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Should You Rent or Buy?

David Leonhardt of The New York Times has a good piece this week debating whether you should own or rent the roof over your head.  

The best part of the article is a table showing rent ratios, or the average cost of a home divided by average annual rents, for major regions across the country.

City

Current Rent Ratio

Rent Ratio, 2005

Average, 1986-2000

San Francisco 27 40 24
Seattle 27 32 15
Orange County 26 40 18
Charlotte 26 25 15
Denver 22 26 15
Richmond 22 23 13
San Diego 22 37 15
Washington, D.C. 19 29 12
Boston 18 22 15
Bridgeport 17 21 17
Baltimore 17 21 10
Houston 16 17 12
Philadelphia 16 17 11
Sacramento 15 33 15
Chicago 15 24 16
Los Angeles 15 27 14
Minneapolis 15 21 12
Inland Empire 14 30 16
Tampa 13 24 12
Orlando 13 27 12
Atlanta 13 20 13
Phoenix 12 25 11

Source: The New York Times.

As a rough rule of thumb, renting is favorable when the rent ratio is above 15. Owning starts to look attractive when it falls below 15.

The decision on whether to rent or own is one my colleague Matt Koppenheffer and I have been having for months. Matt and I are good friends, but we agree on almost nothing, and end most debates with, "I don't know why I even bother with you."

One thing we do agree on: Owning a home is better than renting if it's purchased for a reasonable price, and is owned for an appropriate length of time.  

Matt makes an additional argument for homeownership in a recent article: "A homeowner gets implied returns by nature of the fact that they're not paying rent. It's as if you've bought a home to rent out and you're the renter."

That's where our views diverge. Homeowners may not pay rent to a landlord, but (most) do pay interest to a bank. For many buyers, the difference between the two is slim.

The key is how mortgages amortize, or are paid off over time. Many homeowners focus on their monthly mortgage payments, aiming to pay off their loans. But only a small fraction of the payment does pay down that loan during the early years of homeownership.       

Even those who understand interest often get this wrong. I recently posed a simple question to 10 friends whom I consider fairly smart: If you have a 30-year fixed mortgage at 6% interest, what percentage of your monthly payment goes toward principal in the beginning? Six answered 94%, which is exactly wrong. The correct answer is 16%. In the early days of homeownership, 84% of a mortgage payment goes toward interest in this example. (To see how this works, here's an amortization schedule.)  

This reverses as time goes on. After owning a home for 15 or 20 years, monthly payments begin paying down principal in earnest. But most people don't own homes for 15 or 20 years. Data from the National Association of Realtors suggests that the average is eight years. By that time, monthly mortgage payments are still made up of 75% interest. Homeownership can be great over time -- as Matt says, it can be like renting a house to yourself -- but few stick around long enough to get to that point.

Still, regardless of time, isn't having a monthly payment that's mostly interest better than one that's all rent? A lot depends on the table above. In some regions, the answer is yes, and homeownership makes sense. For others, it's a resounding no.

There are a couple of counterpoints here. One is the tax deductibility of mortgage interest, which makes paying interest to a bank more valuable than paying rent to a landlord. But the tax break only applies to those who itemize deductions -- just one-third of taxpayers. Most take the standard deduction, and gain no tax benefit from mortgage interest.

Second, down payments and marginal equity may grow over time as property values increase, and those gains can be leveraged by a mortgage. But that's not always the case -- and very often it is not. Adjusted for inflation, median home prices nationwide have not gained a single penny since the 1980s, and have actually lost value since the late '70s. This wasn't an anomaly. As Yale economist Robert Shiller has shown, national home values adjusted for inflation performed abysmally for almost the entire 20th century.

There's also an opportunity cost. In nominal terms, the Case-Shiller National Home Index has increased 110% since 1987. The S&P 500 is up 750% over the same period. Even with leverage from a mortgage, the former often lags the latter.  

I'm also being kind by ignoring property taxes, insurance, maintenance, closing costs, realtor fees, and appraisal charges.  

There might be another counterpoint. My reasoning doesn't include is what some consider the most important reason to own a home: stability and social motives, which might trump all financial considerations. These seem like valid reasons to me. Just as long as most buyers know that's the incentive.                                                                         

What do you think?

Fool contributor Morgan Housel doesn’t own shares in any of the companies mentioned in this article. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (10) | Recommend This Article (30)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 12, 2011, at 6:16 PM, 5000monkey wrote:

    I agree with you, I'm a mortgage professional, and my wife a Realtor, and yet I think that homeownership is a mistake for many buyers. One of the biggest fallacies in the media about home owner ship is that your buying an asset. You're not, you're actually buying a liability.

