Renting versus Buying a House – A Contrarian View

I’m often posed with the question, “Given that interest rates are low, why shouldn’t I buy a house instead of throwing money away by renting?” In recent years, buying a home has been all the rage. With interest rates around 6% for a 30-year fixed mortgage and the housing market booming, I’ve been amazed at how many people who have no real need for a house (young singles) have bought one.

As someone in the investment management business, whenever I am asked my opinion about buying a house, I look at it from two perspectives. The first one ignores the financial aspect (assuming the buyer can afford the home) because if you are getting married and starting a family, there are reasons to buy a house that have little to do with return on investment or anything like that. However, for those single people out there who don’t have a true need for a house of their own, I suggest looking at the possible purchase as an investment and running the numbers accordingly.

I have made many spreadsheets for people to determine if buying a house makes sense financially. In the vast majority of cases it does not, as you can usually earn a higher return investing in a bank CD (let alone the stock market) than you can on a house, even after considering the benefits (mortgage interest deduction) and the costs (insurance, maintenance, taxes). The exceptions are cases where you rent out spare bedrooms and that cash flow covers a large chunk of your mortgage-related expense.

As a result, it is baffling to me when people will choose to take money out of their high yield savings accounts, investment accounts, and even their IRA or 401(k) plans in order to fund a house purchase. The common reason given is “renting is just throwing money away.” While this sounds logical (your rent check isn’t going toward the purchase of any asset), you have to look at it from a return on investment point of view.

A Smart Money article published last Wednesday entitled “Why Rent? To Get Richer” outlines the case for renting very well. I suggest those of you faced with the “rent versus buy” dilemma give it a read.

Full Disclosure: No position in a house at the time of writing

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11 Thoughts on “Renting versus Buying a House – A Contrarian View

  1. burn on May 7, 2007 at 7:48 AM said:

    Can you give some example numbers? I don’t see how a CD would be a viable alternative. Sure you could put the downpayment into a CD, but with a house you are building up equity in every mortgage payment. Are you suggesting getting another CD every month?

  2. Chad Brand on May 7, 2007 at 8:11 AM said:

    The crucial calculation is to determine how much your annual return is from buying a house, factoring in everything such as property tax, homeowner’s insurance, PMI, maintenance, appreciation, and interest deductions.

    It’s interesting that oftentimes a single buyer without any rental income can return as little as 0% to 2% per year on their house investment. That supports the view from the Smart Money article that homes do not outgrow inflation.

    In that case, any investment that outpaces inflation is a better alternative (CDs, bonds, stocks, etc).

    Obviously, specific numbers depend on where you live, but even if you live somewhere where home supply is low (the coasts) and you assume 5% annual appreciation, you are still not doing that well after you factor in the expenses mentioned above.

  3. Chad Brand on May 7, 2007 at 8:15 AM said:

    So, if you invest your down payment and the difference between the monthly cost of renting and buying in a higher paying investment, you can oftentimes earn a higher return than you would by buying the house.

    You don’t need to buy a new CD every month, just use a high yield savings account to earn 4%-5%, a bond ETF to earn 5%-6%, or whatever investment asset you prefer.

  4. burn on May 7, 2007 at 10:39 AM said:

    It’s very hard to tell without going into the details of the numbers, though. If you use the $300 you’re saving from renting to buy a bond ETF every month, you have to factor in the commision. A $15 per trade commision already loses 5% of your investment before it starts. Also, your savings interest or bond ETF dividends will be taxed yearly, whereas the capital gains from your house will not be taxed until you sell it. And remember, a 5% return on your house is 5% of the full value of the house, whereas a 5% return on your savings is only 5% of what you’ve saved so far.

    Aside from the numbers, the other big factor is that it’s much harder to stick with the rent and invest plan. With a normal mortgage payment, you have to build up equity, and there is no way to get that money out without selling the house (although you can borrow against it). Under the rent and invest plan, you just have that money sitting in your account, waiting to be used. It’s just too easy to dip into that liquid savings to pay for non-essential things. For example, how many times have you heard of someone using a significant amount of their savings to pay for a wedding? Probably far more often than you’ve heard of someone selling their house or opening up a HELOC to pay for their wedding.

  5. Chad Brand on May 7, 2007 at 11:06 AM said:

    I certainly agree that if you are not a disciplined investor and stick to a plan, then it might come back to haunt you to have easy access to the money, but for these examples I just assume that won’t be an issue.

    Okay, let’s throw some simple numbers out there. You can get even more detailed, but let’s keep it simple for time’s sake.

    I think the key calculation is your ROI on the house. So, let’s assume you want to buy a $250K house with 20% down and you get a 30-year fixed mortgage at 6%.

