In the contemporary North America, buying a house definitely looks to me like a raw deal.
So, perhaps this is a sign of how brainwashed by the status quo I am, but I don’t see how this is obvious, nor indeed how it could be obvious, given that everyone who is renting a house is renting it from someone who bought it, who is presumably not losing money on the deal. (Or is that a false presumption? Do landlords typically spend more to purchase and maintain their property than they make in rental income? How could that possibly be true?)
So I would love some more explanation here. Is the idea here that buying a house N years ago was a good idea, but buying one in 2012 is not?
[E]veryone who is renting a house is renting it from someone who bought it, who is presumably not losing money on the deal. (Or is that a false presumption? Do landlords typically spend more to purchase and maintain their property than they make in rental income? How could that possibly be true?)
You can also ask a different question. If you borrow money to buy a house, you must find a lender willing to lend you at some interest rate. The interest rate is nothing but the price of renting money. So if it costs less to borrow (i.e. rent) the money to buy a house than to just rent the house directly, then how can the lender possibly be willing to lend you the money instead of investing it into a house himself and earning a rent higher than your interest?
When I make this argument, people usually try to argue that somehow you profit from buying by building equity with time. But if the money rent, i.e. interest, is equal to the house rent, then to build equity, you must make payments to the lender above this basic rent/interest rate—otherwise you’ll just keep renting the same amount of money indefinitely. And if you rent the house instead of making these higher payments, you can save and invest this difference, with the same positive effect on your net worth (which will also have an effect equivalent to the reduction in payments as the principal gets lower). Of course, this isn’t true if the interest is lower than the rent, but then we get to the above question of why anyone would be so irrational as to lend at such terms. It also isn’t true if the house price grows faster than any alternative investment—but even ignoring the lessons from recent history, this again gets us to the question why someone would ever lend you the money at this cheap interest rate instead of investing the money himself into these fast-appreciating houses.
What these considerations show is that according to the textbook spherical-cow microeconomics, on a free market for housing, renting and buying should be equally good deals, since in efficient markets there is no possibility of arbitrage. And buying can be profitable over renting only if there is a strange opportunity for arbitrage where it’s cheap to rent money but expensive to rent a house, even though money and houses are readily convertible into each other. A similar argument can of course be made against the possible advantage of renting—except for the issues of risk-aversion and asset diversification, which decisively favor renting over owning.
In reality, of course, these simple spherical-cow models don’t work, and there are lots of complicated and ill-understood factors involved, including all sorts of people’s biases and signaling issues, high transaction costs, Knightian uncertainties, exuberant speculation, and not the least of all, huge government interference in the market by various subsidies, regulations, and other convoluted and dubious enterprises. The result is a complicated mess in which an accurate analysis of what’s really going on is practically impossible, and in which there may indeed be possibilities for arbitrage.
However, regardless of all that, it seems to me that buying has some tremendous drawbacks, for which I can’t see comparable upsides under any realistic circumstances. The first and foremost is that you’re investing the bulk of your net worth (and on top of that a huge pile of borrowed money) into a single non-diversified asset, which seems like a crazy idea by the most basic principles of sound personal finance. [1] For various other drawbacks, one could perhaps argue that they are offset by the downsides of renting (though I would disagree), but this one really seems to me by itself like a decisive argument against getting into house ownership.
[1] Note that this is one possible solution to your landlord puzzle. The tenant may want to pay a premium to avoid placing most of his net worth into this asset because of risk-aversion, while for the (rich or corporate) landlord, it’s just another item in a large portfolio with the risk well spread.
The renter is paying the landlord to assume the risk of tenant mobility. That is, if the renter needs to move, they can do so and the landlord could be stuck with a vacant unit. On the other hand, someone who owns a home and needs to move, needs to find a buyer for the old place, and incurs material (~7%) transaction costs. People who want to stick around for a long time have no reason to pay a premium for an option they won’t use, so longer-term residents tend to buy and not rent.
On the other hand, as long as they can make mortgage payments, homeowners almost never get kicked out of their homes. If you want to bring up kids and build memories/accumulate sentimental value in one place over your whole life, a rental is probably not for you. If you want to customize your home and/or make capital improvements, a rental is also probably not for you.
There’s a kind of pooling equilibrium, and very little incentive to live in the “wrong” arrangement.
