Wednesday, May 28, 2008

Renting and Buying

It wasn't long ago that major defining dichotomies in my peer group included Boxers v. Briefs and 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 really discuss it much in person. I think 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 agents everywhere because it sells houses. Car makers do the same thing. I wouldn't be suprised 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 nice one if you are smart about it. 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. For instance if you put down $50,000 and got a 30 year loan, by the end of those 30 years, the $50,000 would have grown to about $400,000. Putting money down on a house prevents you from pursuing other profitable ways to use the money. 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.
  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.
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 communicate the real financial issues.


At 5/28/2008 , Blogger Teutsch said...

r u thinking of moving? or is one of your family members an inspiration? homeowner by 25 is definitely sexy xoxo

At 5/28/2008 , Blogger ZT said...

not anytime soon.
how's life in LA, J?

At 5/31/2008 , Blogger Barry said...

Good thoughts for openers but there are many points of confusion, too.
The easy ones:

1. You haven't evaluated the tax savings, which depends on your gross income. To a single guy could be worth a lot. And the income tax savings isn't "Offset" by the need to pay property can deduct the property tax too. The federal income tax savings can be substantial.

2. Although you shouldn't buy a house strictly as an investment --- the primary reason to buy a house that you will live in is because you want to live there --- if the house hasn't appreciated dramatically in 30 years, you have chosen the wrong spot. Particularly if you are speaking of DC residential real estate. Assume your $250,000 bungalow (you said that $50K = 20 percent) doubles in value to only $500,000 in 30 years. You end up owning a $500K asset, $100,000 more than the $400K you say you would have earned at simple interest (i haven't done the arithmetic but will take your word for it.)
(Oh to being required to pay the property tax if you pay it if you rent, anyhow. SOMEONE has to pay it and that cost is factored into the rent, unless the bottom has dropped out of the rental market.)

3. If you let the $50K draw interest, unless you use a municipal or other tax free vehicle, you'll have to pay income taxes on the interest at income tax rates. If you trade your $500K house for one more expensive, your capital gains tax (much cheaper rate than the income tax and who knows if McCain is elected, there may be none ever again) But under current law ALL of the $250,000 gain after the 30 years would be excluded. No tax paid (assuming various reasonable requirements are met.)
We WANT people to buy homes and we skew the tax laws to favor buying instead of renting. This could change, of course, but I doubt it.

4. You have toyed with the question of repairs, but haven't factored in to the decision. Water heater goes out on the rented house, under a typical lease (which could be changed) the owner pays. In a purchased situation, the owner pays. Water heater, roof, furnace, plumbing leaks. Everything costs.

5. Forget about 15x rent or whatever rules of thumbs. Each situation has a different thumb. For a first rough cut calculate your carrying costs, principal, interest, taxes, insurance, opportunity cost on the dp...and compare that with the rent on a monthly or annual basis. Maybe toss in 10 or 20 percent for repairs (see above) and maybe deduct the tax savings. That will tell you what you need to know.

People have, recently overpaid for investment houses and can't rent them on a break even basis, but hope to make it up on the appreciation. Of course, that may make it more attractive to rent as opposed to buy, until the market corrects itself (as it may have been doing lately.)

There are many more considerations. If you are seriously interested in buying, talk to a financial advisor, or give me a call or some such.

At 6/02/2008 , Blogger ZT said...

Barry, thanks for the thoughtful analysis. A few responses.

1: The property tax deduction means that you don't pay taxes on the *interest* you pay the bank. This means you essentially retain 25% of the money you pay in interest. Over the life of the loan this can be substantial. "deducting" property taxes means you get about 25% of those back too. On a typical $250,000 property is DC the property taxes will equal about 50% of the benefit of the mortgage deduction. Over the course of the loan as you are paying off more principal and less interest the tax savings goes toward zero and the property tax increases as the value does.
2: Using a 30-year mortgage you end up paying more interest than principal. The dollar cost of that investment is over $550,000. If you want to calculate the whole opportunity cost you have to calculate the amount over rent you pay every month. It turns out to be a lot more than $400,000.

3: Of course, you are correct that some of that will be taxed if it isn't in a tax free account. If it is in a Roth IRA (retirement account), 529 (college savings), or other tax free account, this impact is eliminated.

4: If you own your own home you need a much bigger emergency fund to cover things like roof collapses. This impacts the opportunity cost as well. Your insurance costs are also higher which impact monthly costs and the other calculations. There are also some peace-of-mind issues. It's nice to call someone else to fix your heat. Alternatively there are peace-of-mind advantages to owning your own place. For instance, you don't have to worry about the landlord selling your house forcing you to move or the rent going up a surprising amount.

5: The 15x calculation is built around the assumptions you are discussing but you are totally right that personal tax situation, appreciation projections, and countless other factors impact the decision.

You mention contacting you. With which Barry am I blog-comment-trading?


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