Wednesday, June 8, 2011

The calculus of buy vs rent

First off, thanks for reading and for the comments. The last post wasn't meant to be a full treatment on the rent vs buy argument, but rather some seldom heard facts about homeownership. BUT, I feel compelled to more evenly state the case to avoid looking as if I suffer from cognitive dissonance or some such. These posts are meant to look at homeownership as an investment; while there are many non-financial benefits to owning a home that I'm fully aware of, we'll save those for future posts. To be clear, I don't begrudge people for buying homes. My issue is with the societal belief that one is setting themselves up for a golden future by borrowing $200k from a bank and sinking it into land and a pile of bricks. If the public generally thought of their homes simply as places to live then I wouldn't be writing this.

To begin, as stated in the comments, buying a home with a fixed mortgage payment is a great inflation hedge. While rents will generally increase with inflation over time, the house payment you have today could be the same 25 years from now when your income is much higher (given you don't take out home equity loans or refinance). I remember my parents house payment as being nearly the same as current, typical car payments. This will especially help if we return to the inflation of the 1970s. This doesn't look to happen soon (current 10-year expectations are ~2%/year), but, either way, it's a great feature of the fixed rate mortgage.

The second positive feature of the mortgage is the fact that you can write off part of the mortgage interest. This is one of the only types of debt that the government gives you a tax break on. While many economists rail against it, politicians hold it as somewhat sacred, so it'll be here for a while yet. Granted, it's a deduction and not a tax credit. So if you're in the 25% tax bracket it will lower your taxable income and save you a quarter for every dollar spent on mortgage interest. It's not as great a deal as some make it out to be, and definitely not a reason to spring for a bigger loan, but for those who itemize it's a bonus.

The third major feature of the mortgage is that it forces you to save and thus one day allows you to live without paying monthly for shelter. This obviously best for those who have a hard time saving otherwise. Many such people who would pay a little less each month by renting would likely fritter away the difference and end up renting (and paying for shelter) for life. It's a little easier to avoid the newest iphone or new pair of shoes when the bank can kick you to the curb after too many indulgences.

That last one, though, is where renting can be a decided benefit for those who are able to systematically save and invest the extra each month. While landlords are able to pass on some costs of insurance, property taxes, and repairs, they can only charge renters what the market will bear. Also, their maintenance and repair costs per unit are often lower because of scale on which they operate. Thus, while it's not a ton, often a rental will cost a bit less than an equivalent home. Avoiding having to plunk down ~$40,000 for a downpayment and instead being able to invest it is another benefit to the savvy renter. If you take this $40k (20% down on a $200k home) and instead have it in a 401k or IRA invested in stocks, the results after 30 years can be surprising. Stocks are often said to have a real return of 7% per year, whereas we've seen houses return around 1%. If you take the difference (6%), and compound the would-be downpayment over 30 years, one ends up with 40000 * (1 + .06)^30 = $229,000 which is enough to buy a slightly nicer house, without any debt. And remember, we accounted for inflation. If one is able to save $200/month from renting (not an unreasonable assumption), one ends up with $419,000. It's tough for a lot of people to save, however, so for a large portion of the population this wouldn't happen.

While we sadly can't shoe-horn this issue into a small, neat box, it was (reasonably) mentioned on that there seem to be almost three tiers of suitability: good savers may be best renting, people relatively bad at saving are probably best in a house, and for those with fragile finances, just avoiding the mortgage and leverage altogether would be a boon (whether or not they save the extra). Ryan Avent cogently details some of the downside risks of ownership:

Like a home, a small business is an illiquid, undiversified, highly leveraged investment, the performance of which is likely to be highly correlated with the owner's personal economic welfare. And we encourage small business investments, do we not? With good reason!

But the risk inherent in entrepreneurialism is widely understood. Everyone knows the factoid that half of all businesses fail within the first four years (this statistic is not necessarily accurate, but people understand the risk involved). Starting a small business—even just buying an investment property to operate as a landlord—is not part of the standard advice given to people looking to save for retirement. No one is looking to make three-fourths of the American population small business owners. Why? Because illiquid, undiversified, leveraged investments are dangerous! And while there are nice potential returns to be had by those able to make such investments, it's not the kind of thing we urge on typical working families with barely enough in savings to cover the initial downpayment.

So sure, it's fine to think of homes as investments, so long as the kind of investment you have in mind is the highly risky sort you wouldn't recommend to anyone who didn't have the ample knowledge and financial cushion you'd expect to see in a successful entrepreneur. And that does not describe most potential homeowners.

Things can go terribly wrong. House prices can drop 60% (see Nevada), the house perhaps won't sell for a year when you're looking to relocate for job propsects. Even when it does sell, it you may end up owing tens of thousands in cash to the mortgage company cause you're underwater. Felix Salmon adds another dimension:

Avent is right that buying a home is a bit like starting a small business, but the big difference is that the value of a small business comes in large part down to the owner. Whereas in the property market, the owner can only affect value at the margin.

If you have essentially no control over the outcome of your investment, and you have no way to exit that investment if it starts to go bad, then you’re a gambler. And as Avent says, that does not describe most potential homeowners.

While your prudent home purchase likely will end well, as with all aspects of life, don't treat the unlikely as impossible. To help reduce the risk, put 20% down, don't buy a place bigger than you need, and keep 3-6 months living expenses in reserve for emergencies. There's no downside to being conservative here.

1 comment:

  1. By more clearly couching your position in terms of home-owning as an investment instead of home-owning, period, you're building a more impressive case than your last post was able to make. I appreciate it, and I think you make an excellent point.