Throwing Money Away (Buying vs Renting)

Monday, June 1, 2009
By dreeves

A hypothetical renter, and their home-buying alternate self.

I’m tired of hearing people explain that paying rent is throwing money away. Of course, they don’t mean that literally. You’re getting something for that money (a place to live). But with a mortgage you’re building equity, right? Doesn’t that fundamentally make more sense than renting? No. “Building equity” just means turning some of your money into a house. That’s one of many ways you could invest your money.

Practically speaking, there are some reasons why buying instead of renting really is a good idea for a lot of people:

  1. Self-binding. Committing to a mortgage may force you to save and invest money that otherwise you would have spent (to spend your house you have to sell it or re-mortgage it). Not that there’s anything wrong with spending money (that’s what it’s ultimately for) but you might well want to force yourself to save more than you’re naturally inclined to.

  2. Crazy tax incentives. Mortgage interest is tax deductible in the US and capital gains from selling your home is largely tax-exempt. As part of the current fiscal stimulus plan, many first-time home buyers even qualify for an outright gift from the government of $8000 just to buy a house.

  3. Leverage. Buying a house is the only way normal people can invest a huge amount of money on margin. In other words, buying a house means investing hundreds of thousands of dollars of borrowed money in real estate.

  4. Control. If you are your own landlord you can’t be forced out or priced out, and you can modify your home as you wish. (The flipside is that it makes your place slightly like the Hotel California — ever leaving will be a serious ordeal.)

But beyond all that, shouldn’t it be cheaper to disintermediate your landlord? In fact, landlord profits are probably a very small part of the equation: on par with the cost of collecting your rent and arranging (not paying for) maintenance. We can check this by seeing how much property management companies charge. Casual web searching indicates it can range from 3% to 15% of rent. But that includes the cost of finding new tenants — the equivalent of which home-buyers pay in spades in realtor commissions (directly or indirectly). I think it’s safe to say that only a few percent or so of your rent is wasted in that sense. Perhaps more or less depending on how often you move.

In a sane market, mortgage interest [net of home apprecation rate; see below] plus property taxes plus maintenance costs will roughly equal rent. None of those expenses build equity any more than rent does.

So paying rent is not fundamentally throwing money away, though it may be leaving free money from the government on the table.

Epilogue

The above was pure armchair excogitation. I’m now the proud renter of an apartment in Harlem at $2500/month, which we also have the option to buy for $600k or so. The condo maintenance fees would then be $1000 or so per month. Property taxes and the mortgage tax deduction roughly cancel out for me. This puts the monthly (unrecoupable) cost of ownership at $3500/month — $1000 more than rent.

For that to make sense, the condo has to appreciate at 2%/year indefinitely. I’m not inclined to make that bet.

To reiterate my original point: buying means $3500/month “thrown away” (in the sense that rent is thrown away). When our agent was telling me these numbers he kept repeating the myth that “if you’re going to spend that money on rent every month you might as well be building equity”. Absolutely false! The fraction of your rent that would go toward building equity (if you put that rent money toward buying instead) is literally less than zero. In places like Manhattan where the rent ratio is high, you’re paying a lot for the privilege of investing in real estate and counting on it to appreciate.

Of course, in a sane market you would count on appreciation in line with the historical rate. For the US (as a whole), that is not much better than inflation. Still, in the rent vs buy calculation, you should subtract from your mortgage interest rate the historical appreciation rate. Unless you believe we’re still in a housing bubble, in which case you should subtract nothing, or even add to the mortgage interest rate.

Two more myths busted for the price of one

Myth: By buying a house your costs go down over time as you pay down the principal on the mortgage.

When people defend the “renting is throwing away money” myth, there are a couple of supporting myths they cite in support of it. First is the related claim that by buying a house your costs go down over time as you pay down the principal on the mortgage. This is wrong. It doesn’t account for opportunity costs. Remember that if you were making alternative investments then you’d be raking in enough money in interest to cover most of your rent by the time your home-buying alternate self paid their mortgage off. More generally, the term of your mortgage (or whether you need one at all) doesn’t much factor in to the buy vs rent decision. You can compare renting vs buying as if you’re getting a zero-amortization mortgage. I.e., assume you’ll be paying only interest and never touching the principal so that your mortgage payments are 5% (or whatever rate banks charge these days) of your home’s value per year forever. Whether you have such a hypothetical infinity-year mortgage or a 30-year mortgage or pay up front with a suitcase full of cash doesn’t matter. A long mortgage term means a lot of interest paid but the suitcase full of cash means a lot of interest you would’ve earned forgone. It’s all a wash.

That does, however, ignore the tax advantages of a mortgage. In fact, a zero-amortization mortgage maximizes the mortgage interest tax deduction, which is probably the biggest factor pushing towards buying.

Myth: Building equity in a house beats alternative investments.

The second related myth, and another common rationalization for buying over renting, is the claim that real estate is a fundamentally better investment (and so building equity in a house beats alternative investments). This claim doesn’t hold up, even if you made the (unwarranted) assumption that house prices have bottomed out. You always have the ability to invest in real estate without buying a house.

Illustration by Kelly Savage.

Thanks to David Reiley, Alex Strehl, Andrew Reeves, John Langford, Bethany Soule, Martin Reeves, Dave Pennock, Laurie K. Reeves, Sharad Goel, Bob Soule, Rob Felty, Kevin Lochner, and Jake Hofman for helpful discussions and home-buying anecdotes.

