Owning vs renting

This page reviews the arguments for owning versus renting your home. There are many arguments, some financial and some psychological, for and against owning your home. From a strictly economic standpoint, buying a home will often be more cost-effective than renting if you stay there for at least ten years. If you move more frequently, home ownership can be a negative economically, even a severe one.

Economics
This excellent New York Times [http://www.nytimes.com/2007/04/10/business/2007_BUYRENT_GRAPHIC.html? calculator] can help you calculate how long you will need to stay in your purchased home for it to be more cost-effective than renting. Please consider increasing the Investment Returns under general settings to 7 or 8%, or to try a range of values. (See Historical and Expected Returns for the justification of why an asset allocation of stocks and bonds should return more than the calculator's default value of 5.5%.)

The accompanying article lays out why renting is often more cost effective than owning:

"One of the big lies of the real estate business is the idea that renting a home is tantamount to throwing money away. It’s a useful fiction for real estate agents, because they make vastly bigger commissions on house sales than rentals. But the comparison isn’t nearly so straightforward for the rest of us.

Renting involves one obvious, recurring cost that can never be recouped: the monthly rent check. Buying, on the other hand, involves multiple expenses, some of which aren’t so obvious. On top of closing costs, there are repairs, property taxes, mortgage principal and mortgage interest. (The mortgage-interest tax deduction reduces this last cost but doesn’t eliminate it.) When you own, you also lose the ability to invest your down payment elsewhere, like the stock market."

The transaction costs of buying and selling a home (in particular the 6% broker fee and mortgage closing costs) mean that you need to stay there for several years before lower monthly costs can overtake renting. Further, in the early years of a mortgage, most of your monthly payment goes to interest, which even with the mortgage interest deduction, is still an expense that does not generate any equity. For many properties, only after a decade do your principle payments generate enough equity to cover the transaction costs and make ownership less expensive than renting. For other homes, ownership is always more expensive than renting, and simply gets worse over time.

Unfortunately, in the modern economy, many owners find that they want or need to move every 5 or 10 years. The perfect house you bought a few years ago may now be a grueling cross-town commute from the great new job you were recruited to. The second kid may mean that you need more room. Having the kids leave home means that you're paying for far more space than you need or want. That leaves some homebuyers in a situation where, due to frequent moves, they are always worse off owning than they would be renting.

Inflation and Deflation
In a high inflation environment, homeowning has two advantages: the value of the home generally stays consistent with inflation, while the cost of a fixed mortgage shrinks dramatically. Thus, the 1970's were a great time to own a home. Going forward, it is possible but unlikely that the US will again experience such high inflation. In addition, there are investment securities such as TIPS that more directly let you preserve your wealth in an inflationary environment. If deflation occurred, the fixed mortgage would become more onerous over time, though you could keep refinancing every few years.

Psychology
Many people get a psychological benefit from owning a home. They like feeling that a piece of property is theirs, and that they can settle in and relax there. Homeowners have the maximum say over who can enter their home. Many homeowners get satisfaction from home improvements projects they fund or do themselves.

Of course, that ownership is normally dependent on making monthly payments to the bank. And even after the mortgage is paid off, you still need to pay insurance and taxes.

An owner obviously has far more flexibility to make improvements to a home than a renter. But most homes have city-imposed zoning restrictions and a large percentage of homes are part of homeowner associations that implement significant restrictions known as Covenants, Conditions, and Restrictions (CC&Rs) on your ability to change your home. For example, many CC&Rs restrict the color you can paint your house, the kinds of plantings you can make, and what you can keep in your front driveway.

Although counter-intuitive, many people make improvements to their rental properties. For example, if you're going to be in a rental for a year or more, you may decide to repaint a room or change a fixture. If you have a reasonable relationship with your landlord, she may approve you doing this work. If not, you can change it back again when you move out. However, some leases explicitly forbid any changes (like painting and fixtures) at all, so read your lease and talk to your landlord. Some renter's have put as much as $100,000 into improving their rental, but that is not a recommendation to do so yourself!

Flexibility
The biggest advantage of renting is the flexibility to relocate relatively easily. In the last century, many people worked for one employer in one location their entire lives. But today, most workers are likely to work for a number of different employers, in multiple different cities. Even when switching jobs within the same metro area, a previously convenient house may now entail a grueling commute.

1 in 6 now owe more on their mortgage then their property is worth. Many of these people cannot afford to move under any circumstances, even to pursue a better-paying job. Many more are not willing to sell their homes because they know the price has dropped below what they paid. Many of them stay in a home that is poorly located, or too big or too small for what they can now afford.

Variety
There is a common misconception that only apartments are available for rent. Although most rentals are apartments, homes in every category from 400 sq ft shacks to 15,000 sq ft mansions are available for rent.

