An article I read recently on Yahoo!Finance debunked several “Money Myths.” Among these myths were several related to owning a home. (I recommend reading the whole list, though, as there was much good advice contained therein.) Also, another really excellent article by Jack Hough at SmartMoney.com gives further detail about why owning a home, at least from a financial perspective, is not such a great thing.
I think home ownership is an important issue to discuss with respect to how it relates to personal finance and growing one’s wealth. There’s a lot of glib talk about how “renting is like throwing away money” or that buying a home is good for your financial well-being because “you can deduct your mortgage interest” or “your home is an investment.” However, I believe that more often than not (especially for singles and couples without kids or other dependants living with them), renting is preferable to owning.
Let’s start by addressing the three home-ownership/renting myths discussed in the first article (all italics mine):
Myth #1 – “Renting is like throwing away money.
Do you consider the money you spend on food to be thrown away? What about the money you spend on gas? Both of these expenses are for items you purchase regularly that get used up and appear to have no lasting value, but which are necessary to carry about daily activities. Rent money falls into the same category.
Even if you own a home, you still have to “throw away” money on expenses like property taxes and mortgage interest (and likely more than you were throwing away in rent). In fact, for the first five years, you are basically paying all interest on your mortgage. For example, on a 30-year, $250,000 mortgage at 7% interest, your first 60 payments would total about $100,000. Of that you “throw away” about $85,000 on interest payments.”
This latter point about the “throw away” costs of owning a home is very important in doing a fair comparison between renting and owning. Such costs are often overlooked by people who mistakenly assume that every dollar they put into their home will be reflected in the house’s dollar value. I would add to this list homeowner’s insurance (or at least the amount that exceeds any renter’s insurance you might have), home improvements that don’t permanently increase the value of your home (painting the outside, fixing the roof, replacing major appliances, cleaning the carpets, etc), and also the opportunity cost of the free time you are forced to spend (or the money you would pay someone) to make repairs that a landlord would make if you were renting.
Myth #2 – “Home ownership is a surefire investment strategy.
Just like all other investments, home ownership involves the risk that your investment may decrease in value. While commonly cited statistics say that housing appreciates at somewhere between the rate of inflation [~3%] and 5% per year, if not more, not all housing will appreciate at this rate.
[…] And if your house appreciates wildly, that’s great, but if you don’t want to move to a completely different real estate market (another city), the profit won’t do you much good unless you downsize because you’ll have to spend it all to get into another house. Owning a home is a major responsibility and there are easier ways to invest your money, so don’t buy a home unless you are attracted to its other benefits.”
This myth is particularly dangerous. I think many people have been misled (perhaps willfully) into purchasing a larger, more expensive house than they otherwise would under the faulty justification that “it’s an investment.” While this is sort of true in that a house generally appreciates with at least inflation over the long term, this doesn’t mean a house is a good investment. In fact, over the long term, a house is a terrible investment, with average real returns (adjusted downward by 3% for inflation) of 0-2% per year versus 6-7% for stocks. That means that if you invested $50,000 as a down payment for a home (assuming 0-2% in real returns), that investment would be worth somewhere between $50K and $75K in 20 years. If you put that same amount in stocks (6-7% assumed), you would have $160K to $195K, a difference of over $100,000.
Another feature that makes a home a poor investment is liquidity, or, the ability to turn your asset into cash. With stocks, bond funds, and savings accounts, you can liquidate your assets immediately and receive the cash in a matter of days. With a house, it takes time and effort to sell it, a process which could take months. As Jack Hough notes: “[h]ome buyers pay around 1% in closing costs when they buy and 6% in broker commissions when they sell. Share buyers pay $10 trading commissions, which are negligible for buy-and-hold investors.”
Also, the sentence that I italicized in the Myth #2 quote points out that you only realize the gain on a house when you sell it AND move into something cheaper. My experience is that people are rarely willing to do this, and, if anything, often purchase larger, more expensive residencies as they age (although some retirees may sell their more expensive homes and move into cheaper ones.)
Myth #3 – “One of the major advantages of home ownership is being able to deduct your mortgage interest.
It doesn’t really make sense to call this an advantage of home ownership because there is nothing advantageous about paying thousands of dollars in interest every year. The home mortgage interest tax deduction should only be looked at as a minor way to ease the sting of paying all that interest. You are not saving as much money as you think, and even the money you do save is just a reduction in the costs that you pay. Interest tax deductions should always be considered when filing your taxes and calculating whether you can afford the mortgage payments, but they should not be considered a reason to buy a home.”
Amen. Now let’s transition to the SmartMoney article. In it, Mr. Hough makes the case that the driving force behind the increase above inflation (of about 2% annually) in housing prices since WWII has been favorable legislation:
“…while stock returns have come from increased earnings, house returns have come from ballooning valuations, not increased rents… In 1940 the median single-family house price was $2,938, … while the median rent was $27 a month, including utilities. That means the ratio of prices to annual rents was 9. By 2000 the ratio had swelled to 17. In 2005 it hit 20. […]
Two main events have caused house valuations to inflate since World War II… [T]he government subsidized housing by relaxing borrowing standards. Prior to…1934 house buyers who borrowed typically put up 40% of the purchase price in cash for a five- to 15-year loan. By insuring mortgages, the [government] permitted terms of up to 20 years and down payments of just 20%. It later expanded the repayment periods to 30 years and reduced down payments to 5%. Today down payments for FHA loans are as low as 3%. …The ratio of house values to incomes has risen 260% in just under four decades. […]
For house returns over the next 20 years to match those over the past 20, the government and private lenders would have to “up the ante” by relaxing borrowing standards further. Given the recent attention paid to swelling foreclosures, that seems unlikely. I suspect real returns will turn negative over most of the next two decades … According to calculations made by The Economist in the summer of 2005, house prices would have to stay flat for 12 years with annual inflation at 2.5% for the ratio of prices to rents to fall from its 2005 perch to merely its 1975 to 2000 average.
So to sum up why I rent: Shares…over long time periods return 7% a year after inflation. Houses…over long time periods return zero after inflation. And they look likely to return less than that for a while.”
Hough gives strong evidence for the reasons behind housing’s historic gains since WWII, and why he thinks such gains will not continue. From a financial perspective, I therefore must agree with Hough that the proper place for the majority of a person’s long-term assets is in stocks (like low-fee index funds.) This means that it is generally better to rent an affordable home while stashing your savings in tax-advantaged retirement accounts or elsewhere in equities.
All this doesn’t mean that there aren’t any good, non-financial reasons for buying a home instead of renting one. Perhaps you want to be assured that no landlord can kick you and your family out, or keep you from painting your bedroom wall like a Jackson Pollack. Maybe that darned American Dream of marriage, kids and property ownership is just too hard to shake off. After considering everything above and combining your newfound knowledge with that of your personal situation, maybe you’ll still decide that home ownership is preferable to renting. Just make sure that you don’t try to justify the purchase of a home on faulty financial logic.