Is Owning or Renting Best?

There was a time when owning the roof over your head was considered an attainable and wholesome mark of prosperity for American families.  See, for example, the higher calling for which George Bailey gives up his youth in It’s a Wonderful Life.  (In retrospect, George was making sub-prime loans from a dangerously over-leveraged and illiquid bank.  It was a simpler time.)  Over the decades conventional wisdom on home ownership morphed from Victorian House wholesome goal to sound idea, then to great idea, and finally to such a great idea that it was practically free money.

Then it all went kablooey, and conventional wisdom started denying that it ever said any such thing.  It’s really not clear what mainstream advice on home ownership is right now.  Big time gurus like Suze Orman and David Bach (author of, among other bestselling titles, The Automatic Millionaire Homeowner) now spend time cautioning people about the dangerous waters of home buying and contradict, without apology or even acknowledgement, advice they gave a few years back to jump in with both feet.  (See excellent article on this at the Wall Street Journal here, and my discussion of Orman’s latest book here.)

So perhaps now is as good a time as any to step back, push aside the headlines of the day, and reconsider if owning the place you live in is a good idea in principle or if maybe renting has gotten a bum rap all these years.  Moreover, it’s worth asking if owning vs. renting is a question that should have a general one-size-fits-all answer.

To begin with, it needs to be said that owning/renting is not just an economic decision.  Many people feel a psychological benefit from owning and that benefit is as real to them as anything else that they might spend money on.  Furthermore, some kinds of real estate, e.g. largish houses in the suburbs, are often very scarce as rentals, so if you want to live in that kind of dwelling there really is no owning/renting choice to evaluate.

Considered solely as an economic decision, the owning/renting question is a lot more complicated than it perhaps should be.  In an idealized Simple World, it would be just a choice between renting a house and renting the money to buy a house.  And in Simple World, both choices would cost exactly the same, since under both you are renting a thing of equal value.

Real World is unlike Simple World in quite a few ways.  Four of those ways are worth mentioning here, and all hinge on the specific circumstances of the owner/renter and the real estate market in which they live.

First, and maybe most fundamentally, in Real World the rental rate on the property and the rental (interest) rate on the money to buy it are connected by only the slimmest of theoretical relationships.  In other words, although you can make a nice analogy between the annual rent divided by the purchase price and the annual interest payment divided by the purchase price, there is no practical reason to expect the two to line up.  Not only is the comparison complicated by taxes and inflation (more below) but they are governed by the forces of supply and demand in separate markets.  At times and in places the rental rate is higher and in other times and places the interest rate is higher.

The second of the big differences is the complication brought on by taxes.  Interest you pay on a mortgage is, essentially, subsidized by the Federal government, while rent is not. How much of a subsidy you get depends largely on your income, the more you make the bigger the potential subsidy.  (That doesn’t sound right, does it?  Let me rephrase: the more taxes you pay, the bigger the subsidy.)  Again, general advice is impossible, but if you are not safely in the 25% tax bracket, which starts at $65K for a married couple, and you aren’t at least on the cusp of itemizing deductions before buying a house, then your subsidy will be small or even zero.

Big difference number three is the cost of moving.  Assuming that a renter waits until the lease is up, moving to a new place is relatively cheap, at worst involving a month or two in rent as an agency fee.  Buying and selling houses is much more expensive.  Including the agent’s commission, legal fees, title insurance, etc., it could easily run more than 5% of the purchase price, which could be the equivalent of a year’s rent.  The upshot is that unless a person expects to stay put for a relatively long time, owning will be more expensive than renting.

The fourth and final difference is, unlike the first three, in favor of owning.  It is also the most controversial.  Houses tend to appreciate in value.  Not by much, a person should probably assume only the general rate of inflation, but it is clear that over long periods house prices do, generally, go up.  As recent events have shown, this is not itself a good reason to buy a house.  It is at best a nice side benefit, but not an insignificant one.  If you assume 3% inflation, then you can factor in a gain of 3% of the purchase price annually if you own.

So is owning a good idea?  Possibly.  The awkward truth is that there can be no general answer to the question and so there should be no conventional yes or no advice on the topic.  It depends on personal circumstances.  That said, it is easy to come up with plausible numbers that make a compelling case for owning.

In the Back Bay neighborhood of Boston you can currently buy a serviceable one bedroom apartment for about $375K or you can rent one for around $2500 a month.  Just to make the math easier, assume that you can borrow the entire purchase price at 6%.  Assume also that you are in the 25% bracket, so that your after-tax interest rate is 4.5%.  If inflation runs at 3%, then owning costs you net 1.5% of the purchase price each year, or $469 a month.  Allow a generous $1000 a month for maintenance and property taxes, and owning is $1031 a month cheaper than renting.  If the transaction costs are 5%, or $18,750,  then you would only have to live in the place for about a year and half to be financially better off as an owner.

That’s a pretty strong case for buying, but it’s not hard to imagine a slightly different set of numbers generating a great argument for renting.  (And there is the not unreasonable supposition that real estate prices will keep falling in the immediate future, which would torpedo almost any case for owning.)

The point is not that owning is a good or bad idea, but that it could be a good or bad idea depending on specifics.  Moreover, it should be clear that this is not a new 2009 development, but that the right answer has been “maybe” all along.  Perhaps for once conventional wisdom has stumbled onto the best advice by not offering any.

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