. If the mortgage payment alone would account for 30%, that means payments for student loans, credit cards and car loans shouldn't add up to more than 10% of your gross income. "Those ratios can be tough for young people to meet," says Sarah Blevins, who teaches home-buying classes in Maine.

Do I have enough savings? Cereghino has set aside $5,000, about one-third of the cash she thinks she'll need to buy a house in the Portland suburbs, which should cost about $150,000. Blevins and other real estate experts suggest having between 3% and 10% of a house's sale price in cash to cover the down payment and closing costs.

Where do I want to live? Just because you can afford to rent in a particular neighborhood doesn't mean you can afford to buy there. If finding a home in your price range means looking in a neighborhood you don't like, maybe you should reconsider buying altogether. "Don't fool yourself into thinking that you can afford a town house when you hate the area it's in," says Wolfson. In general, it's cheaper to rent than to buy equivalent housing. For example, in San Francisco, where the vacancy rate is a mere 1%, the average apartment rents for more than $1,800 a month. But the median price of a condominium in San Francisco is $427,780. With a down payment of 5% and an interest rate of 7%, the mortgage payment on such a condo would be $2,704 per month for a 30-year loan. And that's before property taxes and mortgage insurance.

If the monthly cost of buying would be about the same as for renting and you intend to stay in the area, you're better off buying. Even if the monthly cost is higher, buying can make sense if you're getting a reasonably priced home that is expected to appreciate and you plan to say put.

Have I factored in all the costs? Don't underestimate new expenses you may incur. For example, you'll have to pay for water and sewer services, expenses that landlords usually pick up for renters.

If you're not sure whether your budget will stretch to make room for the expenses of homeownership, Wolfson suggests a dry run. For six months, set aside in a bank account the money for additional monthly expenses you expect as an owner. At the end of that period, you'll know whether you can afford to buy -- and you'll have saved money for the down payment.