UPDATE: There are excellent points and additional resources and caveats in the comments. Thanks! I added one myself clarifying why “buying gets cheaper eventually as you pay off the mortgage” is wrong. I stand by the original point: If you ignore price bubbles, taxes, personal preferences, and leverage then renting and buying are roughly financially equivalent. Not that you should ignore those things, just don’t fall for the myths that it’s a no-brainer decision.

UPDATE: Now in Spanish, thanks to ManzanaMecanica.org.

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  • http://emergentfool.com Daniel Horowitz

    Awesome post, I couldn’t agree more. And, doesn’t home ownership directly cause unemployment by restricting mobility? (Or we could say that home ownership reduces earnings power.)

  • Ali
  • http://ai.eecs.umich.edu/people/dreeves dreeves

    Thanks for pointing out that excellent tool, Ali. (See other buy vs rent resources in the links in the sentence “I’m not inclined to make that bet.” in the post above.) Picking assumptions about appreciation rate and rent increase rate is key. Does anyone know where to find region-specific historical appreciation rates?

    Also, I don’t think it makes sense to assume a higher or lower rent increase rate than appreciation rate since rent can only get so far out of whack. Market rent — what you’ll always pay if you move often (or credibly threaten to) — will match home appreciation rates. If your rent starts to deviate from market rates by, say, a couple hundred dollars per month, that difference will pay for professional movers pretty quickly. See my previous post about slimeball landlords: http://messymatters.com/2009/05/24/landlords/

  • Peter Denby

    This is a good document with appreciation rates broken down by region and state going back to 1980: http://www.fhfa.gov/webfiles/1174/3q07hpi.pdf
    Here is a good report for Manhattan that only goes back to 1999 however: http://millersamuel.com/reports/pdf-reports/MMR08.pdf
    I like the post, Danny. It really comes down to where do you want to invest your money? People who bought in Harlem 10 years a go are in a lot better shape than someone who has been renting in Harlem for 10 years (unless they made really incredible investments with the money that would have otherwise gone towards a mortgage and a down payment); but in the same way that someone who bought Microsoft in the early 90′s is a lot better off than someone who bought The North Face (as I did–damn you expensive headquarters!)
    Also you mentioned an extremly valuable point: that you can invest in a house/condo by borrowing up to 95% (well not now, though) of the money for your investment. This kind of investment can only happen in the housing markets, so it is actually a very risky bet in the short run but a very solid bet over time (based on appreciation rates).
    In terms of numbers it really boils down to where do you think your money will give you the best returns. The irony is that I would argue a lot of people make a home vs rent decision based on emotional reasons as oppossed to sound financial ones: I OWN this place (even though they don’t if they have a mortgage), in X amount of years I will have no more payments, and they FEEL it is a good investment without really analyzing their oppurtunity cost of a large down payment and higher monthlies.
    Of course if I had the money I would absolutley buy.

  • http://www.eecs.umich.edu/~congy/index.html Cong Yu

    Dan, I was facing the same decision a year ago. So as a financially responsible person that I strive to be, I made a little spread sheet trying to map out the advantages and disadvantages of buying versus renting. (I can share with you the spread sheet if you are interested.)

    The comparison essentially boils down to calculating and comparing the rates of return of the two approaches for the time frame you plan to hold on to your house (number of periods). In the buying case, you start with the down payment (Present Value), pay a monthly (mortgage plus common charge and property tax) payment (Payment), eventually finish with money in your bank (Future Value) after you sell the house and pay the real estate agent. In the renting case, rent constitutes the Payment, and the Future Value is now your alternative investment portfolio balance grow from the down payment you would have paid to buy the house. Your tax bracket matters since it adds to the Payment in the renting case, while subtracts from the Payment in the buying case. Mortgage term matters a lot (I disagree with you on this in your post) since it has a huge impact on the Payment in the buying case. When the mortgage rate is low, leverage makes a lot of sense! In fact, buying advantage decreases as you pay off your mortgage since your leverage ratio goes down. Finally, it’s how much you expect your house to appreciate and your alternative investment portfolio to appreciate.

    In my case, the common charge is one-fifth of the prevailing rent (vs. two-fifth in your case), living in high income tax states (where income tax alone exhausts the standard deduction) means we get a lot from tax deduction, and the mortgage rate is 4.875%, so buying made sense for us. We also got a huge kick out of Ronglai’s employer, which gave us an interest-free loan for 15% of the house value for six full years (too bad it was only for the first house). The nice feeling of being able to do whatever to your place and not dealing a landlord are also pluses :-)

  • http://reasonablyopinionated.com Alan Pinstein

    I agree with your financial calculations, this is sound advice on that front.

    I also in general agree that it’s unfair for the goverment to subsidize homeowners but not renters. This policy is effectively a regressive tax.

    However, there is one big benefit to homeownership that is initially intangible but may accrete to home values, and that is people act different in a home they own vs one they rent. It might not matter much in a condo, but in a single-family home community, owners take pride in their house and community and make improvements. Homeowners also generally stay put longer and thus have further incentive to “invest in the local community” by improving their house and caring what the neighborhood looks like.

    There is clearly some positive societal and economic benefit from this. I have no idea how to reasonably factor it into your equations.

    Alan

  • Paul

    Well, eventually you do actually OWN the home it is that you are buying, and then all you pay is insurance and taxes (and for upkeep). This assumes you are not in a condo or similar situation where you pay for a valueless homeowner’s fee.

    One could state the money could have otherwise been invested that was spent on homeownership, but I think the difference only really appears if there are those condo-like fees. Essentially, home ownership makes monetary sense as long as you are not buying a condo.

    Of course, there are lots of other reasons you might rather rent, flexibility chief among them.

