This Is Ramit Sethi's Argument for Investing Before Buying a Home. And Why He's Right

Renting a home instead of buying one is often compared to throwing your money away. After all, aren't you just paying your landlord's mortgage instead of building equity?

But Ramit Sethi, author of the bestselling book I Will Teach You To Be Rich and star of the hit Netflix show How to Get Rich, doesn't believe buying a home is the automatic path to wealth as it's often touted. That doesn't mean he's anti-homeownership. But Sethi doesn't believe you should be worried about renting forever if you're a savvy investor.

"I estimate that less than 5% of people understand if you build a large enough portfolio, it can pay your housing in perpetuity," he recently tweeted.

Investing vs. buying a home: which has better returns?

Homeownership has historically been a key driver of wealth in the U.S. But that doesn't mean becoming a homeowner is the only way to grow rich.

On average, S&P 500 annual returns have hovered around 10% before inflation. By comparison, the compound annual growth rate for home prices in the U.S. from January 1991 through March 2023 was 4.4%, according to quarterly Federal Housing Finance Agency data.

So historically, you'd get better returns from investing in an S&P 500 index fund than you would have gotten from buying a home. But this isn't a perfect comparison, of course. An index fund isn't going to provide you with a roof over your head. But Sethi takes issue with a few common claims put forth by proponents of buying a home.

The financial impact of buying a home

For starters, Sethi notes that home prices aren't guaranteed to go up forever. Sethi also says that many would-be buyers forget to factor in "phantom costs" of homeownership, like closing costs, taxes, property insurance, maintenance, and repairs. When you factor in those expenses, Sethi argues that it could be significantly more expensive to buy a home than it is to rent a similar one, even if the monthly payments are the same.

Yes, if you bought the home instead of renting it, you'd build equity. But Sethi points out that substantial equity takes years to build. In the early years of your mortgage, the majority of your monthly payment goes toward principal rather than interest, which is why it takes a long time to build equity. For example, if you had a 30-year fixed-rate mortgage for a $300,000 mortgage and a 6% interest rate, you'd pay about $1,800 a month, but you'd only have about $20,000 of equity after five years.

Buying a home isn't just about the numbers, though. Often, it boils down to a lifestyle decision. If you prefer stability, buying may make sense, whereas if you prefer liquidity, renting is the wiser choice.

But if you start investing early enough, you'll be able to afford whichever type of lifestyle you want. If you invested $1,000 a month in a low-cost brokerage account and earned 8% annual returns, you'd have over $2.1 million after 35 years. Your total investment? Just $420,000.

This example illustrates the power of compound earnings in investment -- and why you don't want to delay investing, even if you're pursuing other financial goals like homeownership. If you give yourself enough time to build a substantial nest egg, the idea of renting in retirement isn't so scary.

Should you buy a house?

Sethi suggests asking yourself the following questions before buying a home.

• Will I live here for 10+ years? Buying is most likely to pay off if you plan to stay put for a long time, because closing costs can eat into your profits. Plus, if the housing market dips in your area, you'll give your home time to recover its value.
• Is my total monthly housing cost lower than 28% of gross monthly income? A general rule of thumb is that housing costs -- including property taxes and insurance if you own -- shouldn't eat up more than 28% of your monthly income.
• Have I saved a 20% down payment? Though it's easy to buy a home with just 3% to 5% down, one advantage of a 20% down payment is that you can avoid private mortgage insurance (PMI).
• Am I OK if the value of my house goes down? Home prices aren't guaranteed to go up, particularly in the short term. Make sure you're buying a home you actually want to live in instead of one that you view primarily as an investment.
• Am I excited about buying? The final question seems easy to dismiss since it's about feelings instead of numbers. But it's essential to buy a home because you want to do it -- not because your parents are pressuring you or because you're worried rent is a waste of money.

Renting and buying can both make sense, depending on your personal situation and preferences. If you invest early and consistently, you'll be able to afford whatever housing arrangement fits your lifestyle.