    Your monthly payment is $1200. To account for insurance, property taxes, and maintenence, let’s assume another $350 per month (that seems reasonable, no?).

    That gets your cost of the house at $1550, but your mortgage interest deduction takes it down to $1350 per month. These are rough estimates, but should be pretty darn close.

    Your total cost over the 30 year mortgage is $486,000 (1350x12x30). That means you need to make 94% in price appreciation over that period to break even (due to expenses that aren’t earning any return — taxes, insurance, interest, etc).

    So, your breakeven point on the house is roughly 3% per year. If you assume that home prices average an increase equal to inflation long term (which they do) and you assume inflation is 3% per year, then you need your house to appreciate by 6% annually to keep pace with inflation.

    To keep pace with stocks, which average 7% above inflation, your house needs to appreciate 13% per year. Even to keep pace with bonds, you need at least 8% per year from your house.

    Now, if you don’t need a house, and don’t really want a house, is it a good “investment” compared with your other options? In general, I would agree with the author of that Smart Money article and say “No.”

    Of course there are always exceptions, but this is a general discussion talking about the most common scenarios.

  6. Andy Kern on May 7, 2007 at 11:34 AM said:

    Chad, aren’t you ignoring the leverage effect? Say you have the choice of buying a $200,000 house or renting an apartment for $800 per month. Further suppose your interest rate is 6% and you put 20% down. Thus, your annual interest expense is (approximately) $160,000*.06 = $9600, or $800 per month. So the money you are “throwing away” in both cases is $9600 per year.

    The disadvantage of owning the home, of course, is the various expenses you list. Let’s suppose those total $4000 per year. The advantage of owning the home is that you can participate in 100% of its capital appreciation. So if the home appreciates by only 5% that represents a $10,000 gain to you, or $6,000 net of expenses. But your investment is only your $20,000 down payment, so your return on investment is $6000/$20,000 = 30%, pretty darn good. And this ignores the tax benefit (which isn’t always applicable if you are married filing jointly). At least this was the rationale I used when I bought my own home.

  7. Chad Brand on May 7, 2007 at 11:51 AM said:

    Andy,

    In that case, you are implying that the entire $10,000 in appreciation is yours to keep. But you don’t own 100% of the house, because you borrowed the money. After year one, you have less than 25% equity, with the bank owning the rest.

    Let’s say you sell the house after 1 year for 5% more than you paid (ignore the sales commission, even though that is a huge expense in this example). You bring in $210,000 but have to pay the bank the outstanding mortgage amount. After factoring in your down payment and one year’s worth of monthly payments, have you really earned a 30% return on your money?

  8. Bobby Kolev on May 8, 2007 at 10:23 PM said:

    That is an interesting and educational disscussion.

    Investment-wise, which one is better: buying your house and paying at 100% or putting 20% down and playing the market with the rest 80% (presumably beating inflation by 7%)?

  9. Chad Brand on May 8, 2007 at 10:35 PM said:

    Given where interest rates are today, I would venture to say paying cash for a house isn’t a great idea, looking at it from a financial standpoint only. On the face of it, that investment (avoiding a 30-year fixed mortgage) is earning 6% per year, but it is actually less than that after you factor in mortgage interest deductions that you are missing out on. If you are a good investor, you would likely do better investing your cash elsewhere.

    I would bet that most people who pay cash for a house do it either because they 1) are swimming in more money than they know what to do with, and/or 2) are extremely debt-averse. Both are adequate reasons if you aren’t focused on the ROI component.

  10. Erin on July 21, 2007 at 5:38 PM said:

    Hello, thanks for the helpful discussion. My husband and I are thinking of buying in Silicon Valley where prices are astronomically high. Given the interest that is owed on a 30 year fixed rate mortgage on a (for the area) ‘cheap’ 700K townhome, the tax break isn’t enough to make it more profitable to buy over taking the difference in monthly payments (btwn buying and renting) and investing the money. Considering the millions of Americans who purchase their homes, I was worried that we were missing a key component to this thought process. Glad to read that our logic, and for that matter, our math, is correct! Renting seems to be the way to go in our case.

    Although one could argue that property values in this area will continue to increase at a much higher rate than the rest of the nation…..and that speculation in this housing market is well worth it!

  11. Chad Brand on July 22, 2007 at 8:59 AM said:

    Glad this post was helpful, Erin. Most people simply assume that renting is “throwing money away” because they’ve heard that so often (even more during the real estate boom) but if you actually run the numbers, it is often not the case. It obviously depends on each individual situation (location of the country, price differentials, etc) because real estate is local, but in many cases, renting can pay off big time for those who don’t necessarily want/need a house.

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