The question of whether to buy or rent a home is of enormous economic significance for most families. Home equity represents the vast majority of American families’ net worth (see chart below). In a post in mid-2011, I discussed some of the major economic variables in the decision to buy a home. My conclusion was that buying a home made sense, but not because housing generates attractive long-term investment gains. The long-term data suggests houses have historically increased in value at a rate only slightly higher than inflation. The best arguments for owning a home, I argued, were historically-low interest rates, the mortgage interest tax deduction, and the inflation hedge provided by locking in your costs for shelter for the long-term. Since that time, housing prices and rents have risen dramatically. In the past week I read two thoughtful and interesting articles on the economics of owning a home that motivated me to revisit this topic for 2014.
Source: U.S. Census Bureau
Is it Cheaper to Rent or to Buy?
The first article, written by Trulia chief economist Jed Kolko, suggests that buying a house looks much more attractive than renting across the U.S. The analysis estimates that buying is, in fact, 38% cheaper than renting across 100 major metro areas. Given that housing costs average about 33% of Americans’ household expenses, a difference of 38% in this area is huge. The relative advantage of buying vs. renting varies by area. In the Denver metro area (where I live), Trulia estimates that buying is a whopping 45% less expensive than renting. While the article discusses various assumptions about future housing prices in their numbers, the baseline estimated difference in cost between buying and renting—38%–is sufficient to offset quite a bit of uncertainty. The economics of renting vs. buying require consideration of taxes, brokerage costs, maintenance, and interest rates. All of these are fairly straightforward to estimate and Trulia provides a handy online calculator to do so. The hard thing to estimate is the expected rate of increase in housing prices vs. rents. The article acknowledges the sensitivity of the attractiveness of housing prices to assumptions about future price gains; the claim of the article—that it is 38% cheaper to buy than rent—is bullish.
There is one large difference between buying and renting that is ignored in this analysis, however, and this is because housing is an illiquid investment. If you suddenly need to relocate to another state or move for some other reason, it is more expensive and takes longer to sell your home than it does to end a lease .
Overall, Kolko’s analysis provides a compelling economic narrative for buying a home vs. renting, with the caveat that a great deal hinges on a bet on price gains in housing.
Americans’ Outsized Spending on Homes
The second article that I recently read is an Op Ed in the Wall Street Journal by Michael Milken, the founder of the Milken Institute, an economic think tank. This piece suggests that American middle class families spend far too much of their earnings on buying homes, as opposed to saving for retirement or funding their children’s college educations. Milken argues that aggressive government programs to increase home ownership have led to a massively distorted housing market as it relates to the economy as a whole. Whether or not you agree with Milken’s arguments about the role of government, his data on the increasing investment that American families have made in houses, without a resulting gain in household net worth, are compelling. The data suggest that what is changing is simply how American’s spend their money and that they are spending more and more on housing. The average new home in the U.S. is now 2,647 square feet as compared to 1,725 in 1983. Over this same period, however, the percentage of U.S. households that own a home has not changed.
When examining Americans’ financial choices and outcomes as compared to other countries, the numbers are striking. The median net worth of American adults is now less than in Greece, and less than a third of the median net worth in France. American households spend 50% of their incomes on housing and transportation as compared to 16% in Asian nations. Note: all of these statistics are from Milken’s article. While our economic policies have encouraged home ownership as a key component of building wealth and securing a position in the middle class, the data suggest that the result has actually been a reduction in household net worth and no increase in the rate of ownership. Your home is not a productive asset beyond providing shelter and should be expected to provide returns only slightly greater than inflation, on average. Investing in human capital (education) or in new businesses can be expected to provide gains in wealth beyond inflation. While the recent massive gains in housing have revived enthusiasm for housing as an investment, the big picture of American households’ net worth suggests caution.
The Case-Shiller S&P National U.S. Home Price Index has returned an annualized 3.4% since 1987. The average rate of inflation in the U.S. over the past 100 years is 3.2%, although the average over the past thirty years is more like 2.5%. Spending a large fraction of household income on an asset (a home) that is unlikely to generate returns much beyond inflation is likely to result in less gains in wealth than investing in productive assets like businesses or in human capital via education.
To Buy or Not to Buy
The current relative imbalance between the costs of renting and buying is real. In most parts of the U.S. buying is cheaper. There are also a range of benefits to buying a house, none the least of which are the current low interest rates and the tax benefits. It is crucial, however, not to forget the lessons of the last housing crash. House prices can be volatile and having too much of your net worth tied up in home equity or spending too much of your income on a mortgage can put a household’s balance sheet at risk. Particularly if people are buying larger and more expensive homes by reducing their savings for retirement or their children’s educations, using buy-vs.-rent calculations to justify buying a house may lead to bad decisions. The overall message from the current research is that this remains a reasonable time to buy a home, but it does not make sense to spend too much of your income on housing—regardless of the current market conditions. Unfortunately, Americans have accepted the idea that spending a large percentage of their income on housing is a good idea and this decision is having a negative impact on the long-term financial well-being of the middle class.