Owning vs renting

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This page reviews the arguments for owning vs. renting your home.

Economics

Buying a home will generally be more cost-effective than renting if you stay there for at least five to ten years. This excellent New York Times calculator can help you calculate the specific breakeven point for your situation. Be sure to increase the Investment Returns under general settings to [[Historical or Expected Returns | 7 or 8%].

The accompanying article lays out why renting is often more cost effective than owning:

One of the big lies of the real estate business is the idea that renting a home is tantamount to throwing money away. It’s a useful fiction for real estate agents, because they make vastly bigger commissions on house sales than rentals. But the comparison isn’t nearly so straightforward for the rest of us. Renting involves one obvious, recurring cost that can never be recouped: the monthly rent check. Buying, on the other hand, involves multiple expenses, some of which aren’t so obvious. On top of closing costs, there are repairs, property taxes, mortgage principal and mortgage interest. (The mortgage-interest tax deduction reduces this last cost but doesn’t eliminate it.) When you own, you also lose the ability to invest your down payment elsewhere, like the stock market.

The transaction costs of buying and selling a home (in particular the 6% broker fee) mean that you need to stay there for several years before lower monthly costs can overtake renting. Further, in the early years of a mortgage, most of your monthly payment goes to interest, which even with the mortgage interest deduction, is still an expense that does not generate any equity. For many properties, only after 5 or 10 years do your principle payments begin contributing significantly to your ownership of your home. For others, ownership is always more expensive than renting, and simply gets worse over time.

Unfortunately, in the modern economy, many owners find that want or need to move every 5 or 10 years. The perfect house you bought a few years ago may now be a grueling cross-town commute from the great new job you were recruited to. The second kid may mean that you need more room. Having the kids leave home means that your paying for far more space than you need or want. That leaves some homebuyers in a situation where, due to frequent moves, they are always worse off owning than they would be renting.

Improvements, Repairs and Psychology

Many people get a psychological benefit from owning a home. They like feeling that a piece of property is theirs, and that they can settle in and relax there. Many homeowners get satisfaction from home improvements projects they fund or do themselves.

Of course, that ownership is normally dependent on making monthly payments to the bank. And even after the mortgage is paid off, you still need to pay insurance and taxes.

Although counter-intuitive, many people make improvements to their rental properties. For example, if you're going to be in a rental for a year or more, you may decide to repaint a room or change a fixture. If you have a good relationship with your landlord, he may approve you doing this work. If not, you can change it back again when you move out.

When a homeowner's toilet floods, you are responsible for the repairs. As a renter, you get the landlord to fix problems with the apartment. Of course, if you find the landlord is not responsive, you can always do it yourself or pay to have it fixed. Thus, a renter has an additional option.

Flexibility

The biggest advantage of renting is the flexibility to relocate relatively easily. In the last century, many people worked for employer their entire lives. But today, most workers are likely to work for a number of different employers, in multiple different cities. Even when switching jobs within the same metro area, a previously convenient house may now entail a grueling commute.

1 in 6 now owe more on their mortgage then their property is worth.[1] Many more are not willing to sell their homes because they know the price has dropped below what they paid. Many of them stay in a home that is poorly located, or too big or too small for what they can now afford.

Houses vs. Apartments

There is a common misconception that only apartments are available for rent. Although most rentals are apartments, homes in every category from 400 sq ft shacks to 15,000 sq ft mansions are available for rent.

If you are concerned about having to move after a year, most landlords would be thrilled to sign 2 or 3 year leases. But this is normally unnecessary. Most landlords are thrilled to have a renter who reliably pays their rent, and will happily keep you as a tenant for a decade or more.

Asset Class

Separate from the value of having a place to live, a home is an asset that increases or decreases in value over time. The underlying housing equity is a real asset, but it is a incredibly poorly returning one. According to economist Robert Shiller, "the average annual real (net of inflation) increase in home prices was a mere 0.40%"[2].

Of course, any given house might double or triple in value. But it also might lose value even faster. In any event, housing is always an extremely illiquid asset. Unlike stocks or bonds, it can take months to sell a home, and there is a serious risk that if selling during the wrong time, a homeowner can get significantly less than the long term average price. As an asset class, homes also tend to be highly correlated with economic conditions of their city. So, if you lose a job because of hard economic times (such as in Detroit), you may find your home equity simultaneously diminished.

Finally, a home is by definition undiversified. Although Homeowner's insurance should protect you from fire, flood, and earthquake, it does not provide any guarantee that you will get back the money you paid for your house.

Negative Bonds

Purchasing a house with a mortgage represents both an asset and a liability. However, the two parts of the transaction interact with your portfolio in different and subtle ways.

As a liability, a mortgage is a negative bond. If you have 300 K in bond funds (loaning money), and a $300 K mortgage (borrowing money), you do not have any net allocation to bonds. The effect of the negative bonds (the mortgage) is to put you in a riskier asset allocation than you might otherwise choose.

Now, let's consider the asset side of the ledger. There are two financial aspects of owning a home, and neither of them are at all like a real ("positive") bond. The appreciation or depreciation of the property and housing stock is a very illiquid, undiversified form of equity. Implicit rent "is the amount a homeowner would pay to rent, or would earn from renting, his or her home in a competitive market"[3]. The implicit rent is only like a bond in that you can think of it paying a coupon, but that "coupon" is a housing voucher good for a month's implicit rent at a single address.

It's simpler to think of the implicit rent as a reduction in expenses rather than as some sort of strange bond. Similarly, Bogleheads often calculate pensions and social security as reducing one's need for retirement income rather than as a form of asset.

The underlying housing equity is a real asset, but as mentioned above, it is an incredibly poorly returning one. So, in summary, buying a house with a mortgage is economically equivalent to making the following three transactions:

  1. Reducing their fixed income ownership by an amount equal to the size of the mortgage.
  2. Investing in an illiquid equity product with a long-term real expected return of 0.40%
  3. Reducing their monthly expenses with a housing voucher good at one house only.

Taxation

There is a large taxation benefit to owning a home versus renting, but it is not the mortgage interest deduction.

Forced Savings

One of the strongest justifications for owning a home is the forced savings. For people who can't be trusted to contribute to their 401(k) and taxable accounts every month, a mortgage payment forces them to save. (Specifically, they are saving the principle, while the interest is an expense that disappears forever.) Of course, there's problems with the idea of forced savings in practice, because spendthrifts can borrow from their 401(k) plans and can take out home equity loans. And with mortgage payments, the first 5 years (the length most people live in a home) is nearly all interest payments.

See Also

Bogleheads Forum Discussions

References

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