It’s also a mistake to compare nominal rent with nominal mortgage payments, as you also have to consider tax deductibility, maintenance costs (which people often underestimate), heating/cooling/electricity/water bills, real estate taxes, and mortgage amortization.
However, regardless of all that, it seems to me that buying has some tremendous drawbacks, for which I can’t see comparable upsides under any realistic circumstances.
Before I bought my house I ran the numbers and came to the same conclusion, that home ownership would not maximize my net worth and would increase certain types of risk. As a result I see home ownership as a luxury, not as an investment. I bought my house because I wanted it as a luxury and believed I could manage the risk.
If mortgage interest is tax-deductible but rent isn’t, then you have to pay higher rent in order for it to be converted into an interest payment that would come out of pretax income. I think this is how Michael Vassar said the market got so messed up, though I don’t know if I’m correctly attributing it to him, or if the notion is unique to him (I expect not).
In booming real estate markets, rent may in fact be cheaper than the interest on the equivalent house price even considering the tax break. I suppose this is because people count on appreciation, but we know how good that assumption is.
The lack of mortgage interest tax breaks in Canada doesn’t make people’s attitudes towards renting vs. buying any different than in the U.S. The only observable effect, as far as I know, is that Canadians on average struggle to pay off their mortgages more quickly.
I’m not sure I understand what “conversion” you’re talking about, but it sounds like you might be saying that the landlord has no mortgage interest deduction, so they need to receive a larger rent payment to break even, than it would cost the renter to own the same property. If that’s not your point, then disregard the rest of this comment.
To the landlord the mortgage interest is a business expense and can typically be deducted. So there’s (ceteris paribus) no difference between the net cost of the mortgage to the landlord, and to a homeowner.
What I’m saying is that you can either pay $2000 of rent using post-tax income or $2000 of mortgage using pretax income. This might work out to the difference between a $3300 mortgage payment (pretax income) or a $2000 rent payment (after the $3300 has been taxed at an e.g. 39% marginal rate by state and feds).
To the landlord the mortgage interest is a business expense
Actually, to a business all of the mortgage is a business expense (as well as property taxes, upkeep costs etc.), and all of the rent is a revenue. Then you have to account for amortization, depreciation and what not. So, there is a lot of difference between a business and an individual homeowner, and no ceterus paribus to speak of.
Owning a house has the advantage that, even in extreme contingencies, you will still have your Maslovian need for shelter under control. Same reason someone would eagerly trade gold for an equal weight of grain in a sufficiently severe famine.
This is true if you actually completely own your house. However, many “homeowners” don’t; they have mortgages which they are not yet in a position to pay off completely. Given sufficiently extreme contingencies (which needn’t, actually, be all that extreme) they could find themselves without shelter as easily as their renting peers.
Paying the mortgage involves a marginal step toward that desirable condition of true homeownership in a way that rent does not. Essentially, a mortage is rent + a commitment to investing part of your income every month, which many people would not otherwise have the willpower to do.
Yes, the structure of a home mortgage loan helps someone save when they might not have otherwise. But your original comment was that home ownership was helpful because it increased your security that you would have shelter—which is a different point.
If you lose your job and the mortgage has not been completely paid off, you are not in an appreciably better situation re: shelter if you own vs. rent. I suspect that the foreclosure process is more time consuming for the party trying to evict you than the landlord eviction procedures—but 1-3 months vs. 9-12 months* is probably not that useful a difference in the grand scheme of your life.
*These numbers are a guess, but I think the relative difference in time is roughly accurate.
Having three or four or twelve times as long to search for alternative sources of income can make an enormous difference in the grand scheme of your life.
Let’s say it’s 3 months for eviction, 9 months for foreclosure, and it takes six months of searching to obtain a new job. Someone who was renting would have to complete the second half of that search while homeless, a condition which brings with it many unpleasant, life-altering complications. Social capital must be burnt on preserving life and limb when it could have been spent to aid the search itself, or hoarded against future calamities.
Comparing monthly costs is a bit misleading. There are a whole bunch of less-direct costs and benefits to ownership. A bunch of these depend on your estimation of future economic conditions and of your future desires.
1) If you own a house, you’re incurring the risk that you have to move for personal or professional reasons, and then can’t easily sell. Landlords typically don’t have to sell on short notice—it’s perfectly possible to be an absentee landlord. Not an absentee resident.