  • http://www.earthinfo.org Chris

    “For that to make sense, the condo has to appreciate at 2%/year indefinitely. I’m not inclined to make that bet.”
    I would make that bet, inflation will soon be rocketing back up, and therefore the price of house will get pulled up too. if you can get a fixed rate mortage now, its going to be easy money.

  • zack

    I think you might have fun over here. http://www.streeteasy.com/nyc/talk/ even if it was just to post a link to this article I’m sure you’d get some um, creative, ahem, feedback

  • Expat

    @Alan P.: Recent studies I have seen indicate that there is NO difference in behaviour or sentiment between owners and renters with regard to community or pride.

    As far as making home improvements, renters have it even easier than owners. I was a renter for about twenty years (just bought); when I wanted to make improvements I simply changed apartments, upgrading what I wanted.

    Ignored in the calculations is renters’s option. When the market is weak, renters can upgrade at the same cost or simply renegotiate much lower rents. When the market is strong, renters are often able to negotiate steady rates or moderate increases. There are moving costs and hassles involved, but I can tell you that in twenty years and seven apartments, I have spent much, much less than any friends I know have spent on renovations and repairs.

  • Nick C

    Your calculation makes sense over the course of the mortgage, but not beyond then a far as I can calculate. If you discount asset appreciation/depreciation, a 250000 house with a 10% deposit and with a mortgage with interest at 5% pa over 25 years will cost you ~170000 in interest. Assuming a rent of 1000 per month, it will take you 14 years beyond the 25 (i.e. 39 years) to amortize the purchase. If you buy a house at 30, and finish paying it at 69, you get the rest of your time in the house for ‘free’ (compared to renting), most likely at the time when you will need it the most (i.e when you are old and don’t have a large income.) And this is disregarding inflation, which is likely to reduce the cost of the house over the years but not the cost of the rent.

    Granted, it’s not a no-brainer, but it’s definitely worth going through the numbers. Note I don’t take any tax or grants into account as they are different here (in the UK) as they might be for you.

  • Paul P

    I simply don’t get how buying can be better in most cases. My apartment is walking distance to shopping, coffee and pizza. It’s nicely painted, has hardwood floors and granite countertops. When something breaks, my landlord’s professional crew fixes it in 1/10 the time it would take me, and they do a much better job than I ever could. There are no property taxes.

    On top of that, I pay $1600/month instead of paying $4000/month (perhaps a couple years ago. Now maybe slightly less) to own the same thing in the same school district (a good one). I bank the savings and earn interest on that savings. Instead of fixing things in my spare time, I do consulting gigs.

    I believe that renting, when you find the right place (which it not hard to do) is by far more efficient than owning. My landlord tells me that he looks for properties with at least 12 units and that smaller properties are less profitable and more time consuming. 12 (or larger) is a good manageable number according to him. So I guess 1 (as in single family home) may be one of the most inefficient forms of shelter.

    Now, of course, there is a downside to all of this. Since I’m married, have a kid, and do not “own” my home, my mother-in-law thinks I’m a complete loser.

  • Jack

    This is so on the money. Renting was THE way to go over the past seven years. I did and I am NOT under a 750K or more loan on a dump worth 150K on a good day, thank you very much. The phrase, renting is throwing your money away is the most idiotic statement used by real estate people to boost sales, there are plenty of dopes that fall for anything. What they do not consider when they are buying is they have taxes, repairs, insurance depending on region can be multiple policies, and also now falling so-callled equity. To the guy who said that his mother-in-law thinks he is a loser for renting, I would ask her “would you rather I had your grandchilden and daughter under a 750K mortgage on a house worth 150K? Or worse bankrupt?” Then let her think what the term loser means. The smart man works to avoid such pitfalls before they occur.

  • Milo M.

    Another factor in favor of renting is that you don’t tie up your down payment. In today’s environment, I’d rather keep my 60K (20% of, say, a 300K house), in a liquid savings account than tied up as a down payment in a house I may have trouble selling.

  • Steve V.

    Losers who bought homes recently might agree that renting is better. Just down the street from my suburban apartment, a nice house is on sale for $549,000. The owners have left, the house is empty, and it’s been for sale for about half a year. They paid $599,000 for it (I checked), and had to leave for some reason. My guess is that they must be desperate at this point, and they’d take $500,000 for the house, which means a loss of app. $100,000. I suspect it will take the rest of their lives to recover the loss.

  • Ed

    There’s absolutely NOTHING “free” about living in a home after the mortgage is paid off. I’ve watched my property taxes ESCALATE over the years and now the maintenance on an older home makes me wish for better days. I often ask myself why do I “throw away money” on taxes and maintenance.

    Looking back, I would say my advice to folks who do buy a house is for them to buy a modest home and invest the difference (preferably in tax deferred/protected accounts – you need to keep governments’ hands out of there too!!). Generally, a house just isn’t a very good investment – PERIOD. Most people list a house as their greatest asset, but you can just as easily classify a house as a liability. Don’t worry about keeping up with the Joneses (afterall, many of the Joneses are financially inept!!).

    Be VERY wary of Real Estate agents, builders and mortgage brokers as they have THEIR best interests at heart not yours. There really weren’t mortgage brokers in my day; the loan officer at the bank had a VERY VESTED interested in seeing that I could pay my mortgage as loans weren’t typically sold off back then.

    If I had to do it all over again, I would definitley have a different view on this whole home ownership as the American Dream scheme. It wouldn’t surprise me if that concept had its roots in NAR propaganda. I’m not saying I wouldn’t buy a house…I would just buy a modest one and I would sell during any perceived bubble as I approached retirement. “House prices always go up” is the biggest lie out there. I’ve seen a couple of times in my life where they were going down. More propaganda for someone else to take your money.

