How mortgages work: Buying vs. renting

"Should we continue renting or go ahead and buy?" That's the question hundreds of thousands of Americans ask themselves every year.

It's not an easy one to answer. Emotions, family and personal reasons all come into play in any home-buying decision.

No one knows what the future holds for you, your family, your job or your finances. But we can help you understand what you're going to encounter when you embark on the sometimes-difficult journey toward the American Dream of owning a home.

Economic differences between renting and owning
If you're looking for the best return on your money, historically you're better off investing in the stock market than buying a house. Primary homes generally don't earn the investment return of financial instruments such as mutual funds. While the stock market's long-term average rate of return is in the range of 8 percent to 10 percent, housing has appreciated on average in the low- to mid-single digits for many years. That means you shouldn't buy solely to generate an investment gain.

On the other hand, Uncle Sam helps out by letting taxpayers deduct part of the mortgage interest and real estate taxes they pay each year. Borrowers get the benefit only if they pay enough in one year to exceed the standard deduction. But that usually happens, especially during the first few years of a mortgage when most of each payment goes toward interest rather than principal.

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By the numbers ...
Say someone with gross annual income of $50,000 bought a home using a 7 percent, 30-year mortgage of $150,000 on Jan. 1, 2002. The monthly payment would be $998, excluding taxes and insurance, and this year, that borrower would pay $9,585 in interest. If he didn't have the mortgage, he would take a $4,700 standard tax deduction on his 2002 tax return (assuming he was a single filer). But by itemizing his mortgage interest, he would have $4,885 more to subtract from his income.

Sunny side of homeownership
Owners enjoy other benefits, too. They build equity over time as home values rise and their mortgage balances shrink. They also don't have to worry about their housing costs shooting through the roof because mortgage lenders can't boost borrower rates and payments, unless those borrowers have adjustable-rate mortgages.

Cloudy side of homeownership
When something breaks at an apartment, it's the landlord's problem. When your name's on the deed, it's yours. Someone who throws every penny into a down payment just because homeownership sounds like a good idea is taking a big risk because there's no money left to fix leaky pipes or buy a new air conditioner.

Potential buyers may want to hold off for other reasons. Workers on shaky ground with their employers or those who don't think they'll be able to find jobs nearby if their firms go belly up might want to wait on getting mortgages. The same goes for people who plan on leaving a job soon. The monthly payment isn't the only obstacle for this kind of customer. Closing costs and other home-buying fees, as well as the commission that most owners end up paying to real estate agents when they sell their homes, add up. People who have to sell after living in one place for only a short time can end up in the hole on their investments.

Explore all the options
Some middle-ground approaches to homeownership blend elements of buying and renting. Some of the more popular loan types are seller financing, "lease with an option" and "contract for a deed" plans.

Seller financing
With seller financing, the seller actually assists the buyer in purchasing the home, by "lending" the buyer either a portion of the amount to be financed or the entire amount.

Let's say the buyer and seller agree on a price of $150,000 for the house. In many cases a lending institution would require a 20-percent down payment -- $30,000 -- and give the buyer a mortgage for $120,000. But if the buyer has only $15,000 cash, the seller could "take back" a second mortgage for the $15,000 the buyer is short. The buyer makes payments on the first loan to the bank and the second loan to the seller.

Another example of seller financing: If the sale price of the home is $150,000 and the buyer has only $15,000 for a down payment, the buyer gives the $15,000 down payment directly to the seller who agrees to carry the entire mortgage amount of $135,000. The buyer would make all payments directly to the seller.

Pro: Seller financing reduces the cash needed to get into a home and could dramatically reduce closing costs. Often the seller will be more flexible in accepting an underqualified buyer.

Con: The seller determines the interest rate for that portion of the mortgage being carried, and it usually comes with a higher rate and a shorter term. Perhaps most importantly, it very often comes with a balloon payment. This means that monthly payments would be computed as though the mortgage was to continue for, say, 30 years, but at the end of five or 10 years the entire remaining balance has to be paid in one lump sum. That normally requires refinancing at that point, when rates could either be lower, higher or about the same, or selling the house to meet that balloon payment.

Lease with an option
In a lease with an option, the buyer leases a $125,000 home from the seller for 12 months at $1,200 a month, with $200 a month going into a savings account for a down payment and $1,000 going to the owner. Before moving in, the would-be buyer pays maybe 4 percent, or $5,000, of the purchase price upfront that goes toward the down payment. At the end of one year, the buyer gets the home with $7,400 down (his $5,000 upfront plus his savings account) and a regular loan from a bank that pays off the seller.

Pro: It's good for people who don't have a lot of cash, plus you get to "wear" the house before you buy it.

Con: The seller owns the home during the lease period.

Contract for a deed
In a contract for a deed, the buyer arranges a contract with the seller. The buyer makes payments to an escrow agent, who holds the deed to the property. After 180 months or some other term of payments to the escrow agent, the seller tells the escrow agent that payments have been made, and the escrow agent gives the buyer the deed. No financial institution is involved.