2) As a landlord, you can potentially hold the house as one asset in a portfolio. As a homeowner, you’ve locked up a lot of your potential capital in that high-risk illiquid asset; you’re much more exposed if property values go down.
On the flip side:
1) Residents with a mortgage get a tax break that landlords don’t.
2) Being an owner means you don’t have the risk of future rent increases, and can profit if property values go up.
3) Being an owner entitles you to make structural or other changes—repainting, say—that a tenant can’t easily.
Being an owner means you don’t have the risk of future rent increases...
That is true, but as far as I can tell, rent increases don’t follow soaring house prices during real estate booms. Rather, the price to rent ratio tends to go out of whack. (Check out these graphs—I can’t vouch for the accuracy of their numbers, but they are consistent with what I observe on the ground. Since I’ve been renting my current house, my rent hasn’t gone up by a single cent, not even to compensate for inflation, while the house prices where I live have gone up by something like 40%.)
Moreover, the standard ways in which mortgages are done leave one exposed to the risk of future interest rates increasing, and they can go up much faster and higher than rent. (And as far as I can tell, one must pay a huge premium to get a permanent fixed rate and avoid playing this financial equivalent of Russian roulette.)
In the US, the large majority of mortgages are fixed rate. Until about 10 years ago, virtually all were. I think mortgages are a lot more popular in the US than in Europe. I’m a bit surprised that fixed rate mortgages haven’t spread into Canada simply by proximity. Maybe they’re propped up by Fannie Mae.
I have no idea what the ultimate reasons for it are, but in Canada, I don’t think it’s even possible to fix the rate for more than ten years. When Canadians speak of “fixed rate,” they typically mean fixing it for only five years or so.
All Canadian banks offer up to 10-year fixed rate terms, none do longer. “A typical mortgage in Canada has a 5-year term with a 25-year amortization period.” Not sure what is so scary about that...
Regarding 1… can’t a resident of a home, should the need arise to move on short notice, become an absentee landlord on the same property? If the monthly costs of renting equal or exceed the monthly costs of owning, presumably the rental income covers the cost of owning the property, and the former resident can go rent property wherever they happen to need to be.
I would add to your second list: 4) Owning the property means I get more upside if property values go up. 5) Renting the property means I am subject to the owner’s whims in addition to my own.
So, perhaps this is a sign of how brainwashed by the status quo I am, but I don’t see how this is obvious, nor indeed how it could be obvious, given that everyone who is renting a house is renting it from someone who bought it, who is presumably not losing money on the deal. (Or is that a false presumption? Do landlords typically spend more to purchase and maintain their property than they make in rental income? How could that possibly be true?)
So I would love some more explanation here. Is the idea here that buying a house N years ago was a good idea, but buying one in 2012 is not?
You can also ask a different question. If you borrow money to buy a house, you must find a lender willing to lend you at some interest rate. The interest rate is nothing but the price of renting money. So if it costs less to borrow (i.e. rent) the money to buy a house than to just rent the house directly, then how can the lender possibly be willing to lend you the money instead of investing it into a house himself and earning a rent higher than your interest?
When I make this argument, people usually try to argue that somehow you profit from buying by building equity with time. But if the money rent, i.e. interest, is equal to the house rent, then to build equity, you must make payments to the lender above this basic rent/interest rate—otherwise you’ll just keep renting the same amount of money indefinitely. And if you rent the house instead of making these higher payments, you can save and invest this difference, with the same positive effect on your net worth (which will also have an effect equivalent to the reduction in payments as the principal gets lower). Of course, this isn’t true if the interest is lower than the rent, but then we get to the above question of why anyone would be so irrational as to lend at such terms. It also isn’t true if the house price grows faster than any alternative investment—but even ignoring the lessons from recent history, this again gets us to the question why someone would ever lend you the money at this cheap interest rate instead of investing the money himself into these fast-appreciating houses.
What these considerations show is that according to the textbook spherical-cow microeconomics, on a free market for housing, renting and buying should be equally good deals, since in efficient markets there is no possibility of arbitrage. And buying can be profitable over renting only if there is a strange opportunity for arbitrage where it’s cheap to rent money but expensive to rent a house, even though money and houses are readily convertible into each other. A similar argument can of course be made against the possible advantage of renting—except for the issues of risk-aversion and asset diversification, which decisively favor renting over owning.