  • Jay

    The point nobody every brings up (and that you allude to) is that any insurance, maintenance, property tax, and interest expenses you pay that you don’t get back in the form of a tax deduction are all throwing money away the same way rent is. Anybody who thinks “at least I’m paying down principal and building equity” should take 1 minute, got to a mortgage calculator website, and see how much of their mortgage payment is paying principal. *OVER 90%* is interest. Principal payments don’t even exceed interest payments until around year 20. And that doesn’t factor in insurance, taxes, etc. “Renting is throwing money away” is one of the greatest lies ever to become part of conventional wisdom.

  • http://ai.eecs.umich.edu/people/dreeves dreeves

    There’s a more fundamental reason that home ownership doesn’t become free after the mortgage is paid off, even if there were no property taxes or maintenance: opportunity cost. I didn’t make this clear enough in the post.

    Imagine yourself 30 years from now with a house you fully own, with no more payments to make. Now imagine your alternate renting self who, instead of steadily paying down the principal on the mortgage, has built up hundreds of thousands of dollars in equity in some other investment. You still have rent to pay each month but that’s also about how much you’re collecting in interest on your investments. So the renter now lives for free just like the home-buyer.

    Another way to say all this is that if you ignore price bubbles, taxes, personal preferences, and leverage then renting and buying are roughly financially equivalent. Not that you should ignore those things, just don’t fall for the myths that it’s a no-brainer decision.

  • Diomedes

    Very well stated.

    I have had this discussion copious times with many individuals. Because most are using borrowed money to purchase their home, they are ‘throwing’ money away via interest payments.

    What is laughable to me were the dopes that began using interest-only and option-ARM mortgages to purchase their properties. If that isn’t throwing money away, I don’t know what is. You are essentially building NO equity and increasing your costs for no reason. It is basically renting with all the added risk. How people were moronic enough to fall for that Red Herring is beyond me.

    One side note that I believe is worth mentioning is that one of the major benefits of renting is the upward mobility it provides. Let’s face it; the days of being guaranteed that one can work for the same company in the same area and retire comfortably with a pension are GONE. Many of us will change jobs multiple times due to various circumstances, the primary one being a lay-off. If one is a home owner, they are many times tied to a specific geographic location. It is far more difficult to uproot yourself in that scenario. That makes looking for a job far more bleak since you are keeping your search local.

    A renter however, when confronted with a job loss, is easily mobile and can move about if necessary. No fuss with having to arrange open houses, deal with realtors, negotiate prices, etc. Just give your 30 days notice and out the door you go!
    I think the future of the job market is going to make a mobile individual far more viable.

    If you live in my area (Northern California) the disparity between renting versus owning is HUGE. In certain more afluent areas, you can rent for sometimes half the cost of what it would take to purchase the equivalent property. This makes absolutely no fiscal sense (and demonstrates the nature of the bubble), but it does show that in certain cases, renting is a better option. Couple that with the typical traffic that we get around here and I would personally much rather be in a position where I could move to a different rental in necessary should I have to switch jobs.

    Finally, there is one additional key item to factor in: if you live, like I do, in an area that generally pays higher salaries, you are actually saving MORE for your future if you simply rent and bank the savings. I’ve done the math several times and if I can maintain my current level of employment and salary over a longer time frame, I could retire comfortably at an earlier age by merely picking up and moving to a a lower cost area and buying a house outright.

  • christine

    I rent, and rents are still ridiculous in California. Someone who makes a median wage of $40k like me would be able to afford $1000 rent at the standard 1/3 income criteria. Few studio apartments are at this rate in SF, Los Angeles, Silicon valley.

    Anyway, what you didn’t consider in your comparison of real estate vs. other categories of investment is that a house is the only type of investment asset where you don’t need to set down the entire cost on the first day. You still get to keep all the price increase over the whole period that you own the house, but you keep making payments over many years. In comparison, if you buy stocks, you have to come up with all the money at the start and keep it locked there.

  • http://housing-analysis.blogspot.com jesse

    http://housing-analysis.blogspot.com/2009/01/ownership-premium.html

    Tax advantages don’t matter in the long run because landlords, who must declare income from rents, will inevitably set prices at the margins. It seems counter-intuitive but the mortgage interest tax deduction has played a part in producing massive housing oversupply but now the tax deduction is peanuts compared to money lost from a depreciating asset.

  • http://ai.eecs.umich.edu/people/dreeves dreeves

    @christine, that’s actually what I meant by leverage. Good point.

    @jesse, that would be true if everyone got the tax benefits, but only individuals, not corporate landlords, get it.

  • http://www.housingnewslive.com Marc

    A house is affordabe if its renting cost does not exceed 25% of a household’s gross income and its buying cost mortgage does not exceed 35% of a household’s gross income. When the monthly carrying costs of a home exceed these numbers, then the housing is considered as unaffordable.

    http://www.housingnewslive.com/affordable-housing.php

    See this article: Affordable Housing Rent Vs Buy

  • http://housing-analysis.blogspot.com jesse

    @dreeves: “that would be true if everyone got the tax benefits, but only individuals, not corporate landlords, get it.”

    Actually it’s the opposite. The point is that tax benefits to a portion of the market don’t matter. As long as investors are in the market, which they are, you can pile in any sort of tax relief you want for owner-occupiers but the investor still needs to make a decent return from rents in the absence of speculation. That means cap rates need to be reasonable again by way of lower prices.

