In Defense of Home Ownership

As the housing market soared skyward a few years ago, renters were the ugly step-child of the community. I can remember renters literally gazing at the floor as homeowners discussed their new found wealth at parties and around the water cooler. Today, homeowners are the ones gazing at the floor and renters are thumping their collective chests in victory as housing prices head downward. It seems that the emotions generated by sudden changes in asset prices trump the old adage, “buy low and sell high.” And out of the ashes of the housing wild fire have come a slew of “renting is better than buying” articles. Well it ain’t so. I assert that for most people most of the time in most places, the financial benefits of home ownership trounce renting. It seems odd to me that I might have to go to great lengths to defend that proposition, but allow me to put forth my case for home ownership.

Taxes, Leverage and Inflation

Three things help make home ownership a better, long-term financial move than renting:

1. Taxes: First, interest on mortgages and property tax are tax deductible, which reduces the cost of owning a home. True, not everybody can benefit from these deductions, but most who own homes can and do. Second, the first $250,000 (if single) or $500,000 (if married) of gain from the sale of a primary residence is excluded from capital gains tax. This is a significant benefit, particularly when comparing real estate to other forms of investment. These benefits are not available to renters.
2. Leverage: Most real estate is bought with borrowed money. For example, a $300,000 home typically may be purchased with anywhere from a 0 to 20% down payment. Assuming a 10% down payment, $30,000 plus closing costs buys the home. If the home goes up in value by say 4% the first year, the increase is $12,000 ($300,000 x .04). The point is, appreciation applies to the value of the home, not the amount the homeowner has invested in the property. Now of course the value of real estate may go down one year, as it has in 2007, but over the long term, real estate has gone up in value, which brings us to point #3.
3. Inflation: Inflation benefits homeownership in two ways. First, as noted above, inflation increases the value of real estate regardless of the amount invested in the property. Second, inflation increases the cost of renting. In contrast, assuming the homeowner obtains a fixed rate mortgage, the monthly payments are fixed for the life of the loan. Taxes and insurance will increase, but the monthly payments for the borrowed money will not. This last point cannot be overstated. I lived in my first home for 11 years. When I moved, my monthly mortgage payment was $1,200, which included taxes and insurance. The cost to rent my home would have been about $2,200.

It is worth pointing out that each of the above factors could turn against home ownership. Congress could change the tax laws. They did in 1986 and real estate took a dive. Inflation, something we’ve come to expect since leaving the gold standard, could turn to deflation. I doubt it will, at least over the long term, but it could. And the cost of leverage could become prohibitively too expensive. But right now, all of these factors favor owning over renting.

You’re not relying on a rent versus buy calculator, are you?

For many of you, my three factors above are worthless if I can’t defend my view with hard, cold numbers. Enter the rent versus buy calculator. These calculators are lots of fun, but they must be used with care. They can only spit out numbers based on numerous assumptions that you enter. These assumptions include the future rate of inflation on real estate and renting, maintenance costs, your tax bracket, and future increases in insurance and property tax. Second, you must compare buying and renting the same house. If you’ve sold your home and moved into a small rental unit to save money, that’s terrific, but it says nothing about the relative benefits of buying and renting. Third, even if you get all of the assumptions right, they will change over time. You may live in an area where home prices have far outpaced rental values. This may make renting more appealing today, but eventually rental values will catch up or home values will come back down (everything reverts to the mean, everything).

All of that said, my favorite rent versus buy calculator can be found here.

JD at Get Rich Slowly mentioned this calculator the other day, and it’s one of the best I’ve seen. I used the calculator to determine if renting or buying one of our rental properties would be best. I picked one of our properties–”No Basement” to be exact–because I know the rental values and value of the property. My assumptions include 3% inflation rate, 10% return on stock market investments, and a 20% tax bracket. The calculator includes costs for taxes, insurance and maintenance. Here were the results:

So under these assumptions, buying beats renting after just 2 years. And note that I assumed home values would go up by just 2%. The better assumption is 3-4%. My guess is right now you’re screaming, “yea, but look at the assumptions you’ve entered! A home worth $130,000 rents for $1,045, are you nuts?” Good point. Actually, that’s what No Tenant does rent for when it has tenants, but that’s for another article. Fine, let’s set home value increases and rental increases to 4%, jack the price up to $200,000 and keep the rents at $1,045. The results are that buying beats renting after six years. Of course, we could keep increasing the cost of the real estate and eventually buying would never beat renting, which brings me to the third and final section of this Apologia.

Are Mike and Rob hypocrites?

TWA is a real estate investing site. Mike and I make money because some choose renting over homeownership. The fact is that home ownership is not the best choice for everybody all the time. We rent to families in the military who move every couple of years. We rent to younger couples just starting out. We rent to families who don’t plan to stay in the area permanently. And we rent to families with credit issues. Sometimes renting does beat buying, and here are some situations where renting may be the best alternative:

1. You move frequently. The transactions costs associated with buying and selling a home will eat away at any financial gains home ownership offers.
2. Monthly rent is less than 0.5% of the home’s value: This is a very general rule of thumb, but if you can rent a $200,000 home for $1,000 or less, renting may be the way to go. Keep in mind, however, that this rent versus value disparity may not last forever.
3. Bad mortgage terms: If you can’t get a competitive, fixed rate loan, buying may be too risky. The news is filled with stories of homeowners (and former homeowners) who bought more home than they could afford using exotic loans. If it takes more than 10 words or so to describe the terms of a loan (as in, “Your mortgage is a 6.5% fixed rate 30 year loan.”) be afraid, be very afraid.
4. You lack savings: Most loans today require a down payment, and 20% is required to avoid private mortgage insurance. Buying a home with no money in the bank is very risky. Renting while you save for a down payment and an emergency fund is a safe, conservative approach to home buying.

Notice that one of the reasons to rent that is NOT included is falling home prices. If you want to time the market, go ahead. It seems that everybody cautions against it, but everybody thinks they can do it. Falling prices should encourage buying, and eventually they will. But don’t let the current housing market conditions convince you that real estate is a bad choice. And if you don’t believe me, would you consider listening to Warren Buffett: “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”