Wednesday, November 7, 2007

Renting vs. Buying: which is the better choice for you?

Mommy Millionaire Next Door has been shaking up the PF blog community with the unconventional wisdom that renting is better than buying a house, and revealed herself as someone who has managed to become a millionaire due (in part) to this fact. Given the current state of the post-bubble real estate market, this may seem like a no-brainer, but she runs the numbers to show that it could hold true at any time. You can read her well articulated posts on this topic here.

After reading the articles, the takeaway is that 1) renting is cheaper than buying when supply is greater demand, and 2) from an investment perspective, renting (and investing the difference) beats home ownership over the long haul. This shouldn't be mind blowing news, and prior to the recent housing boom people didn't view their homes as ATMs or stock-beating investment vehicles. People traditionally bought residences to live in, not to get rich with.

The idea of houses as get-rich-quick vehicles is a recent phenomenon. Real estate investors generated artificial demand driving up home prices, and ordinary people got caught up in the frenzy. However, as incomes failed to keep up with the rising home prices, the trend has come to a screeching halt and even started to reverse itself, leaving latecomers holding the bag. The problem has been compounded by buyers who stretched themselves or used creative financing to pay more than they could conventionally afford.

Except for the lucky few (myself included, see update below) who managed to cash out during the height of the housing rush, most people won't experience gains that approach anywhere near historical long term stock market returns. The primary purpose of housing is to provide shelter, not to make you rich. So if your top priority is maximizing return on investment, then renting and investing is probably your best bet. To help make this determination, you can run the Rent vs. Buy calculator as explained by Millionaire Mommy Next Door.

That said, there are valid reasons (financial and otherwise) that can make home ownership a rewarding experience once the housing market stabilizes. Here are some that I came up with:

  • Home as a forced savings vehicle. Let's face it, most Americans are terrible savers. They tend to spend every penny they make, and live paycheck to paycheck. Often times, a home is the only asset many people will ever have to show for all the years they spend working. For the financially savvy, renting can make sense if they have the discipline to invest the savings. For others, they will most likely spend the difference and wind up with nothing to show for it.
  • You're not at the whim of a landlord. Some people get really attached to their homes and the memories created there, and being forced to move can cause significant emotional tolls that outweigh the financial gains. Other people find that being able to customize and improve their living space provides a level of personal satisfaction that cannot be measured in dollars.
  • Homestead protection. All states afford some kind of homestead exemption to home owners, with Texas, Florida, Iowa, Kansas, and Oklahoma offering some of the broadest protection levels. Besides retirement plans, a person's house is the only asset that cannot be seized for the payment of court judgments (ever wonder why OJ Simpson lives in Florida?). With today's litigious society, this can be an important point to consider. While umbrella insurance can also provide cheap asset protection, it can be difficult to get a policy if you've had an accident, lawsuit, or other significant insurance claims in the past 5 years. Homestead protection is also a completely legal means of asset protection, as opposed to other questionable asset protection methods offered by some companies.
  • Pride of ownership. It's true, people tend to take better care of their own stuff than that of others. This is why many people won't buy used cars (I personally won't buy used rental cars), and some people dislike having renters as neighbors. You can usually distinguish the rental houses from the owner occupied homes in most neighborhoods, particularly those without HOAs. Of course some peoples are just slobs, but the likelihood is that people will take better care of their homes if they own them.
  • A house is a tangible asset. There is something rewarding about being able to physically see and touch an asset that you own. Perhaps I'm more of a visual person, but when my first house was paid off and I was buying stocks with my disposable income, it just didn't provide the same fuzzy feeling. When you own shares of a company, you cannot walk into the company headquarters and claim a piece as your own. While it may not seem like that big of a deal, my motivation to keep working and saving was reduced because I was physically disconnected from what I was working for.
  • A house is usually a safe investment. It might not beat stock market gains, but a house can be a smart purchase because it's likely to keep its value over time. You can't say that about most other consumer goods such as cars, boats, etc.
I think Mommy Millionaire Next Door has done a great service by dispelling the notion that home ownership is the path to wealth. Unfortunately, it's a lesson that has come too late for some. However, hopefully it will prevent others from making the same error.

Update: I calculated the rate of return on my first home using this CNN Money calculator. I purchased the house (and added some improvements) for $102.50 per sqft. in 1997, and sold it for $206 per sqft. in 2005. My result:

Return on investment:
Annualized return: 9.18%
Return for the entire period: 101.18%

Note: does not include Realtor fees (which I avoided by using FSBO), taxes, insurance(although the difference between homeowner and renter insurance is nominal in my case) and upkeep costs.


Anonymous said...

Thanks for carrying this discussion onto your blog, too.

Yes, there are certainly pros and cons to both choices. I wrote a post discussing some of the pros of renting (above and beyond the financial ones), but I haven't yet done the same with owning. Funny though, people put different aspects into one category or another (pro or con), but often they don't put them into the same category as someone else would. It's such a personal matter.

Knowing your priorities is the key. For me and my family, financial freedom and early retirement takes priority over owning a home.

I appreciate your civility in discussing this surprisingly controversial concept. It’s certainly been a lively one!

azphx1972 said...

Thank you for your comment, MMND. I think you've covered the pros of renting (and cons of owning) pretty well in your blog, so I didn't include them here.

Investing everything in the stock market (REITs not withstanding) is too aggressive of an investment strategy for me, but it's obviously worked out very well for you. Congratulations on your success, and that of your blog.