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 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.

Housing, Media | Frank Curmudgeon | June 26, 2012 11:59 am

91 Comments

By Eric, June 26, 2012 @ 1:06 pm

Super analysis. Every article I see treats a mortgage payment as if it’s 100% interest. As you point out, the principal repayment is not trivial.
By Neil, June 26, 2012 @ 1:52 pm

I’m not sure it’s relevant to treat interest and principle as separate. The interest is what I’m paying to borrow the money, and the principle is what I’m paying to buy the house. They’re both part of my cost of housing, as is the initial down payment.

Monthly payment vs monthly payment is a good way of establishing relative affordability – which is more closely related to cash flow – rather than the actual better deal. But the whole thing should be worked out as a capital budget if you actually want to establish the “better deal.”
By Neil, June 26, 2012 @ 3:50 pm

Today’s BMA inspired spreadsheet – a rent vs buy capital budget. Simplified to only 17 variables.

https://docs.google.com/spreadsheet/ccc?key=0Arilf8SVoAokdHlrcXdZUTBwa2hoTDZKeFlWUEhIaXc

Result: for most reasonable assumptions, the 5 year rule appears to hold. If you expect to stay in one place for 5 years or more, you should buy. If you expect to move sooner than that, you should rent.
By Craig, June 26, 2012 @ 4:05 pm

You can’t really count on 100% recovery of principal payments, though–everything associated with selling the house (above the cost of simply moving your stuff and cleaning up, which renters also incur) comes out of your hide when you do sell, and it adds up.

In weighing whether to keep our former residence as a rental property, I assumed selling the house would ultimately cost 10% of the sale price–so our opportunity cost to become landlords was 90% of the estimated sale price minus the mortgage payoff.
By Paul Williams, June 26, 2012 @ 5:35 pm

Don’t forget homeowner’s insurance (less the cost of renter’s insurance if that is applicable for your situation).
By AP, June 27, 2012 @ 3:25 pm

I sure wish the housing bubble burst would come to Toronto. Buying makes no sense right now, given the house prices and non-deductability of mortgage interest here on top of that.

We have 1bed room shoe box condos approaching half a million bucks. For no reason other than cheap easy credit that the Feds just said has to end (no more 30 year mortgages here unless you put down 20%). Time for this bubble to burst.
By Frank Curmudgeon, June 27, 2012 @ 10:19 pm

Neil:

Paying back principal just isn’t a cost. It’s spending in the same sense that putting cash into a savings account is spending.

“Today’s BMA inspired spreadsheet” implies that BMA habitually inspires you to make spreadsheets. I’ve never been prouder. “Simplified to only 17 variables.” is the BMA comment sentence of the year.

Craig:

No question that the transaction costs of buying and selling are substantial and need to be considered. I was just trying to redo SmartMoney’s monthly cost analysis properly. I think an even bigger issue is that what is available for rent and for purchase are, at best, partially overlapping groups of properties. Some sorts of places are hard to rent and others are hard to own.
By Martin, June 28, 2012 @ 12:45 pm

Thanks for writing this. I’ve been a little baffled as to the dont buy but rent instead approach of current financial blogs. Because for me the big difference between my mortgage and renting is that my mortgage will eventually end. Renting never ends.
By Adam, June 28, 2012 @ 12:51 pm

I can’t believe I missed your return until today, Frank! So glad to have you back.
By Neil, June 28, 2012 @ 1:09 pm

“implies that BMA habitually inspires you to make spreadsheets.”

It does. Kind of. It turns out that picking out questions that can be answered through spreadsheets (and then building them) is what makes me good at my job, and I have a hard time turning off that skill when nobody’s paying me for it. PF and Econ blogs provide interesting questions, and it’s usually a fun challenge to figure out how to put numbers in and provide a solid answer. Your blog in particular is helpful because it includes some suggestions about the right way to do the analysis.

Last time I tried to do “rent vs buy” it was inspired by a blog post comparing buying a house to renting and investing the cash flow savings in the stock market. With that as my starting point, I went down the completely wrong path and ended up with a mess.

I tried blogging for a while at one point, but it turned out that mostly all I wanted to do was play with numbers, which makes for boring (and largely unread) blog posts.
By Potato, July 1, 2012 @ 3:02 pm

I find it funny how many [mainstream] American rent-vs-buy articles, after the crash, skew the analysis towards renting, even though most of the risk has come out in the correction and buying is probably a perfectly wise choice. While those in Canada (and American ones before the crash) ignore all kinds of important factors, or add in crazy rates of appreciation to skew the result to support buying.
By usa green card, July 3, 2012 @ 3:18 am

Hey frank. informative update. It is even more better if you update details on banking and loan process for real estate. Hope you will update this in your next post.
By David, July 5, 2012 @ 1:41 pm

I like a lot of your stuff, even if I don’t agree with some of it. This is one of those times. You said:

“Paying back principal just isn’t a cost. It’s spending in the same sense that putting cash into a savings account is spending.”

My reply: I see your point, but I think you’re mistaken. Maybe I’m nitpicking, but it’s not like a person can go down to the bank and withdraw money from a home’s equity like they can a savings account. Yes, you’ll get the equity out of the house, but only if you take out another loan or sell the house and only if the market value is there (which, it probably will be unless you’re unlucky enough to want the money when there’s a slump in real estate).

The former increases the cost of ownership, the latter leaves you without a place to live.

It *is* a cost, since the principal of the mortgage is the cost of the home. That’s why every business with a balance sheet puts mortgages down as a liability (with the equity as an asset).

The fact that it has a market value means that it’s worth that much money IF you can sell it. The market value may mirror the initial cost, but there’s no guarantee that that will happen. It’s like saying “stocks are the new savings account” or “bonds are the new savings account” or “gold is the new savings account.”

*Savings accounts* are the new savings account. Everything else is a commodity, a claim on ownership, or a loan.

It’s not exactly a 1:1 comparison to savings.
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