May 31, 2011 -- Stan Humphries, chief economist at Zillow, and Celia Chen, senior director at Moody's Analytics, spoke with ABC News about what potential homeowners need to consider before deciding whether to buy or rent. Here are their tips:
On average, if you are planning on living in a home for five years or more, you should consider buying. If not, renting is usually the best option.
Humphries: "The longer that time horizon is, the more the buy decision looks better than the rent decision. ... If you're going to hold an asset for 20 years, buying is almost always better than renting."
Chen: "The first question you want to think about is how long you're going to live in a place. When you purchase a home there are a lot of transaction costs related to the home purchase, and these are sunk costs that will be difficult to make back."
2. Income Stability
If you do not have a sustained and stable income, you should look to rent because it is easier to change your living situation depending on how much money you are earning.
Humphries: "If there is uncertainty [regarding income] the more that militates toward a rental scenario. As that income stream changes, you can get out of your current situation and get into a cheaper one, or if it ramps up you can get into a more expensive rental home. But with a mortgage, it's harder and more economically costly to make those types of changes."
3. Percent of Income
You don't want to spend more than a third of your income on all housing-related expenses. That includes mortgage payments, property taxes, insurance and any other housing-related costs.
Humphries: "The more margin you have, the more unpredictability you can suffer in your income stream. ... You can suffer some economic shocks and still handle it."
4. Price-to-Rent Ratio
The price-to-rent ratio is the real estate price divided by the annual rent. If a house has a price-to-rent ratio of 15, that means the price of the house is 15 times the annual rent that home would earn. The New York Times has an easy-to-use calculator that will help you crunch the numbers.
Humphries: "The higher that ratio is, the more renting is going to become favorable. Typically, the break point there is something in the 15 to 20 range. So if that ratio is 15 to 20, meaning that buying a home is 15 to 20 times more expensive than the annual rent, you would spend on the same house. Then that's a range in which renting is more advantageous. ... The higher that ratio is the less attractive buying looks, and the more attractive renting looks."
Chen: "If you can find information on the price-to-rent in a particular region and compare the average of price-to-rent over some period of time, say over the last 15 years, compared to the current price-to-rent ratio, that's a good way to measure how far out of whack that price-to-rent ratio might be."
5. Quality and Inventory
The rental and for sale markets vary in the quality and inventory they offer. It is important to compare the markets and see where you are able to find the place that fits you the best. In a normal market, it is usually easier to find what you are a looking for in the for sale market. However, with the increased number of people looking to rent, many investors are converting single family homes that were once for sale into rentals. The quality and inventory vary greatly by the market you are looking in.
Research the overall economic health of the neighborhood. Chen recommends using websites such as RealtyTrac and Foreclosure.com to see the number of foreclosed and distressed homes in the area. She says there is a likelihood that in communities with more foreclosures that price corrections will be much more severe.