To Rent or to Buy?

Updated on July 23, 2007.

THINGS BEING EQUAL it's almost always better to own your home rather than to rent. After all, you build equity and get to write off your mortgage interest. And if you play your cards right, when you sell you'll be eligible for one of the best tax breaks around. But that doesn't mean that everyone should be a homeowner. If your move is short-term or if interest rates are high and property values deteriorating, it may be worthwhile to deal with a landlord for a while. Our worksheet will help you determine which path is best.

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Keep in mind that while home ownership provides security, it almost certainly won't give you the returns provided by equities. If history is any indicator, you can reasonably expect an 8% to 10% annual gain on your stock portfolio. Home prices, on the other hand, typically follow the rate of inflation over the long term.

That said, home ownership has a signficant tax advantage. Married couples can earn up to $500,000 in gains on home sales tax-free, while singles get $250,000. For a breakdown of how to qualify for this generous break, click here.

Of course, buying a home isn't strictly a financial decision. For most folks, the thought of constantly worrying about losing our security deposit every time we pound a nail or paint a wall isn't particularly appealing. Here are some other things to consider before making your purchase:

This may sound simplistic, but first and foremost you should find a neighborhood and a home that you just plain like. "You're not going to wake up in the middle of the night and say 'Wow! Look at my tax deduction!'" says CFP Lewis Wallensky.

Moreover, you should check on the sales price trends of homes in that neighborhood. If it looks like the area is declining in value, then avoid commitment: You're probably better off renting.

Finally, don't forget that even with the tax-breaks of home ownership, you will still be incurring out-of-pocket costs that you wouldn't encounter as a renter — from the cost of ripping down wallpaper to repairing a leaky roof. So before you buy, estimate how much those costs will be. After all, you don't want to live hand-to-mouth — even if it is in your own home.

If you do decide to buy, it's in your best interest to put down at least 20% of the purchase price, to avoid private mortgage insurance (PMI).

Congress has a soft spot for first-time home buyers. IRA owners can withdraw up to $10,000 as a lifetime credit penalty-free (but not tax-free) for the purchase of a first home. This means you and your spouse together can withdraw up to $20,000 (as long as each of you pulls $10,000 from your individual accounts). It also means that your relatives can raid their own IRAs penalty-free to make a gift to you for a first-time home purchase.

Believe it or not, you can actually use the first-time home-buyer exemption more than once. You simply must not have owned a home during the previous two years. But don't get too excited: No matter what, each person is limited to $10,000 over a lifetime. For more on breaks for first-time homebuyers, see our story.

Even though it is an option, withdrawing money from your 401(k) to fund a home purchase is a rotten idea. Assuming you're not at least 59 1/2 years old, you'll owe taxes plus a 10% penalty. You will also cripple your retirement savings, since most plans won't allow you to contribute to your plan for at least a year following a withdrawal. This means you're going to lose out on your company match as well as future tax-deferred contributions, not to mention the earnings on the money you've withdrawn.

Borrowing from a 401(k) isn't much better. If you leave the company for any reason, you run the risk that your loan will be called immediately. While out of your account, those dollars will also miss out on any market gains, and that tax-deferred growth.