A few years ago, I flew down to Florida for Christmas to spend time with family, and we ended up playing that game Taboo. It was boys vs girls. The word was “Nike.” The clue was “Prefontaine.” They guessed correctly. We lost.
I was dumbfounded.
Right then and there I made a New Year’s resolution to work on my Taboo skills.
OK, I’m lying. I made no such resolution. But, with the new year still fresh in my mind, I thought I would revisit one of those myths in finance that just won’t die – the idea that you should always own your own home and that owning is always superior to renting.
This year, hundreds, possibly thousands, of people are resolving to pay off their home. Many are thinking about buying a home for the first time. When it comes to business property (especially buildings and storefronts), many business owners understand the economic benefits of leasing and renting. Yet, when it comes to personal residences, they buy.
Since a house is one of the largest personal purchases you will probably make in your lifetime, you should know what you’re getting yourself into. Seriously.
Don’t take your financial planner’s word for it.
Don’t take your mortgage broker’s word for it.
Don’t take your real estate agent’s word for it.
Don’t even take my word for it.
For me, I don’t start to really benefit, economically, from buying a home unless I can find a nice place selling for under $350,000. Ideally, that home would cost about $300,000 or less.
One of the “undeniable” truths you’re told is that it’s always better to own a home than to rent an apartment.
The logic behind this advice is that when you own a home, you are always (or often) building equity, when you rent, all you’re only ever left with are receipts.
But, is it true?
There are two ways to look at it.
When Buying A Home, And Building Equity, Is A Bad Idea
When I lived in central New York, I was renting an apartment for $600 per month. It included gas (heat) and water/sewer. The electric was not included. Electric ran me about $80 per month. So, my total household expenses were roughly $680 between rent and basic utilities. Sure, there’s T.V., phone, and Internet, but let’s keep things simple for now.
People used to tell me all the time that I should be buying a home – that I was losing money by renting. But, I was always curious about this idea. I didn’t really know what the market was like.
So, I started going to a lot of open houses, I checked the local listings in the newspaper, and I spent some time driving around new housing developments.
What I noticed was this: most of the homes in the area sold for about $100,000. Some of nicer ones went for $150,000 or $200,00, but this was somewhat unusual.
If I purchased a home in the $100,000 range, my mortgage payment would have been about the same as my rent at the time (assuming a 6 percent interest rate on the home loan).
However, I would have had to pay for homeowner’s insurance ($35 per month), and I would have been responsible for paying for my own natural gas/heat. What about renter’s insurance? Shouldn’t I be including the cost of renter’s insurance in my analysis when I say I’d have to buy homeowner’s insurance?
Well, I was in my 20s – young, dumb, and without anything worth insuring, so no.
This wasn’t a cost I was considering at the time. When you take out a massive loan for a house, though, they pretty much make you buy homeowner’s – at least basic fire coverage, so that would have been an increase in outlay for me.
The natural gas would have cost me an additional $100 per month (based on an average of about 20-30 homes I walked through during “open house season”), and taxes on the property would have likely been $225 a month or more (taxes are really high in the Corning/Elmira area). Some of the nicer homes in the new housing developments came with a property tax bill in excess of $10,000.
So, right out of the gate, I figured it would cost me an additional $360 every month to own a home – just in the added cost of the utilities, taxes, and homeowner’s insurance.
That doesn’t even include mortgage interest. But, I know what you’re thinking:
What about the equity that my house would have been building?
For a moment, let’s assume that I took the standard deduction on my taxes instead of itemizing. If my home appreciated an average of 3-4 percent a year, that gain would have been offset by the additional $360 I would have had to pay over renting. The additional mortgage interest would put me in the red. So, I’d need an appreciation of more than 4 percent annually to make it worthwhile. In Corning/Elmira area, homes don’t really appreciate in value all that quickly. If I continued to rent, I could save and invest that $360 every month and wouldn’t have to worry about the interest on a new mortgage loan – so, I continued to rent. If you’re still doubting the benefits of renting, consider this: most people don’t take out just one mortgage on a house. Electrical wires fray, furnaces break, plumbing leaks, roofs sag. That’s just a fact of life.
The interest on the original mortgage alone (assuming a $100,000 home at 6 percent interest) amounts to $116,000 over the life of the loan, or $3,866 per year (average over 30 years). Now, add in any additional interest from a second or even a third mortgage that you take out to do remodeling or repairs. When I add the $360 per month extra over renting ($4,320/yr) to the $3,800 in interest per year, I end up with a total of roughly $8,120 a year that I have to overcome for the house to be more profitable than renting. Even if I let my hypothetical house deteriorate over time, and do no repairs on it, my home would have had to consistently appreciate faster than 8 percent a year, every year. That’s just not realistic.
Now that I’m living in
Raleigh Durham a much smaller town in the country, has the story changed any? Sort of.
I used Michael Bluejay’s awesome rent vs buy calculator (which I talk about in one of my videos) to help me get a rough idea as to when it made sense to buy a home. After my son was born, what we needed was a 3 or 4 bedroom home with a finished basement or… a garage with 8-foot ceilings, minimum. Because of all the lockdowns and restrictions that happened during COVID, we wanted to build our own home gym and avoid the hassle of going to a commercial gym. We needed a 2 bedroom (minimum) home with a den or a separate room that could be used as an office for me.
Something like that (the 4-bedroom) could run us anywhere between $65,000 in a dumpy neighborhood to $3 million for something really very amazing.
Really, I can find something OK for about $200,000 to $350,000 in OK neighborhoods. If I were to buy, the mortgage payment would be around $1,500/month with a 5 percent interest rate. If I were to pay rent on a 4-bedroom home, it would have run me around $1,200 on average at the time I was making this decision.