    The own-vs-rent calculation always falls on its face when you look at it from the landlord’s perspective. This has been muddled recently due to a significant speculative component to a landlord’s returns. But these days it’s only the cash flow from rents compared to purchase price, and not capital appreciation, that makes it a competitive return.

  • TED

    Renting is great! I don’t know that I’ll ever buy a home again. I sold my home at the top of the bubble, and am now renting and I love it. When I owned, I never had any cash. If the air conditioning broke, there goes my cash. If the washing machine or furnace broke, there goes my cash. Now, when something breaks, I call the rental office, they send the ole’ trusty maintenance man, and I don’t even have to sign anything. Sometimes I forget and go running for my checkbook, like when my oven went out just as I was about to add my homemade pie, and the guys says, oh no ma’am, you’re all set! 1 hour, on a rainy night, and it’s done.

    Buying a home is bondage. It’s slavery. You have no freedom to quit your job when you’ve had it with your lunatic boss, because you have to think about that mortgage. Like the earlier entry, you can’t look for jobs out of town. You are so not free! When I look for a job I look everywhere. I tell them, oh, I’m a renter, I can go wherever I want for work.

    Let me pose this question: Is paying for closing cost an investment? Seems to me, that’s truly throwing your money away. Fees? What is that? Administrative costs? Again, tossing it out the window? Funny, I didn’t have to pay any of that. I didn’t even have to pay last months and a security deposit because they have this new $59 one-time fee insurance program now.

    Life is grand as a renter. Oh yea, I can paint too. Just have to change it back before I leave, or pay a $25 repaint fee.

  • anonymouse

    your calculations are off, at least in this area. Portland has succumbed to condo-ification, and that really increases the rental rate on a ‘reasonable accomodation’. bargains are to be had only if one prefers living in a motel-like multi-unit where cars are parked under your kitchen window, and one must worry about being robbed by the neighbors. last week we looked at a ‘duplex’ for $1500 which was obviously not maintained at all (the foundation had a large hole boarded up, and other things that the owner assured us he would be fixing, even though it was obvious that those issues had been there for years, and he’d owned since ’91) and was basically someone’s attic turned into a tiny 2 bed (closet, more like) apartment. so, one could pay the same as rent here and purchase, or deal with horrid landlords and maintenance issues that they never want to spend money on.
    yeah, renting is great when you like to move every few years. we don’t. there are large psychological downsides to living in a building with constantly changing neighbors (and their noise) who’ve had bigger and bigger dogs with each filled vacancy.
    some of us are just tired of it, regardless of the fees and financing.

  • one more thing

    There is one more option you left out. Buy it and rent it yourself. The tax write-offs for landlords is virtually unlimited if you do it right. This must be considered when you do this sort of analysis because even a buy and rent situation that doesn’t appear close to breaking even can be in the black after taxes.

  • http://ai.eecs.umich.edu/people/dreeves dreeves

    @jesse: We may be making different points. If the tax benefit applies to all buyers (individuals and corporate landlords) then you’d expect home prices to rise and perfectly negate the tax advantages. If only a small minority of buyers are getting the tax benefits then you wouldn’t expect an impact on market prices. (That minority is literally getting paid to buy houses.) In reality, it’s not a small minority (around 70% of homes are owner-occupied in the US, I believe, though that may be an old statistic) so you’d expect something in between. Unless sellers can price discriminate.

  • Over the top

    @dreeves who claims: “Imagine yourself 30 years from now with a house you fully own, with no more payments to make. Now imagine your alternate renting self who, instead of steadily paying down the principal on the mortgage, has built up hundreds of thousands of dollars in equity in some other investment. You still have rent to pay each month but that’s also about how much you’re collecting in interest on your investments. So the renter now lives for free just like the home-buyer.”

    What you are overlooking, it seems to me, is that the equity you build up in “some other investment” may fizzle out on you, say if you had invested in what may have seemed like sure-fire investment bets at the time you made them, such as with someone like Bernie Madoff, who has indeed lived up to his name and “made off” with his investors’ money. Think of all the people whose “hundreds of thousands of dollars in equity,” to use your words, have gone up in smoke — and not only with frauds like Madoff. Almost everyone has lost big time on their investment portfolios. Who would have thought that a blockbuster stock like GM, for example, would fizzle as well. And now you’re really cooked because not only don’t you have any real property to show for your investment, but your trusty “renting self” can no longer afford to pay the rent either. At least when you buy a house it becomes a *tangible* asset, so all the talk here about the intangible benefits of owning miss the fundamental point that homeownership is a “real” asset beyond its present calculable worth in hard currency; other investments, by contrast, are for the most part virtual assets that can “virtually” disappear overnight.

    Bottom line, your paradigm only works if your investments are winners and not losers. Especially in light of the recent financial meltdown, you must see that building equity in other investments — especially stock — is even riskier than investing in real estate.

  • http://ai.eecs.umich.edu/people/dreeves dreeves

    @”Over the top”: Madoff “made off” — ha! But your house could also go up in smoke (literally; or get destroyed in some way that’s not covered by insurance, since insurance companies are slimy like that).
    A single stock (like GM) can certainly become worthless but a diversified portfolio of investments (maybe including REITs) is arguably safer than investing in a single house.

  • Rick Wash

    Dan, there is one thing that you forgot to mention. Quality of living abode. Out in NYC, I’m sure you can find good, high quality housing on the rental market. Out here in the midwest, (do you remember the midwest?) it is only the really run-down places on the rental market. It is really hard to find a nice, quality house to live in for rent. I’ve been looking for a house to rent (1-year visiting prof gig) and it is hard to find a decent place to rent. Availability on the market can make a big difference in the rent vs. buy decision if the market is sufficiently thin.

