Values Added

Renting and Buying

It wasn’t long ago that major defining dichotomies in my peer group included things like Science v. Humanities. As the years have gone by Renting v. Buying has made a big showing as an important and interesting question. People don’t discuss it much in person considering how important it is. I think that this is related to the American taboo on discussing money. There are a lot of incorrect assumptions used in general. Here are a few thoughts:

  1. Buying is an important part of living the American Dream. This is put forward by real estate agents everywhere because it sells houses. Car makers do the same thing. I wouldn’t be surprised if the white-picket-fence lobby was involved in the initial framing.
  2. Renting is throwing away money. Buying things generally requires upfront costs and renting requires ongoing costs. At some point, there is usually a breakeven point. For instance, it costs about $125 to rent a tuxedo. It costs about $300 to buy a comparable one if you are a careful consumer. If you plan to wear yours 3 times in the next 5 years, buy–don’t rent. In the case of houses, they require borrowing money. The way to price it out, is to make assumptions about how much the house will appreciate in market price, and pair those with the actual knowledge of how much it will cost you to borrow the money to buy it. If the interest rate is higher than the appreciation rate, you may be making a mistake. There are two other major issues to consider, the mortgage deduction and the opportunity cost of owning. The bad news about getting a loan is that much of the money you pay the bank is interest. The good news is that you get a special tax break called the mortgage deduction. Basically, you don’t pay income tax on the portion of your income that goes to paying interest from your mortgage. This advantage is partially offset by the fact that you have to pay property taxes. Lastly, if, instead of putting 20% of the purchase price as a down payment, you invested the money, you’d be getting interest on it. Putting money down on a house prevents you from pursuing other profitable ways to use the money. For instance if you put down $50,000 and got a 30 year loan, after 30 years you’d own a house. If instead of using it as a down payment you invested the same $50,000 by the end of those 30 years, the $50,000 would likely have grown to about $400,000. A major cost of putting money down is those lost oppurtunities, this is called opportunity cost. Your house would need to appreciate dramatically to makeup for the $400,000 you theoretically could have made if you kept on renting.
  3. These numbers are like super complicated, man. There is a great calculator here, put out by the NYT which addresses some of the above issues.
  4. According to this article if price to buy is 15 times greater than annual rent the two options are financially similar. (Not sure how, if at all, he factored in opportunity cost.) It follows that if a house costs more than about 15 times the annual rent, you’d pay less renting over the foreseeable near future and if a house costs less than about 14 times you’d be best off buying if you plan to stay a while.
  5. How about if you don’t plan to stay a while? There are one-time costs when you buy a house. These non-recurring expenses are often called closing costs. In DC they tend to run about 3% of the transaction and include things like broker fees, paperwork costs, etc. The shorter you live somewhere the greater the issue of closing costs. If you move after two years the closing costs work out to about 1.5% per year that you lived there. Over ten years it’s just .3%. Given that home appreciation over time approximated inflation (~3%), if you move quickly closing costs eat up most of your appreciation. Selling is more expensive since you typically have to add another 6% to cover real estate broker’s commissions.
  6. But my landlord doesn’t get things fixed quickly. That’s a good point. It is nice to be in control of your living situation. There reasons to own that aren’t financial.
  7. My real estate agent is so nice why shouldn’t I totally trust him/her?! It is very important to be substantially skeptical of anything real estate agents tell you. Agents make their money based on a commissions.* This means that if you get the place for $350k rather than the $400k it was listed for, you “win” and they “lose”. From their financial perspective the best outcome is for you to buy a more expensive house without doing many visits (more profit, less work). Agents, even goodhearted, kind ones  over time usually respond to the incentives. As a result, you can’t expect that the advice they are giving is in your best interest. That said, many agents are lovely and it would be much better if they were all paid hourly fees to align their incentives more precisely with their clients.

All things considered there are good arguments for owning, some financial, some not, but there is a lot of bad information out there and it’s rare, so far as I have heard, to find real estate professionals who understand or correctly communicate the real financial issues.

*Redfin agents don’t work on commission but rather for hourly wages and they have different incentives.