I spend a lot of time at work thinking about the value proposition of housing, and wrote this bad boy up when I was bored... Interested in any thoughts/criticisms.
The mortgage banking industry is the largest consumer lending industry on the planet, responsible for $6 trillion in loans in the U.S. alone. As a result, it has a tremendous ability to convince the public to make sub-optimal decisions with their money. The following example describes two individuals with identical financial characteristics, including earnings power, initial savings, and housing needs. One chooses to purchase a home, making use of the traditional mechanism; the 30 year mortgage. The other opts to rent. Which path leads to greater wealth?
a typical man in his early-30s. Married, with a child, a good stable job, and about $50,000 in the bank. John decides to buy his first home. After all, he had spent his entire 20s "throwing money away" in the form of monthly rent. After scouring the market, he found a nice three bedroom home for $500,000. He decided to use his $50,000 savings as a down payment on the house, and take out a 30 year fixed rate mortgage for the remaining $450,000. Mortgage rates were still close to record lows, and with his good credit he was able to secure a rate of 4.5%. John's monthly payment would be $2,280. He would also have to pay $6,000 a year in property tax. In addition, there would be other monthly fees including homeowner's association dues, homeowner's insurance, water & trash, gardening, and repairs that John was previously unaccustomed to as a renter. However, these seemed like a small price to pay for John to have his own place.
The beauty of homeownership to John was that he would be building equity in his home over time. Sure, it would start slowly, but over time John would continue to pay down the principal in his mortgage until after 30 years he would own the home outright. Even after factoring in the real estate agent's costs upon closing (approx. 5% when John realized he pays both the buyer and seller's agent's costs), John would still be making money. The housing market had historically appreciated in value by 2-3% per year, so John felt good that equity would be building in his home. John did the math, and realized that:
- After 5 years, John would have $127k equity in his home
- After 10 years, John would have $248k equity in his home
- After 20 years, John would have $558k equity in his home
- After 30 years, John would own his home outright, and would have equity worth $996k.
John felt pleased that he would be worth a million dollars after just 30 short years.
Across town, Marcella Lannister was also trying to decide whether to purchase a home or to continue renting. Marcella was a mother of two, with the same income as John, and the same $50,000 in savings. If she were to take a mortgage, she would qualify for the same 4.5% interest rate that John received. However, Marcella was much more familiar with economics than John, and she understood that returns in the stock market had averaged around 10%. Although stocks were volatile, she knew in particular that this 10% return was quite certain over a longer time horizon, such as 30 years. Marcella looked carefully at the housing market, and identified some costs associated with homeownership that she currently didn't face as a renter. First, property taxes in CA of 1.2% meant that she would be paying $6,000 a year to the government. She was also aware of the mortgage interest deduction, which could shelter her from some federal income taxes. However, over the full term of a mortgage, Marcella calculated that she would spend $371k in interest, and that this would yield an average tax savings of $3,100 a year. This meant that on balance, she would be paying $2,900 more in taxes each year as a homeowner than she did as a renter (=$6,000 - $3,100).
Marcella also knew she would need to pay HOA dues ($200/month), homeowners insurance ($1,000/yr), gardening/water/trash ($500/yr), and some basic repair expenses ($1,000/yr). Together these fees would add another $4,900 a year. This meant that owning a $500,000 home would cost Marcella about $7,800 a year more than renting a home with the same monthly payment. On the other hand, while a mortgage would remain fixed, Marcella's rent was likely to keep going up. However, Marcella realized that repair and remodeling expenses (such as those for new appliances, new roofing, carpets, furnace, paint and insulation) would likely offset the cost of those rent increases, so this seemed like a push.
This got Marcella thinking. What if instead of buying the house, she took her $50,000 down payment and whatever amount she would save each year on taxes and housing fees ($7,800), and invested it in the stock market? So Marcella did the math; what would she have if she invested $50,000 today, plus carefully added $7,800 each year, which she would certainly have left over given she wasn't paying all the homeownership costs?
- After 5 years, Marcella would have $128k, which was $1k more than John.
- After 10 years, Marcella would have $254k, which was $7k more than John.
- After 20 years, Marcella would have $783k, which was $225k more than John.
- After 30 years, Marcella would have $2.157mm, which was $1.16mm more than John.
Marcella Lannister of course opted to make the smart move and be a renter. She would be a multi-millionaire in just 30 years.
So why does Marcella's path result in so much more wealth formation than John's? The main difference was that instead of paying interest on a large amount of debt (mortgage), she would be generating dividends and capital gains from her savings which was invested in the stock market. Over time, the returns on the stock market would be much greater than the 2.5% a year that could be expected from the housing market. Even though John would be using leverage, the amount of the gain that interest would eat away would significantly reduce John's total net worth at the end of the 30 year period. Over short time horizons, Marcella's investment strategy is riskier. However, over longer time periods (like 10+ years), Marcella would fare much better.
Some might argue, "but at the end of 30 years John would not have to pay anything for his house, and Marcella would still be paying rent". That is true, but Marcella would also have $2.2 million in the bank (John would have nothing, all else equal), and she could easily go and pay all-cash for a house that is more than twice the value of John's. She would avoid paying a dime of the $371,000 in interest to the bank, which John so happily paid over 30 years.
If it is true that renting leads to faster wealth accumulation than owning a home, then why does the vast majority of the public (including investors) argue the opposite? The simple answer is because the banks have been extremely effective at convincing the public of "the dream of homeownership". In reality, homeownership is quite a bad investment (assuming it is done using a traditional 30 year mortgage). However the mortgage is an extremely profitable product for the banks - it offers steady coupons over long time horizons with very little downside risk, since it is secured by the home itself (which very rarely declines in value, 2008 notwithstanding). The more people the banking industry can convince to "lever up" to purchase a home, the more money flows into their pockets in the form of interest payments. Did you know that your bank stands to make $370,830 in your $450k mortgage?! A Lannister always pays their debts...