Earlier this week I was talking to an elderly gentleman, a successful healthcare lawyer and college professor, who told me that the worst advice his grandfather ever gave him was Own your own home. The fact that my friend had recently sold his house at a 25 percent loss may have soured him on home ownership, but I agree that buying a home is only occasionally the best investment vehicle for one’s money.*
New research on home ownership seems to support this view :
The sense that homeownership was an essential building block to household wealth was a key psychological driver of the mortgage boom. As much as government policy was to blame for getting people to purchase homes that they otherwise wouldnt, it is important also to acknowledge the role played by societal coercion. As Yale professor Robert Shiller explains , bubbles are impossible without extreme public enthusiasm. Individuals who would have otherwise been content to rent were often asked by friends, colleagues and acquaintances, why throw your money away on rent? Whereas the rent check simply vanished each month, the mortgage payment helped to secure something tangible and allowed one to participate in the upside of house price increases. If a household could afford to buy a dwelling, the prevailing wisdom went, why in the world would they be so dense as to rent? This sentiment was intensified by expectations of continued price gains in 2004-2006, when first-time homeowners worried that if they did not buy soon, theyd never be able to afford a home.
A new academic article in Real Estate Economics turns this conventional wisdom on its head. Using data from 1979 to 2009, the authors demonstrate that renting was the superior investment strategy for most of the past 30 years. Counterintuitive as the finding may be to some, it is actually quite logical. Unless someone possesses the cash necessary to buy a residence, he or she will be renting one way or another. The choice is between renting the property directly or instead renting the capital necessary to buy the property. The amount of capital to be rented is a function of house prices, while the bulk of a mortgage payment is interest, which is the rental payment on this capital. After 2 years, the typical 30-year amortizing mortgage balance has been reduced by less than 3%. This means that a household that took out a $300,000 mortgage with a 5% interest rate to buy a home has only reduced its mortgage balance by $8,600 after two years despite spending nearly $39,000 in total over this period.
* As the article notes, this is true only if “the renting household has the discipline to invest its marginal savings into financial assets.” While it is true that buying a house can be a form of “forced savings”, it would be smarter (and cheaper) to simply do whatever it takes to develop the discipline to save money.