    Other than that, good article.

  • Luoo

    Jay, it doesn’t matter what the breakdown of the mortgage payment is if the total payment is cheaper than rent (and remain the same until its paid–which then it will be free, after taxes and insurance–as rent increases with inflation). In FL my house payment (bought this year) is $585/month…the rent for smaller houses in the same area go for about $850-950/month NOT including landscaping, utilities, etc. I don’t care if 100% of my mortgage is interest it’s still a better deal. The breakdown does not matter, it is the total pay-out vs rent. Also, as the years go along the interest/principle ratio will change with the principle gaining more percentage-wise throughout the amortization.

  • Keith

    Some interesting discussions and points here. In ideal situations, it can make sense to buy, but renting has its positives too. Also, in the huge cities (Los Angeles, New York) buying anything near affordable is difficult and many newcomers renting is the starting point or only option.

  • http://yahoo.com Joe

    the cost to rent a place just keeps going up and up. a mortgage payment doesn’t. you also get all the money you paid each month if you sell your home, rent you never get back. also, i never enjoyed living in apartments, too noisy and way too much riff raff to deal with, some places i wouldn’t have kept living in for free they were so lousy. i’m paying the same amount now in a mortgage payment each month as i was in rent. if i would’ve stayed where i was and kept renting, my landlord wanted to raise my rent $100 a month. So, I am paying less now to live in a home than i would to rent one. And, I will get back all the money I paid each month plus some just for living here.

  • The Monks

    We’ve crunched numbers and concluded that you can have far more riches NOT buying a house. It’s a weird concept….follow us on our journey:

    In our situation, rent is $805 monthly. This equates exactly to a 5% fixed rate loan on a $150,000 home. But there are many other expenses that we would incur, including
    Property tax ($250)
    Homeowners Insurance ($100)
    Water Sewage ($75)
    Lawn Maintenance ($50)
    Increases in electricity expenses
    Purchasing items (furniture appliance etc)
    Repairs and upkeep

    Aprox. $700+ a month in NEW expenses. (Well that’s much more than our rent)

    Conclusion: Since we rent, we are able to instead INVEST those additional costs ($700+ a month) into Roth IRAs which grow tax free. Over a 30yr period of time (same time as the average mortgage) our investment would be $1,050,206 with an 8% return….or….$2,470,938 with a 12% return.

    You never really truly own a home till the day its paid for in full. The average annual price increase of a home according to the USA Real Estate Median Sales Prices of Existing Homes since 1968 is 6.4%(before the bubble burst) Therefore a $150,000 home purchased today would be worth $850,000 in 30 years. (best case senerio) That sounds great however it is not really since we would have paid
    $252,000 (mortgage with interest) plus
    $700 a month we were unable to invest since it went to the above listed maintenance items..look at the cost over the 30 year period!

    $90,000 in property taxes,
    $30,000 in homeowners insurance,
    $45,000 in home repair upkeep,
    $27,000 in lawn/maintenance services
    $36,000 for water, sewage and additional utilities and repairs

    Conclusion:
    Although the home would be worth $850,000, the expense to purchase and maintain the home would be aprox. $353,715 which leaves a “true profit of ONLY a 2.8% profit. So many people forget to include ALL the cost associated with a house its not just the mortgage. And a home is worth only what you sell it for. And there is another house on every block.

    Never listen to the closed minded people who claim YOU’RE THROWING AWAY YOUR MONEY PAYING RENT. These people are brainwashed into the ideal that you must own a home. Many have debt beyond belief.

    No, it enables us to invest so that we can live our retirement with dignity. We will never become house poor and always be debt free.

    We can take advantage of our most powerful wealth building tool, our income. With that power we have compounding interest that will work FOR us and not Against us in ALL our financial decisions.

    Buy buying a home we would have thrown away our retirement and would have lost a million dollars or more! With our investments we will always be able to find a place to live, or even get this buy a home with cash when we retire.

    We believe that you are throwing you money away by having a mortgage! Imagine loosing $1,595,527 in investments for a $850,000 house…who thru their money away? Correct answer NOT US!

    We were shocked when one day we thought what if by some miracle poof we were the owners of a PAID for house. Our first thought was we would be rich, NOT so fast my friend.. Even with a paid for house we would only save about $250 a month after all the new expenses. We were floored! Again with a paid off house we would only save $250 a month!!! So if we spend an extra $500,000 the cost of a mortgage and expenses over 30 years, then 30 years from now we can save $250 a month…(Approx $550 in new expenses less the $800 rent) No worth it at all.

    Yes rent will go up, but so will insurance, repairs & utilities, so its close to a wash. In addition by RENTING we able to keep our expenses low and will continue to add to our investments and saving plans over time all with compounding interest already established.

    A HOME PROVIDES SECURITY….IT’S THE AMERICAN DREAM.

    This is a fallacy that has been pressed upon us all. Yes, the paid for house has replaced the BMW as the stasis symbol of choice. The only way paying off a mortgage saves you money is if you already HAVE a mortgage. However one very important part of this “dream” is not often thought of…Introducing RISK

    Sorry but over 30 years RISK is an indisputable fact. 100% of all foreclosures have a mortgage on them. I repeat 100% of all foreclosures have a mortgage on them. Over the time of a 30 year mortgage so many things can happen…illness, accidents, loss of jobs, or even death. By carrying a mortgage and all those NEW expenses mentioned earlier, many mortgage holders have little savings period let alone any retirement accounts.

