All the 20-somethings who have jobs are asking me: should we buy a house or keep renting? The answer isn’t so easy. The common wisdom for decades was to buy a house as soon as you can, because it’s a great investment. That “wisdom” turned lots of people upside down in the past decade. Let’s take a cold, hard look at the economics of owning a home.
In the past, the own-or-rent decision was largely about whether to live in a house or apartment. That’s no longer true. Condos allow ownership of a multi-family residence, and the opportunities to rent a stand-alone house are greater than ever before. So the own-rent decision should be apples-to-apples with comparable properties. If you are thinking about moving from a small apartment and buying a medium sized house, you’ll find that it’s more expensive simply because you’re getting more square footage and a yard.
Is housing still a good investment? Since 1975, housing has appreciated by an average of 4.5 percent per year. (Good data start in 1975.) Estimates of housing appreciation since 1890 (courtesy of Robert Shiller) show 3.0 percent annual increases in nominal value, and just a hair above zero after adjusting for inflation. Stocks, on the other hand, have a long-run average return of 9.8 percent including dividends.
Housing seems to be a great investment in good times because it is usually leveraged to a great degree. With a 20 percent down payment, a price increase of just three percent turns into a 15 percent increase in the homeowner’s equity. (Do some arithmetic with a hypothetical $100,000 home to verify that result.) Real estate proponents call this the “cash-on-cash” return. However, leverage applies to the downside as well. With 20 percent down, a 20 percent price decline wipes out all of the buyer’s equity. That’s not an outlandish scenario, we’ve learned from the price declines of the recent housing bust.
Interest on home mortgages is deductible, which sounds good but is frequently overrated. Yes, it’s deductible. But the deductibility doesn’t offset the fact that you are paying someone interest. It’s an expense, and you are worse off because of it. If you want a big tax deduction, you could make a contribution to charity. You’ll end up with less money than before your contribution despite the deduction. The same is true for interest expense. It may be worthwhile, all things considered, but it’s still an expense. Talk to your accountant first, because the actual benefit from a deduction varies from family to family.
The housing-stock market comparison ignores a key point: housing pays something like a dividend in that you can live in it without paying rent. To be as good as stocks (on average), the benefit from living in a house has to pay an “occupancy dividend” of about seven percent. So if you’re thinking of a $200,000 home, you need to get $14,000 per year of benefit from living in it. That’s comparable to $1,167 of monthly rent, before we get around to the pesky details.
When you rent, the landlord picks up the taxes, insurance, maintenance and sometimes utilities. If you buy, plan on replacing the water heater some years, the back fence other years, the roof occasionally. Hope that you don’t need to replace all of them the same year. If you are going to hire out all of the maintenance, you’ll probably pay more than your landlord does. The landlord is in the business of maintaining properties and is probably very efficient. However, if you can do some of it yourself, your cash outlays will be much less than the landlord’s. And you can do it yourself if you’re be willing to learn. Try Googling “leaky faucet” and you’ll find plenty of advice.
Most people thinking about buying compare monthly payments to rent, which is a good starting point. However, some of that monthly payment goes to principal. It’s like saving. To put buying on a level playing field with renting, look at just the part of the monthly payment that will go to interest.
Example: you borrow $200,000 house with a 30-year mortgage at 4.25 percent. Your monthly payment would be $993, but $285 of that would be going to principal. (Your parents will be surprised that you’re paying so much to principal. When they got their first mortgage, rates were much higher and only a small portion of their payments went to principal.) To do your own calculations, use Excel functions PMT, IPMT and PPMT.
Transaction costs are large in housing. Real estate agents charge six to seven percent commission on sales, which will make moving expensive. You can sell the house yourself, but keep in mind that it’s a lot of work and your house may not be exposed to as many buyers, reducing the price you can get for it. This argues against buying unless you are confident you want to stay in the house for several years, preferably even longer.
Renters should keep in mind that they do not control their housing destiny. If the landlord decides to sell the property, you’ll be looking for a new home. The landlord can also raise the rent at the end of the lease. The landlord can also decide not to rent to you, though that’s rare for people who are well behaved.
One of the benefits of owning a house is the ability to do with it what you want (subject to neighborhood rules, of course). When your daughter wants her bedroom walls black, you can be the cool parents who show her how to use a paint roller. You can build that gazebo in the back yard and have toilets in any color of the rainbow.
Owning a house gives you some flexibility, but also requires flexibility. When you get a bonus from work, you can upgrade your housing by adding a hot tub. Renters don’t have that option. When you lose your job, you can defer replacing the carpet.
Flexibility is required of you, too. When the roof starts to leak, there’s no telling the rain that this is a bad time. You need to have reserves for unplanned repairs.
If you are looking to step up to a higher-cost living arrangement, here’s a good first step. Start putting money aside now. Let’s say that you’re paying $1000 a month in rent, and you estimate that your all-in cost for a nice house would be $1,500 a month. Fine. Put aside $500 a month, every month, to show that you can cover the higher monthly payment. You’ll accumulate some money for your down payment or cash reserves.