In reality, of course, these simple spherical-cow models don’t work, and there are lots of complicated and ill-understood factors involved, including all sorts of people’s biases and signaling issues, high transaction costs, Knightian uncertainties, exuberant speculation, and not the least of all, huge government interference in the market by various subsidies, regulations, and other convoluted and dubious enterprises. The result is a complicated mess in which an accurate analysis of what’s really going on is practically impossible, and in which there may indeed be possibilities for arbitrage.
However, regardless of all that, it seems to me that buying has some tremendous drawbacks, for which I can’t see comparable upsides under any realistic circumstances. The first and foremost is that you’re investing the bulk of your net worth (and on top of that a huge pile of borrowed money) into a single non-diversified asset, which seems like a crazy idea by the most basic principles of sound personal finance. [1] For various other drawbacks, one could perhaps argue that they are offset by the downsides of renting (though I would disagree), but this one really seems to me by itself like a decisive argument against getting into house ownership.
[1] Note that this is one possible solution to your landlord puzzle. The tenant may want to pay a premium to avoid placing most of his net worth into this asset because of risk-aversion, while for the (rich or corporate) landlord, it’s just another item in a large portfolio with the risk well spread.
Here are some complicating factors:
The renter is paying the landlord to assume the risk of tenant mobility. That is, if the renter needs to move, they can do so and the landlord could be stuck with a vacant unit. On the other hand, someone who owns a home and needs to move, needs to find a buyer for the old place, and incurs material (~7%) transaction costs. People who want to stick around for a long time have no reason to pay a premium for an option they won’t use, so longer-term residents tend to buy and not rent.
On the other hand, as long as they can make mortgage payments, homeowners almost never get kicked out of their homes. If you want to bring up kids and build memories/accumulate sentimental value in one place over your whole life, a rental is probably not for you. If you want to customize your home and/or make capital improvements, a rental is also probably not for you.
There’s a kind of pooling equilibrium, and very little incentive to live in the “wrong” arrangement.
It’s also a mistake to compare nominal rent with nominal mortgage payments, as you also have to consider tax deductibility, maintenance costs (which people often underestimate), heating/cooling/electricity/water bills, real estate taxes, and mortgage amortization.
Before I bought my house I ran the numbers and came to the same conclusion, that home ownership would not maximize my net worth and would increase certain types of risk. As a result I see home ownership as a luxury, not as an investment. I bought my house because I wanted it as a luxury and believed I could manage the risk.
If mortgage interest is tax-deductible but rent isn’t, then you have to pay higher rent in order for it to be converted into an interest payment that would come out of pretax income. I think this is how Michael Vassar said the market got so messed up, though I don’t know if I’m correctly attributing it to him, or if the notion is unique to him (I expect not).
There are two puzzling observations here, though:
In booming real estate markets, rent may in fact be cheaper than the interest on the equivalent house price even considering the tax break. I suppose this is because people count on appreciation, but we know how good that assumption is.
The lack of mortgage interest tax breaks in Canada doesn’t make people’s attitudes towards renting vs. buying any different than in the U.S. The only observable effect, as far as I know, is that Canadians on average struggle to pay off their mortgages more quickly.
This is a common notion among econobloggers.
I’m not sure I understand what “conversion” you’re talking about, but it sounds like you might be saying that the landlord has no mortgage interest deduction, so they need to receive a larger rent payment to break even, than it would cost the renter to own the same property. If that’s not your point, then disregard the rest of this comment.
To the landlord the mortgage interest is a business expense and can typically be deducted. So there’s (ceteris paribus) no difference between the net cost of the mortgage to the landlord, and to a homeowner.
What I’m saying is that you can either pay $2000 of rent using post-tax income or $2000 of mortgage using pretax income. This might work out to the difference between a $3300 mortgage payment (pretax income) or a $2000 rent payment (after the $3300 has been taxed at an e.g. 39% marginal rate by state and feds).
OK, that’s what I thought you meant, thanks for clarifying.
Actually, to a business all of the mortgage is a business expense (as well as property taxes, upkeep costs etc.), and all of the rent is a revenue. Then you have to account for amortization, depreciation and what not. So, there is a lot of difference between a business and an individual homeowner, and no ceterus paribus to speak of.
OK. Thanks for clarifying.
Owning a house has the advantage that, even in extreme contingencies, you will still have your Maslovian need for shelter under control. Same reason someone would eagerly trade gold for an equal weight of grain in a sufficiently severe famine.
