With Interest Rates so High, Is it Cheaper to Rent or Buy a Home?
As of November 2022, mortgage rates have hit their high since they were at 8% in 2000, housing prices are beginning to stabilize, but weary potential homebuyers still have to account for the 7% interest rate that we’re currently seeing.
With this in mind, it’s easy to think that renting may be the cheaper route, but as you’ll find out in this article, interest rates and inflation affect rent prices as well as home prices. So, which is cheaper: Renting or buying?
To determine the answer, we must look at how both home prices and rents are affected by interest rates and different factors that determine the best housing decision for your particular situation.
Why are interest rates rising?
This is a complicated question to answer, but it’s important to understand the cause of the rate increases. The Federal Reserve ideally wants the inflation rate — the rate that prices go up each year — to hover around 2% year-over-year (YoY).
April 2021 saw inflation jump from 2.6% YoY in March to 4.2% YoY, and it continued to rise until its peak in June 2022 of 9.1%. The economy and inflation are complicated, but the rise in inflation according to Fortune has been attributed to “nearly everything.”
Beginning with the pandemic, we’ve seen supply chain issues, which has led to decreased access to certain goods. The Fed lowered interest rates to encourage spending during the pandemic recession. Consumer spending rose when the government sent out stimulus checks to ease the impact of the pandemic.
While wage gains haven’t kept up with rising inflation, wages are going up, consumers are still spending, and the job market is still strong. Without intervention from the Fed, there’s no way to know when, or if, inflation will level out or begin to go down on its own.
Enter rate hikes.
According to John Taylor, a Stanford economist, “the most effective monetary policy is to increase the interest rate by a sufficient amount when inflation rises. This will tend to reduce the rate of inflation and bring it back down to the 2% per year target of the Fed.”
And the Fed has done just that, raising rates six times in 2022, taking the Federal Funds Rate from 0.25% to 4%. This rise in the Federal Funds Rate directly impacts interest rates which increases the cost of borrowing money, therefore slowing spending and reducing employment with the goal of curbing inflation.
So how does this impact whether renting or buying a home is cheaper?
How are home prices affected by interest rates?
When the Fed lowered interest rates in March 2020, mortgage rates fell to their low point during the pandemic—with the national average falling below 3% on a 30-year fixed mortgage—buyers could afford to take out a larger mortgage, which, among other factors like high demand and low inventory, kept driving home prices up.
Today’s mortgage rate—at a national average of just above 7% on a 30-year fixed mortgage—means that buyers aren’t getting as much home for the money they’re spending.
Let’s take a look at an example:
Mortgage Amount Interest Rate on a 30-Year Fixed Rate Mortgage Monthly Payment (Principal + Interest)
$400,000 3% $1,686
$400,000 7% $2,661
The goal of raising interest rates is to slow the demand for housing, encouraging people who would otherwise be in the home buying market to stay in their current home or rent instead. This decrease in demand should then help to lower, or at least level out, home prices.
But it makes owning a home more expensive.
How are rent prices affected by interest rates?
It’s easy to think that because you’re not taking out a mortgage, interest rates don’t affect how much you’ll pay in rent. But on the contrary, interest rates, inflation, and high demand have contributed to a rise in rent.
Landlords and building owners have to cope with the rise in price of goods and services, and if they’ve taken out a recent mortgage on the building, they’re also dealing with high mortgage rates.
These costs get passed to their renters.
According to a Freddie Mac survey conducted in June 2022, 58% of renters saw their rent increase in the past 12 months, with 6% of those seeing an increase of more than 30%.
Higher interest rates on mortgages can discourage would-be homeowners from buying, so they jump into the rental pool—which is already a little full at the moment. And higher number of renters increases demand which, in turn, increases rent prices.
What to consider when deciding whether it’s cheaper to buy or rent
1. Take potential rent increases into account
Rents typically go up around 3-5% per year, but in recent years rent increases have regularly gone up by double digits year-over-year. This is beginning to cool, but there’s no way to know what the future holds. Regardless of the actual amount, you can be sure that your rent will increase at some point during yourresidence.
2. Take interest rates into account
Interest rates have a large impact on mortgage payments, but they also impact the rental market. And interest rates fluctuate over time, so if you buy a home, you may have the option to refinance your home purchase at a lower interest rate down the road which would lower your monthly payment.
Even if interest rates drop, it isn’t likely that your rent will go down, though it may not go up as quickly.
3. Look at the entire picture
It’s easy to look at the monthly payment on a home vs. rent payment and jump to a quick decision based on which one lookscheaper on paper. But there are a lot of other factors to consider:
Maintenance costs
Home maintenance costs are typically about $1 per square foot of livable space or about 1% of the total purchase price. So if you buy a 2,500 sq. ft. home for $300,000, you can estimate the maintenance costs will be $2,500-$3,000.
Maintenance for rental properties is typically covered by the landlord or property management company, so you won’t have to account for these costs in your monthly or yearly budget, but they are accounted for in the rent.
Quality of life
Everyone’s needs are different, so considering how renting vs. buying will impact your quality of life is an important consideration. It may be cheaper to rent, but if you really want to be a homeowner, buying may be the way to go. It’s hard to put a price on living the life you want.
The area where you want to live
Where you want to live will also impact whether it’s cheaper to rent or buy. For instance, if you want to live near the ocean, buying might be out of reach, but renting a home with ocean access might be doable.
It can also be more cost prohibitive to buy a home or condo in a large city, and if renting near your work means you’re spending less on your commute, that might be the way to go.
Your ideal area might offer lower home prices and the opportunity to pay less to buy a home than you would to rent one.
Access to amenities
Access to amenities will also impact whether it’s cheaper to buy or rent a home with high interest rates. Apartment buildings often offer amenities like a fitness center, pool, rooftop terrace, and more.
So, weighing what it would cost to have some of these amenities at your home rather than a rental should factor in as well.
Resale value on a home
Owning a home is widely regarded as a good investment, so make sure to consider the potential resale value when you decide to sell down the road. If you’re in a neighborhood where home values are rising, that’s a good sign that when you sell your home in the future, you could make a profit.
But be sure to factor in the total cost of the home (sale price + interest + maintenance) when you’re running the numbers.
How much you’ll pay over the life of the loan vs. years of rental payments
Other than quality of life and resale value of a home, this is probably the most important factor in determining whether it’s cheaper to buy or rent.
When you buy a home, you should take into account the interest you’ll pay over the life of the loan as well as any maintenance and improvement costs — you should also factor in the potential resale value.
To determine how much you’ll pay in rent, multiply the monthly rent payment by the amount of time you plan to rent and include rate increase estimates. A 2-5% increase yearly is a good place to start.
Bottom line: Is it cheaper to rent or buy?
The answer to this is highly dependent on each person’s individual circumstances. Choosing to rent rather than purchase a home can mean you’re not covering the cost of sky-high interest rates, but rents also tend to go up when interest rates are high.
Demand, supply, and market conditions in your area will vary, and the cheaper decision today may not end up being the cheaper decision in a few months.
The best way to determine if it’s cheaper to rent or buy is to take stock of current interest rates, home prices, and rent prices and do some math to figure out how each one will affect you in the long term.
