Renting vs. Buying

It is real estate day again. The S&P Case-Shiller for April came in at +1.3% from the previous month and –1.9% from a year previously. Since the great swoon in house prices ended three years ago, house prices have given Two-story_single-family_home up another -2.5%. I had predicted sideways motion from that bottom, and I consider –0.84% annual decline to be essentially sideways. So good for me.

I have also previously declared house prices to have become boring. And boring is good.

Keeping with the theme of the day, SmartMoney just ran an item on buying versus renting houses. It was based, loosely I am assuming, on a Deutsche Bank report from March that said that although as a nationwide average owning is a better deal, in some places including California and the Northeast, renting is cheaper.

California and the Northeast are not exactly sparsely populated backwaters. In fact those are the bits of the country with the highest house prices, so this should be important news. I could not find the DB report, it is presumably only available to clients, so I have only the SmartMoney version to work with.

And they helpfully provide illustrative examples.  There is a 4 bedroom 3 bath house in Englewood Cliffs, NJ listed for sale at $699K but also for rent at just $3000 a month. Assuming a 10% down payment, current mortgage rates, and adding in property tax, owning that house would set you back, SmartMoney tells us, $3410 a month.

So renting is $410 a month cheaper. That is impressive. The only way that might not actually be the best economic choice would be if there was some kind of government subsidy of the mortgage, for example if interest payments were deductible on income taxes. If you were in the 28% bracket (a reasonable guess given the cost of the house) then the $1939 monthly interest payment would then save you $543 in taxes.

Actually, there is another way the $3410 a month could be cheaper than the $3000. SmartMoney could have misunderstood how mortgages work. The Englewood Cliffs example does not come with a breakout of what goes into the monthly payment for owners, but the one they give before it, in the inexplicably named town of Ho Ho Kus, NJ, does.

In that example, the house costs $754K. SmartMoney assumes 10% down and a 3.7% mortgage. This will result, they tell us, in a $3123 monthly mortgage payment. Add that to the $897 in property taxes, and the $4020 monthly owner’s cost is higher than the alternative $3700 rent. But as we advanced personal finance types understand, that mortgage payment is partially principal being paid back, essentially forced savings. And paying down the principal may not be entirely convenient, but it is not a cost.

$754K times 90% times 3.7% gives annual mortgage interest of $25,108. Divide that by 12 and you get $2092, meaning that in the first month that $3123 payment is $2092 in interest and $1031 in principal. In subsequent months the interest will be a little smaller and the principal a little larger. $2092 plus $897 in property taxes is $2989 pre-tax, assuming a 28% rate it is $2152, which is rather a lot less than $3700.

I do not have the patience to go through every SmartMoney example. It would only upset me. In an effort to remain constructive and positive, let me lay out how a person ought to calculate the monthly cost of owning for the purposes of making an apples-to-apples comparison with renting.

Start with the mortgage. You will likely want to put down 10% or 20% to get a good rate. But that presents a problem in that the down payment is not free money dropping from the sky. It has a cost relative to renting as you could have otherwise invested it and gotten some kind of return. How much return is a tricky question, but a convenient and reasonable assumption is that you would have gotten the same return as the mortgage rate.

In other words, for the purposes of this calculation, assume that you borrowed the full purchase price at the mortgage interest rate you expect to pay. From this work out the annual interest payment as purchase price times interest rate. (Actual interest paid will be lower, both because of the down payment and because you will be paying down principal starting in the first month.)

Add in the property tax. Then adjust for the tax deductibility of both interest and property taxes. In general, you would do this by multiplying by (1-T) where T is your marginal tax rate, but it gets a little more complicated if your mortgage is over $1M or you do not itemize deductions.

That takes care of the factors that SmartMoney considered. But there are two other significant ones they overlooked.

First, there is maintenance. As every homeowner knows, a house is a collection of expensive things and systems that can break and that owners, but not renters, must pay to fix. What this is likely to cost will vary from house to house, depending on size, age, etc., but if you are not assuming a few hundred a month you are kidding yourself.

Second, there is the change in the value of the house. I am being careful not to call this appreciation. But I do, in fact, expect that in the long run houses will go up with inflation, which is to say that they will just hold their real value. If you expect 3% inflation long-term, then you would rationally assume that the house price will go up by 3% a year. On a $754K house, that is $22,620 a year, or $1885 a month.

Your mileage may vary. As noted above, on a national basis average house prices lost –0.84% over the past three years, against an average inflation rate of 2.4%. But that national average hides a great deal of local variation. In New York, which suffered its bust a little later, houses declined at an average of –2.6%. In San Francisco, they went up at a 3.2% rate.

A thoughtful observer might note that at current mortgage rates, and accounting for tax effects, what a homeowner pays in interest could easily be expected to be less than a conservative estimate of appreciation from inflation. Put another way, if you can borrow at 3% and inflation increases the nominal value of the house by 3%, you are living there almost for free.

Beats renting.

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