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.

14 Comments

  • By ryan, March 23, 2009 @ 8:26 am

    Frank,
    I found this blog while you were at Disney. I wasn’t deterred by the Gone Fishin’ signs because I took the opportunity to read your entire archive. I love all of it. It’s the most intelligent and humorous personal finance writing I’ve ever read.

    One of the key differences in your posts and analyses is the lack of consideration for personal mentality, what is now called “behavioral economics.” I actually find this very refreshing and enjoyable. On the other hand, I often find myself wanting to add those points to your posts.

    Regarding the topic of this post, I’ve said to anyone who will listen that America is far too in love with houses and mortgages. Most people grossly overestimate appreciation, tax savings, and their own equity stake. They underestimate or practically ignore taxes, insurance, maintenance, transaction costs, opportunity costs, and their own illiquidity. You, and any loyal readers of yours, know all this already, and further elaboration is unnecessary. In most cases the root cause of all this could be boiled down to mathematical incompetence and/or an unwillingness to think beyond the “conventional thumbrules” like “borrow three times your annual income.”

    The manner in which some of these rules has evolved and been selectively applied is something that will kill a person’s chances of ever accumulating a comfortable level of wealth. Specifically, it might be prudent for a 25 year old couple to take a 30 year mortgage at 3x their income. At worst, it will be paid off at 55, and hopefully a payment that might have been a financial stretch at 25 will be pretty insignficant when that person is nearing 50 in his peak earning years.

    But now what we see quite regularly are people “responsibly” following that 3x rule and starting 30 year amortizations in their forties, or later. Not only are they scheduling debt well into their 70′s, but their calculations of a “comfortable” level of debt are based on what will often be just about the most they can reasonably expect to earn.

    And for the most part, all of this is justified because they’re “moving up” to their “dream house” which they “deserve” after “working so hard for.” The kids are still a couple years from college, the near insolvent grandparents haven’t cried uncle yet, so things look OK. And if there’s ever any doubt about “Should we get this big of a house?” they subconsciously fall back on what they heard as kids growing up “A house is one of the best investments you can make. It’s ‘good debt.’ And you get a tax deduction.”

    So again, the root of the problem: Selective application of “Conventional Wisdom.”

    And here’s one more thing I thought of over the weekend; I’m including this since you like to challenge the conventional wisdom:

    If you ask most responsible, middle class or affluent Americans if it would be a good idea to borrow a fixed rate loan from the bank and buy a bunch of stocks hoping to make money on the spread, they will say “No, that’s not prudent.”

    But if you ask the same people if one should max out a 401k or Roth IRA even before he pays off his mortgage, the answer will be “Yes, mortgage debt is fine, and it’s important to save for retirement.”

    What’s the difference?

    I realize taxes for one, and of course 401k’s have employer matches, and there are conservative and FDIC insured options.

    But what I’m asking about is risk balance, since any expert will now advise these folks into some kind of target date index fund with a 90% allocation to stocks.

  • By Frank Curmudgeon, March 23, 2009 @ 10:36 am

    Ryan,

    I think that comment is longer than the post. I’m not complaining, mind you.

    You bring up two (mildly off-topic) things I wanted to comment further on.

    First is my attitude to what I’ll call consumer psychology. I think that in the long run people are happiest if they deal with money in as rational and unemotional a way as possible. Of course I know this is an ideal and not reality, but I think it is important that when people vary from the logical they are aware of it. There’s nothing wrong with buying a house not because it is cheaper but because it makes you happier, provided you acknowlege that is what you are doing. My issue with the major gurus that give what is essentially pop-psychology advice rather than personal finance advice is that they never admit that this is what is going on.

    The other thing is the excellent point you make about people sleepwalking their way into strange and unintended debt/asset situations. Another example that particularly gets me is that only 20% of new cars are bought for cash. I’m really pretty sure that more than a few of the remaining 80% of buyers could pay cash but don’t want to touch their savings.

  • By ryan, March 23, 2009 @ 10:50 am

    About a year ago a former colleague bought a brand new speedboat for about $25k by taking out a loan. She had at least three times that amount in liquid savings. When I asked her why, she replied without any sarcasm or irony “That’s too much money to spend all at once.”

  • By Alexandra, March 23, 2009 @ 11:12 am

    One aspect this article does not address is that buying a home is akin to forced savings. Many of my friends point out that here in Toronto, their rent payments are actually (slightly) lower than their mortgage (plus other) payments might be if they had bought a house or condo of equal value. That is true, but unless they are taking the difference they save each month and investing it, buying a home is a better option. Most of them are NOT.

  • By Mike, March 23, 2009 @ 11:39 am

    Apropos of It’s A Wonderful Life….

  • By Beth, March 23, 2009 @ 4:01 pm

    Alexandra, your comment has been bugging me because I’m not sure if I agree or not :)

    I could find a condo to buy and make my payments equal to what I pay in rent, but it wouldn’t be equal in value when it comes to size. (I’d lose a bedroom). I also couldn’t say that my mortgage payment would be an investment (compared to my rent) because I’d be paying interest, condo fees and insurance, and I’d also be responsible for repairs and maintenance on top of my payments. Not to mention gardening, redecorating, updating and landscaping.

    In short, only a portion of my potential mortgage payment would actually be “forced savings”. If your friends are like me and don’t know where they’ll be living in the next five years, buying/selling and moving can easily blow the budget.