This is true if you actually completely own your house. However, many “homeowners” don’t; they have mortgages which they are not yet in a position to pay off completely. Given sufficiently extreme contingencies (which needn’t, actually, be all that extreme) they could find themselves without shelter as easily as their renting peers.
Paying the mortgage involves a marginal step toward that desirable condition of true homeownership in a way that rent does not. Essentially, a mortage is rent + a commitment to investing part of your income every month, which many people would not otherwise have the willpower to do.
Yes, the structure of a home mortgage loan helps someone save when they might not have otherwise. But your original comment was that home ownership was helpful because it increased your security that you would have shelter—which is a different point.
If you lose your job and the mortgage has not been completely paid off, you are not in an appreciably better situation re: shelter if you own vs. rent. I suspect that the foreclosure process is more time consuming for the party trying to evict you than the landlord eviction procedures—but 1-3 months vs. 9-12 months* is probably not that useful a difference in the grand scheme of your life.
*These numbers are a guess, but I think the relative difference in time is roughly accurate.
Having three or four or twelve times as long to search for alternative sources of income can make an enormous difference in the grand scheme of your life.
Let’s say it’s 3 months for eviction, 9 months for foreclosure, and it takes six months of searching to obtain a new job. Someone who was renting would have to complete the second half of that search while homeless, a condition which brings with it many unpleasant, life-altering complications. Social capital must be burnt on preserving life and limb when it could have been spent to aid the search itself, or hoarded against future calamities.
How important the difference between 1-3 months and 9-12 months is in that scenario depends a lot on how long it takes me to find another job.
Comparing monthly costs is a bit misleading. There are a whole bunch of less-direct costs and benefits to ownership. A bunch of these depend on your estimation of future economic conditions and of your future desires.
1) If you own a house, you’re incurring the risk that you have to move for personal or professional reasons, and then can’t easily sell. Landlords typically don’t have to sell on short notice—it’s perfectly possible to be an absentee landlord. Not an absentee resident.
2) As a landlord, you can potentially hold the house as one asset in a portfolio. As a homeowner, you’ve locked up a lot of your potential capital in that high-risk illiquid asset; you’re much more exposed if property values go down.
On the flip side:
1) Residents with a mortgage get a tax break that landlords don’t.
2) Being an owner means you don’t have the risk of future rent increases, and can profit if property values go up.
3) Being an owner entitles you to make structural or other changes—repainting, say—that a tenant can’t easily.
That is true, but as far as I can tell, rent increases don’t follow soaring house prices during real estate booms. Rather, the price to rent ratio tends to go out of whack. (Check out these graphs—I can’t vouch for the accuracy of their numbers, but they are consistent with what I observe on the ground. Since I’ve been renting my current house, my rent hasn’t gone up by a single cent, not even to compensate for inflation, while the house prices where I live have gone up by something like 40%.)
Moreover, the standard ways in which mortgages are done leave one exposed to the risk of future interest rates increasing, and they can go up much faster and higher than rent. (And as far as I can tell, one must pay a huge premium to get a permanent fixed rate and avoid playing this financial equivalent of Russian roulette.)
In the US, the large majority of mortgages are fixed rate. Until about 10 years ago, virtually all were. I think mortgages are a lot more popular in the US than in Europe. I’m a bit surprised that fixed rate mortgages haven’t spread into Canada simply by proximity. Maybe they’re propped up by Fannie Mae.
I have no idea what the ultimate reasons for it are, but in Canada, I don’t think it’s even possible to fix the rate for more than ten years. When Canadians speak of “fixed rate,” they typically mean fixing it for only five years or so.
Wow. Yeah, signing up for a mortgage I expected to pay off over thirty years would frighten me with that arrangement.
All Canadian banks offer up to 10-year fixed rate terms, none do longer. “A typical mortgage in Canada has a 5-year term with a 25-year amortization period.” Not sure what is so scary about that...
Regarding 1… can’t a resident of a home, should the need arise to move on short notice, become an absentee landlord on the same property? If the monthly costs of renting equal or exceed the monthly costs of owning, presumably the rental income covers the cost of owning the property, and the former resident can go rent property wherever they happen to need to be.
I would add to your second list:
4) Owning the property means I get more upside if property values go up.
5) Renting the property means I am subject to the owner’s whims in addition to my own.