A friend I knew from high school recently posed an interesting question on Facebook: should she and her husband buy a house, or continue renting while paying off debt? The buying/renting trade-off is something I’ve had on my mind recently, given our home purchase late last year. While home ownership comes with some benefits and can sometimes be a financial boon, it often proves to be far costlier than anticipated and ultimately a poor financial decision given alternate uses for capital.
Where I’m Coming From
Before getting to my model of home ownership costs, I should state my own biases.
The home you live in is probably not a good investment. Historically, housing prices have beat inflation, but not by much. This table from CNBC, to which I have added an inflation-adjust ROI column, shows housing prices since 1940:
| Year | Median home value | ROI since 1940 |
|---|---|---|
| 1940 | $30,600 | – |
| 1950 | $44,600 | 3.8% |
| 1960 | $58,600 | 3.3% |
| 1970 | $65,600 | 2.6% |
| 1980 | $93,400 | 2.8% |
| 1990 | $101,100 | 2.4% |
| 2000 | $119,600 | 2.3% |
In the sixty years from 1940-2000, the inflation-adjusted return on home values has been a paltry 2.3%, which is approximately the same as today’s going rate for online savings accounts. And this is actually a substantially generous estimate, as it does not consider transaction, ownership, and opportunity costs. For comparison, the stock market has historically returned around 10% in nominal dollars, or 7% in real dollars.
Leveraging your purchase with debt makes the numbers better at first, but return on equity degrades over time as you own more of the house. If you have $10,000 equity in a $100,000 house, and that house goes up in value by $1,000, you have made 10% return on your equity. Sweet! But if you own the whole house and realize an increase in value of $1,000, you have made only 1% return on your equity. Folks fetishize having a house that’s fully paid-off, as if that allows them to live for free. That’s an attractive idea, and I understand the instinctual aversion to debt, but the fact remains that having a cheap mortgage is sometimes financially better than having no mortgage given the opportunity cost of having your money tied up in your house.
Caveats and Assumptions
Before delving into the model, it’s important to define the question I’m trying to answer with this model. The foremost question, of course, is whether it’s better to buy or to rent. The answer depends on many inputs, some of which can be known, and some of which must be guessed. For example, it is possible to exactly know primary inputs like:
- How much cash do I have on hand?
- What kind of interest rates are available?
- How long will I stay in this house?
- What will my property taxes be after the first year?
- How much will my house appraise at in 5 years?
- What are rent prices going to be like in 5 years?
- What are my maintenance costs going to be like?
All of these inputs are provided directly to the model by the user. Even though all inputs have default values, the first-order primary inputs of purchase price, cash on hand, and length of ownership must be provided for the model to produce anything meaningful. Further down the list, though, other inputs (like maintenance costs and appreciation) have what I consider sane defaults. I’m not an oracle; the numbers are wrong. But hopefully they’re not so wrong that the result is meaningless. Either way, feel free to tweak these as you wish.
Using the Model
Without Further Ado…
At minimum, fill in “cash on hand”, “purchase price”, and “length of ownership” below. The defaults in the other fields are probably fine, but make some assumptions about where you live (Texas), how you sell (realtor), the condition of your home (not falling apart), and other things that you might find worth tweaking.
Thanks for reading.
How do I adjust this to account for a first time homebuyer's credit?
Good question. I would need to see the terms of the credit somewhere (google is failing me), but essentially credits look like a lump-sum inflow in whatever year you take them. This would obviously make buying more attractive than before, especially if you plan on only owning for a short period of time (per whatever constraints the tax credits impose).
I'd need to think about this some more, but I think the real value of the tax credit decreases the longer you own the home. e.g. if you consider the extreme case where you buy a home, receive a credit, and sell it the next day for your purchase price (and ignoring all taxes/fees/etc) the entire transaction would net you almost infinite ROI (value of tax credit / negligible cost). At the other extreme, if you buy a home, lump-sum the credit into the mortgage in year 0, and own the house forever, you'll very likely end up worse off than if you had just kept renting and invested your money in the stock market. The reason for this is that if you hadn't bought, you'd initially be much poorer (because you wouldn't get the tax credit), but you'll also have much less capital tied up in an illiquid asset that historically has not come close to performing as well as the stock market as a whole. Even though you'd be starting with a lower net worth as a renter, you would expect higher returns on your money than if you just owned part of a house.
Another way to think of it that just occurred to me would be to start by estimating how long you'll own the house and then divide the tax credit by the number of months, to amortize the tax credit across however long you own it. This is *not* mathematically correct, since $1 today is worth slightly more than $1 in the future, but it will get you within spitting distance.
So, the upshot: if you qualify for a $12,000 credit, and plan to own the home for 10 years, you would expect to get around $12,000 / (10yrs * 12mo/yr) = $100/mo benefit. If you do the math and you find out that renting is only $100 better than buying without the credit, then this credit would be enough for you to come close to breaking even.