Another misconception is that one buys to be located in a good school district. There are expensive and inexpensive rental properties available in every school district in the nation.

If you are concerned about having to move after a year, most landlords would be thrilled to sign 2 or 3 year leases. But this is normally unnecessary. Many landlords are grateful to have a renter who reliably pays their rent, and will happily keep you as a tenant for a decade or more.

Return
Separate from the value of having a place to live, a home is an asset that increases or decreases in value over time. The underlying housing equity is a real asset, but it is a incredibly poorly returning one. According to economist Robert Shiller, "the average annual real (net of inflation) increase in home prices was a mere 0.40%".

Of course, any given house might double or triple in value. But it also might lose value even faster. In any event, housing is always an extremely illiquid asset. Unlike stocks or bonds, it can take months to sell a home, and there is a serious risk that if selling during the wrong time, a homeowner can get significantly less than the long term average price. As an asset class, homes also tend to be highly correlated with economic conditions of their locale. So, if you lose a job because of hard economic times (such as in Detroit), you may find your home equity simultaneously diminished.

Finally, a home is by definition undiversified. Although Homeowner's insurance, flood insurance and earthquake insurance should protect you from fire, flood, and earthquake, it does not provide any guarantee that you will get back the money you paid for your house, even if the housing market in general does well.

Impact on Portfolio (Negative Bonds)
Purchasing a house with a mortgage represents both an asset and a liability. However, the two parts of the transaction interact with your portfolio in different and subtle ways.

As a liability, a mortgage is a negative bond. If you have 300 K in bond funds (loaning money), and a $300 K mortgage (borrowing money), you do not have any net allocation to bonds. The effect of the negative bonds (the mortgage) is to put you in a riskier asset allocation than you might otherwise choose.

Now, let's consider the asset side of the ledger. There are two financial aspects of owning a home, and neither of them are at all like a real ("positive") bond. The first is the appreciation or depreciation of the property and housing stock, which is a very illiquid, undiversified form of equity. The second is implicit rent, which "is the amount a homeowner would pay to rent, or would earn from renting, his or her home in a competitive market". The implicit rent is only like a bond in that you can think of it paying a coupon, but that "coupon" is a housing voucher good for a month's implicit rent at a single address.

It's simpler to think of the implicit rent as a reduction in expenses rather than as some sort of strange bond. Similarly, Bogleheads often calculate pensions and social security as reducing one's need for retirement income rather than as a form of asset.

The underlying housing equity is a real asset, but as mentioned above, it is an incredibly poorly returning one. So, in summary, buying a house with a mortgage is economically equivalent to making the following three transactions:


 * 1) Reducing your fixed income ownership by an amount equal to the size of the mortgage.
 * 2) Investing in an illiquid equity product with a long-term real expected return of 0.40%
 * 3) Reducing your monthly expenses with a housing voucher good at one house only.

Taxation
There is a large taxation benefit to owning a home versus renting, but it is not the mortgage interest deduction. That deduction is only open to the 30% of taxpayers who itemize their deductions. Plus, the deduction phases out at a high income, and is not available on a second home or with a large set of mortgages.

In any event, mortgage interest is an expense that makes less of the cost of home ownership go toward your equity. The deduction (when you can claim it) lowers that expense, but the expense remains.

The biggest tax advantage of home ownership is the capital gains exemption. The first $250 K of profit ($500 K if you're married) from your primary home sale is exempt from capital gains taxes. If you make $500 K on your home sale, that is $75,000 (at the 15% long term capital gains rate) that you don't have to pay. The value of this exemption depends on your opportunity cost. If you would have invested the excess money for your home into tax-advantaged retirement accounts, the exemption may not mean much. If your choice is between purchasing a primary home and investing in a taxable account, and you plan to sell the asset (house or mutual funds) before you die, then the $75 K is a significant benefit. If you leave the house or the mutual funds to your heirs, the capital gains treatment is the same, in that they get a stepped up basis at your death.

Asset Protection
One advantage of home ownership over owning mutual funds is that in many states, one's primary home is protected against creditors in nearly all circumstances. This could come in to play in bankruptcy or if there were a large lawsuit judgment against you. Florida's homestead exemption has no limit to the value of the house that is protected.

Forced Savings
One of the strongest justifications for owning a home is the forced savings. For people who can't be trusted to contribute to their 401(k) and taxable accounts every month, a mortgage payment forces them to save. (Specifically, they are saving the principle, while the interest is an expense that disappears forever.) Of course, there's a problems with the idea of forced savings in practice, because spendthrifts can borrow from their 401(k) plans and can take out home equity loans. And with mortgage payments, the first 5 years (the length most people live in a home) is nearly all interest payments.

Bogleheads Forum Discussions

 * Mortgage as bond component in AA
 * Why do Bogleheads buy houses?