Yes, there were $3,000 rents – but those are high-rent districts.
According to Bluejay’s calculator, I really needed a home under $350,000 to benefit, economically. At $350,000 or more, it takes more than 30 years for buying a home to be more profitable than renting.
Even at $325,000, it takes a good 19 years for the home purchase to pay off – and that’s assuming I earn no more than 5.5 percent on my investments (remember, I will save the money I’m not spending on mortgage interest, taxes, etc.).
I am pretty confident in my ability to earn 5.75 to 6 percent annually over the long-term. This means that I really need a cheaper house – somewhere in the $300,000 range – for buying to become profitable.
You want to know what’s weird? Even if buying a home eventually does start to pay off, there’s no guarantee that it will always pay off in the long-run.
If I adjust the calculator to show what would happen if I earned 8 percent annually on my investments over the long-term, instead of 5 to 6 percent, I end up with a scenario where buying a home is a better deal than renting after 12 years – but that deal eventually turns sour on me. In year 19, renting becomes more profitable again. Ouch.
Now, while I know my situation is unique to me, I’d wager a guess that there are many scenarios under which renting would work out to be a better deal for you too. Now, onto the qualitative side of things.
When Buying A Home Is A Good Idea
Buying a home can be a good idea when the qualitative factors outweigh the quantitative ones, when the quantitative factors make sense, or both. Qualitative factors include things like your own personal needs, optional objective values, and rational wants. Quantitative is numbers. So, either you have to really, really want it (in spite of whether it’s a good “investment”), the numbers have to work out so that it’s a good investment, or both.
So, for example, I lift weights. Currently, I pay a membership to a gym. Really, it’s not that much money, and it would actually cost me a lot more to set up a proper gym in my own home.
But, I want the ability and freedom to lift weights on my own schedule. I don’t really like the idea of waiting around for some guy who’s hogging the squat rack so he can do bicep curls (which is a universal annoyance in a public gym). It wastes my time, and that is presumably a real cost though not something I bother to sit down and calculate.
I also would like to have a larger yard for a future child to play in. How do you quantify joy?
I don’t know.
Finally, I want my own garage so I can do “guy stuff” like change the oil in my car and sit around and use foul language with other guys while we eat chicken wings and drink beer. Having a garage with a rental is difficult to impossible. So, all of those things are big benefits of buying a home.
Likewise, if I can buy a home, and it appreciates faster than what I’m paying in interest on a mortgage plus the cost of maintenance, then numbers-wise, it makes sense to buy a home.
What Do The Experts Think?
Lots of people, besides yours unruly, have stepped up to the plate to debunk the idea that buying a home is always a good idea. Here are a few of them. Go check out their full analysis. I think you’ll be pleasantly (or maybe not-so-pleasantly) surprised:
Natasha Hakimi — Natasha is a PhD candidate, and freelance journalist, but you don’t need to be a PhD to understand this stuff. In this article, she cites Yale economist Robert Shiller’s work on the subject. According to Schiller:
…human thinking is built around stories, and the story that has sustained the housing boom is that homes are like stocks. Buy one anywhere and it’ll go up. It’s the easiest way to get rich… It can’t be true that homes rise 10 percent a year. If they did, in the long run no one would be able to afford a house.
James Altucher — Now, James is a guy that lots of people love to hate. But, love him or hate him, you have to respect the guy. He’s run a hedge fund, authored numerous books, has operated I don’t know how many businesses, and is probably Superman for all I know.
Anyway, his take on buying a home? I’ll let him tell you in his own words:
…I’m never going to buy a home again.
According to Altucher, they’re expensive, they leave you with no cash (and lots of debt), and they trap you in ways you never realize until after the loan docs are signed.
Paula Pant — Paula warmed the frigid cockles of my own miserly Scrooge McDuck heart when she dared to post this article on renting vs buying a home. She’s a professional real estate investor. Anyway, I highly recommend Paula’s “rant,” if you can call it that, because it’s highly informative and lacks the usual B.S. you see on the web about this topic.
Giovanni Isaksen — Isaksen owns a successful real estate investment company. Like other professionals in the industry, his business depends on understanding these kinds of analyses. And, he spent a lot of time breaking down the numbers. In fact, he threw down the gauntlet when Zillow published its now-famous study which concluded that buying a home was awesome.
What Isaksen brings to the table is a keen eye on what things really cost in real estate. According to the analysis:
…previous calculation ignored the real costs of maintenance, repairs and saving up for replacing big expensive things like the roof, the furnace and the driveway and that is a pretty big chunk of money over time. Industry figures for repairs and maintenance on single family housing run from one to three percent of the home value.
Underestimating costs isn’t new. Investors do this all the time.
All. The. Time.
But, you’d never figure a respectable site like Zillow would do it. But, they did.
Anywho, if you read the full analysis, you’ll see some stuff in there that you will not see anywhere else (including my blog).
So…Why Do Real Estate Investors Own Homes?
I know what you’re thinking: But David, real estate investors own homes!
You’re right. They do. And, here’s why: Because it can be an excellent (and profitable) business.
They also use lots and lots of leverage.
Paying off a home isn’t necessarily the goal. Making rental income is.
So… it’s profitable because they are basically lending the house to renters and using the bank’s money to make a very high return on investment.
But, if all you want to do is live in your home, then you’re (probably) going to be disappointed by the ROI (especially if your goal is to pay with cash or pay off the home and live in it “free and clear”).
Yes, a you can use leverage (a mortgage) to get a good return (on paper) on buying a home to live in… but you have to sell the home (and buy another) to realize that profit… and really… a house is something you buy because you don’t want to deal with your landlord’s B.S. anymore or maybe you just want to paint the walls puce without getting permission first, and you’re willing to pay a premium for that benefit.