    Personally this would not be a blessing it would be a curse! I’d be worried all the time “what would break next?” or damn I’ve got to do the lawn this weekend” or “damn I have to take off work (not paid) to meet the plumber…or an unexpected assessment fee.

    We may not OWN a home but we OWN our lives and live a resort lifestyle. A beautiful lake view setting, swimming pools, fitness centers, and every walk with our dog is just like being at a private park. We are able to be DEBT FREE! WORRY FREE! And are investing with gazelle intensity for our future. It’s the best felling in the world and that my friends is priceless.

    If happiness is truly where the heart is we’re already there. A wise man (that Dave Ramsey again) says that be weird, normal is broke. We’ll these are our beliefs.

  • Offline

    well.. time is different this time. At least, if you buy house with this artificial suppressed interest rates.. I believe, you will not regret when high or hyper-inflation kicks in, within few years, but your mortgage payment remains same. It would be like paying for one time grocery charge today. But, your rent will be different as its adjusted to the market inflation. So, forget these calculations and just use an oppertunity to borrow cheap money to buy tangible assets before your dollars are back visiting china/japan from last few decades!! and don’t forget, we are printing like never in the history before… just look at Zimbabwe or German or Argentina post-inflations era and housing prices thereafter. Disclosure – I am buying NOW.

  • offline

    Offline you are correct – rents follow market rates.

    So when the market crashes and people have to struggle to pay their mortgage after they’ve lost their job, or those people who took flexible interest loans find their monthly payments shoot up sometimes to triple, renters are laughing because our rents either stay the same or go down.

    also for long term renters like myself, when the owner is happy with the way you’ve maintained the property they are inclined to let you go on renting at a reasonable rate rather than risk having you move out if they hike it up. they may not get a good tenant and keeping the place empty for a couple of months is a loss for them.

  • http://www.standrewsapts.com/index.aspx Delaware Rental Communities

    I think that renting was commonly thought of as “throwing money away” in the past; however, the volatile state of our economy is pushing more people to rent. Even some homeowners are packing up and moving into rental properties in order to save some money. The fact that they can save money will ensure that they can become homeowners again when the markets rebound. I think more people should consider this option instead of staying in a house they can’t afford. Most times this causes foreclosure and can actually decrease your chances of homeownership in the future.

    Leah

  • tangie

    I thought buying was a good idea too, but with a home that’s worth less than half as much as I paid for it 24 years ago I’m underwater with my mortgage. Not to mention the house is falling apart because I don’t have money to make the repairs. Plus not to mention the inflated amount you pay for repairs because most contractors are probably charging you double of what something really cost. I’m trying to sell my house for half of what I paid 24 years ago and still can’t sell. Can’t take advantage of lowering my payments either with the lower interest rates because the home value had depreciated to much lower than the mortgage I owe. So I will probably rent from now on. Probably a better option to buy if you knew how to do most of your own repairs.

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  • Homeowner

    You’re taking a personal anecdote and applying it broadly without really looking at the actual facts of your situation, which is essentially that $600,000 is way, way, way too much to pay for that apartment. If the rent is $2500 a month, then purchasing should get you at about the same level after deducting the tax savings from the monthly cost. Then, it’s a true benefit to buy, because that same money you paid in rent would go into the home equity.

    You’re problem is that you are renting from an owner who paid significantly less than $600,000 for the apartment and therefore is able to rent it out relatively cheaply, with the hopes that someone will come along and buy it at the ridiculous price. Which of course, people will do because it’s Manhattan and people are irrational when it comes to Manhattan real estate.

    To give my own anectode, I and my family live in Weehawken, which is about the same distance to midtown as your Harlem location (actually, probably less). We bought an apartment several years ago for $350,000 and now rent it for $2400 a month, which puts us about even or slightly ahead when accounting for current taxes and mortgage interest. At the same time, while that apartment is now being rented, we bought a house for $500,000.

    In both cases, we needed a large chunk of change to put as a downpayment and there’s definitely a bit of math to do there when looking at what’s the best investment vehicle right now (but at current interest rates and with the state of the equity market, it was a pretty easy decision). But the essential points are that 1) we have full control over our living space, we are not beholden to landlord’s rent increases, we can decide if and when things should be repaired, our mortgage interest and taxes are deductible and the rest of the money just goes into the home equity, which we will eventually use in the future when we decide to make a lifestyle change.

    The point is that if you have the money for a downpayment and the money is not going to give you a better return elsewhere, you are looking for a stable, longer term living situation (have a solid job, kids going to school, no plans to move in the next few years), buying is a no brainer, as long as the price is right and comparable to what you’d pay in rent. If, for some reason, the equation for buying does not work out in your favor, then the market is just not right and it’s very likely that the home for sale is overpriced.

  • Investorhouston@yahoo.com

    Wonderfully written article. I’m a full time investor who owns a lot of property and am constantly amazed at everything the common myths about real property.