    I’m just throwing ideas out there. I’m not really sure myself. I’m looking forward to hearing from people who disagree with me :)

  • By Phil, March 24, 2009 @ 5:55 am

    As a long-time homeowner (20 yrs) another benefit we’ve used is the home equity line of credit. Since we’ve built up a good deal of equity over the years (original mortgage is paid off), this is the vehicle we use whenever we need a short term loan. It’s basically a signature loan with a (currently) very low, deductible interest rate. Having the HELC available has reduced the wad of cash needed in reserve for emergencies.

  • By ryan, March 24, 2009 @ 8:03 am

    I don’t know, Phil. I think it’s a misconception to rely on debt or the availability of debt as a “reserve for emergencies.”

    Personally I keep about a year’s worth of expenses in cash in very boring bank accounts. When we bought our house a couple months ago we made a 60% down payment, so I have plenty of “equity,” whatever that really means.

    Here’s the way I see it: I imagine I lose my job and can’t find another. So I think about my necessary expenses. I have two kids to feed, catastrophic health insurance I would need to buy, utilities and energy, and a mortgage payment due every month. The last thing I need at that point would be a second mortgage that is also due each month.

    Maybe for an emergency expense that creeps up, like you need a new septic system, then that’s not too bad. But an emergency that somehow involves a loss of income, adding additional debt is only going to compound your problems very quickly.

    But maybe your case is different. Maybe you have a very safe income stream like a government pension that would cover all your basic needs, and your emergencies would be unanticipated expenses.

    I think we’re seeing the repercussions now of too many people thinking that a HELOC equaled savings. And they got so used to it that now the news spouts headlines like “The Banks Are SLASHING Your HELOC! What Should You Do???” The thinking now is that it’s some sort of entitlement that’s being wrongfully stolen [even from RESPONSIBLE BORROWERS!!!] rather than an offer of secured debt that is no longer on the table.

  • By Alexandra, March 26, 2009 @ 2:48 pm

    Hi Beth,

    I am just saying that buying may be a better option for people who would not save their money otherwise. I know that generally speaking, buying a place is a more expensive monthly payment than renting. But renting ONLY makes sense if you take the difference between a rent payment and what you would have been paying in a mortgage, insurance, other fees, etc., and you INVEST that difference. If you blow the difference instead of investing it, then 20 years down the road you have nothing, whereas the mortgage payer has a house.

  • By Jennifer, March 27, 2009 @ 11:20 pm

    Just started following your blog (love it). I am responding because this issue has been bugging me lately. DB and I bought a home 5 years ago in the suburbs and now I want to live in the city. My reason is that owning is more expensive and we could rent something in the city. When we bought the home we knew that the house payment was equal to what we were paying in rent. I never realized how much it would cost to maintain and it is killing me. I would love to sell, move into the city, rent, and invest the money we would have left over. DB’s argument is rental space would be smaller and not have tax write offs. We go back and forth. I feel like his arguments are the “keeping up with the joneses” syndrome. All of our friends have bought a house. Again, I would rather retire than pay for a house forever!

  • By Frank Curmudgeon, March 28, 2009 @ 8:01 pm

    Not knowing the numbers, I wouldn’t dream of offerring an opinion on your situation. However, I think there is a terrible cultural bias we all carry that successful and responsible adults don’t rent, they own. In fact, for lots of people, maybe including you, renting is cheaper.

  • By ryan, March 29, 2009 @ 8:54 am

    Jennifer,
    Frank’s right. But just to add some things to think about…

    One of the problems with the 30 year mortgage is that many homeowners (and I use that term liberally) don’t even think about a time when they won’t have to pay a mortgage or rent, as it’s so far in the future. But it does factor into any cost/benefit analysis. The portion of your mortgage payment that goes toward principal is just a little bit like investing in the treasury’s inflation protected security. It’s not horrible, it has its benefits. All else equal, it’s better than paying rent. Score one for your boyfriend.

    Your boyfriend is likely way overestimating the benefit he’s getting from the tax deduction. Compare it to what you would get by taking the standard deduction, not no deduction as most people figure. Score one for your case.

    There is a ton of other questions your post raises that we could write pages and pages addressing. You probably won’t sell your house right now for as much as you think. Then you’ll pay 6% to the agents. Obviously the rent in the city can be raised. Depending on where you invest the cost difference you could lose it all. Or it could go nowhere. Or inflation could defeat it.

    You could be spending a huge amount right now on transportation by living in the suburbs, and realize a big savings living in the city. Or you might find that living so close to all the action makes you go out to every single happy hour, and you’d drink away any savings.

    You could sell your house in a down market now, rent for five years; after you have two kids you might want to go back to the suburbs for grass and space and schools, and buy a house in a higher market.

    And this post could go on and on forever. You’ve got to think about what you really want, and be honest with yourself about what the differences in lifestyle will mean for you and your wallet.

    I think we will all be interested to know what you end up doing.

  • By fcmm, April 3, 2009 @ 4:57 am

    ryan, you make an innocuous little comment there that I think people overlook all the time. A mortgage isn’t forever (it just feels like it). I’ve paid my house off and could now afford to live on 1/4 of the income I have now. My only housing costs are maintenance and council rates… :)

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