    Some other bits of info you might find useful would include:

    – It’s usually about 15% round trip costs (with a 6 month hold – in Texas) to
    buy, hold and sell; so you’d need for the property to appreciate (inflation)
    for about 10 years or so JUST TO BREAK EVEN.
    – According to NAR, the average expense margin for rental property is about
    45%. I think this numbers low and ignores depreciation (that’s right; all the
    board will rot and the slabs will slide, etc.) In real life, with these costs, it’s
    more like 50% BEFORE mortgages and taxes.
    – The ‘interest tax savings’ is a MYTH. Yes, it’s deductible; but you must
    itemize to claim this deduction, and when you do this, you lose your
    standard deduction ($5,800). So, in order to calculate your real ‘interest
    savings’ you’d: (Total Itemized Housing Costs) – ($5,800 standard
    deduction lost)= Incremental housing costs x marginal tax rate.
    Sometimes this has value, but frequently, it doesn’t. The more expensive
    your state and the higher your other itemizable expenses, the more likely
    this is to benefit you; but claiming, it’s a ‘savings’ is sloppy analysis.
    – You aren’t really INVESTING in your house when you pay off your
    mortgage; it’s falling apart, and the general idea from a lenders perspective
    is that you’ll pay off the house slightly before it’ll fall down and then you’ll
    have the land; of which you’ll have to pay it’s value to scrap it to build
    another house, that will, once again, fall down…When you pay down your
    mortgage, even if you pay these other capital costs (fixing roofs, buying
    boards, updating wiring and plumbing) out of pocket, you’re basically
    ‘investing’ – (defined very loosely) – in the debt and are thus ‘making’ the
    future interest cost saving: i.e. the after tax cost of debt. So, if the debt was
    incurred intelligently (cheaply) you shouldn’t have the incentive to pay it off;
    and if was/is expensive then you DO have the incentive to pay it off; but
    you likely made a mistake and your certainly still losing money operating.

    I could go on and on….

  • http://profile.yahoo.com/RQTCYPJBFWDCEUUHCRTU2L57BM Vesta

    I love this post
    .

  • blah

    This is amazingly flawed and biased… a mortgage TAKES PLACE of rent, there is no lost investment opportunity. You don’t magically end up with all that extra mortgage money by deciding to rent, you have to use it on rent! The only loss would be if the mortgage were to cost more than rent. You could MAYBE argue that the down payment would be a lost investment opportunity, although it’s more accurately just an alternative investment, especially with your Roth IRA argument. Max contributions to a Roth IRA are now $5500, once you hit that cap you don’t even have the choice to put your money there. A better scenario would be to cap your Roth IRA to secure those long-term investment benefits while building equity in your home. It’s basically just “diversifying your portfolio” between different investments. Renting is not an investment. It alleviates you of the pressures of coming up with a sizable down payment (although a rental property requires a security deposit which is the same thing, only smaller), but it doesn’t have much financial benefit other than freedom to move whenever you like. Ultimately, buying vs. renting is arbitrary and can only be determined on an individual basis considering basic finances, income security, preferences, and responsibility.

  • RealLife?

    My mortgage is $1,700/mo + $400/mo tax/insurance + $400/mo expected long term maintenance costs = $2,500/mo. It would cost me $2,350/mo to rent this exact house right now. 30 years from now: rent = $4,250/mo, ownership = $3,150/mo (2% rise in inflation-risk expenses). Over the course of a 30 year mortgage, I would have saved $155k regardless of the equity I will then own. The higher the average inflation, the worse off you are renting. This accounts for the negatives of home ownership and ignores the positives.

    If you’re smart, you’ve pulled equity out of your house on a sub-3% loan and are holding a 3%+ yield dividend portfolio or buying a rental property with an 8% CAP rate (your home equity isn’t being held hostage).

    Don’t believe everything you read, do your own homework, and don’t take candy from strangers.

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  • jonah

    They are talking about the additional costs associated with homeownership, not the mortgage alone. For example, I rent a condo with $360/month homeowner dues and $160/month taxes. If I were to buy, my mortgage would be similar to my rent, but then I’d have to pay an extra $520/month instead of being able to invest the difference. Then there are lost opportunity costs with the downpayment, plus money lost with closing costs, replacing utilities, remodeling, etc.

  • Chris Mountford

    Very interesting and intelligent analysis. It’s good to hear things that challenge the “wisdom” of the crowd.

    I wonder what you think about the impact of knowing significant info about the area you intend to buy in. It may be where you grew up. You may have influence over how local government resources are deployed. You may have information about future infrastructure developments which distinguish this piece of real estate from the norm. You may be at a distinct advantage in comparison to a real estate trust (which may involve you delegating that important selection role) and by comparison you may find yourself easily out of your depth in the stock market where professionals move prices by their presence in large volume trading and you don’t learn about your investment category through the course of normal life. Lastly, you may be in a position to gradually and cost-effectively improve the property which, apart from its effect on the future sale price, can improve your daily life for an instant non-zero return, doubly so for trained trades people.

    There are some real estate markets (for example, *quality* residential properties in Sydney, Australia) which represent a record of return on investment that far exceeds the vast majority of alternatives over many decades. Anyone advocating a performance-based analysis should conclude favourably in this case.

    So I’m not opposing your advice, but I am generalising it to suggest that the performance of the investment category should be divided according to natural distinctions that the market makes. If real estate is a single investment block, it includes both mass developments built on reclaimed swamps near towns entirely reliant on one or two companies in a single industry vs quality suburban real estate attached to a large city with great weather and perfect beaches in a first-world country with stable government. If the market can easily distinguish between the two, then the performance differences of these investments can be vastly different and should not be ignored. Lumping real estate in one category makes swamps look better and beaches look worse and this is never more misleading than in a downturn when everyone heads for the high ground.

  • Chris Mountford

    Where I live, rents have been going up and so have house prices. Inflation means that the real amount I owe the bank is going down because my debt is in nominal dollars, not real dollars.

  • milt

    One thing that is not considered on this article is that you have are able to sell and take a $250K or $500K if married on the profit if you live in a property which is your primary residence 2 out of the last 5 years. If you do that a couple times you could exclude up to a million tax free. What other investment can you do that?

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  • Phil

    But then you ignore the fact that as interest rates go up, a renter, admittedly one who diligently saves, will be able to invest their savings at these higher rates. Rates cut both ways