    An asset is something that adds to your bottom line, a liability... one that takes away. Now don't get me wrong sometimes it makes since to buy, just not all the time like the media would have us believe. Having said that owning realestate can be a good investment. I currently own and live in a 4-plex. My 3 tenants pay me more than my mortgage payment every month... That is better than renting or owning a single family residence that I couldn't otherwise afford.

  • Report this Comment On May 12, 2011, at 6:33 PM, Vesta108 wrote:

    I'm renting in West Los Ageles and investing what would have been a downpayment. After some years I will be able to buy w/cash and avoid interet payments. Meanwhile my money grows faster in the stock market, than it would have in real estate market.

  • Report this Comment On May 12, 2011, at 10:49 PM, DonkeyJunk wrote:

    I'm surprised people don't seem to realize that the loan interest you pay every month is paid on the balance of the loan, not as a percentage of the monthly mortgage payment, which is why interest charges diminish as you pay off more of the balance (apparently everyone you interviewed is a renter). The real interest rate on a 30-year mortgage can easily top 100% if you only pay the minimum payment, even at the current "low" interest rates.

  • Report this Comment On May 13, 2011, at 10:29 AM, karlm1 wrote:

    We live in San Diego and bought 13 years ago. After 10 years we paid it off. I suppose if I put the money plus interest paid in the stock market perhaps I would have more than the 400,000 its worth now. As I get older its a nice feeling when I sleep at night knowing its been paid off.

  • Report this Comment On May 13, 2011, at 10:32 AM, TMFHousel wrote:

    Karlm1,

    I completely agree with your situation, and think it's how most should approach homeownership. Congrats to you!

  • Report this Comment On May 13, 2011, at 2:37 PM, 5000monkey wrote:

    Guys you're missing the point. Paying interest to a bank isn't evil or financially ruinous. If I could borrow at 10% and invest at 12% I'd take a trillion dollars of that trade. (and thats exactly what banks have been doing for centuries)

    The problem lies in over paying for the roof over your head. Buying anything on leverage or margin can be a good or a bad investment depending on the value of the asset you're purchasing. You don't make money when you sell you make money when you buy, and that is true of stocks commodities and real estate.

    What you should be taking away from this is that even at the now severely discounted property values after the bubble has "popped" realestate is still over valued. And the proof of that is that mortgage payments are still far more expensive than rent payments. What this doesn't take into consideration is that rent appreciates as fast or faster than inflation (which works against renters), but also that most people over buy when they buy a house.

    How many people do you know start out in a 750 sqft 1 bed apartment and end up in a 750 sqft 1 bed house? If they did it would probably be cheaper to buy and a very wise investment as they would gain equity, pay down principle and avoid appreciating rent. But instead what usually happens is that they get suckered into the allure of the american dream and buy the 4 bedroom 3000 sqft house that they can't actually afford.

  • Report this Comment On May 15, 2011, at 8:48 PM, TMFGalagan wrote:

    The assumption that always get made in rent vs. own discussions is that you can actually get your hands on the same house as a rental that you can as as a purchase. Mileage may vary in different markets, but everywhere I've lived, finding quality rentals of anything above starter homes has always been dicey at best.

    What that means is that there's probably an entrepreneurial opportunity for someone willing to make a business of renting single-family residential property. So far, that market is just about nonexistent. Maybe the banks will be forced to create that business if their REO portfolios get big enough.

    best,

    dan (TMF Galagan)

  • Report this Comment On May 16, 2011, at 11:08 PM, FutureMonkey wrote:

    There is no doubt that buying a single family home is more expensive than renting, especially if you live there less than 7 years.

    The only financial advantage to owning is if you stay in that home for an extended period, the longer the better. A decade from now, your monthly mortgage is the same, while cost of a comparable monthly rental is likely to have risen with your local rental market. Add the maintenance, insurance, property taxes and you still may not be gaining much advantage until the 15 year mark, depending on your local rental market goes. Everytime you refi, take out a equity loan, or otherwise re-up your debt you postpone the benefit.

    If you are the rare beast actually lives there for 20-30 years and pay off the mortgage, then you are a smarter person for having bought, lived, and enjoyed your home. If you are like most folks and stay in a home less than 7 years, then you are a fool to buy (at least financially).

    Anybody that views their home as an investment is a fool. I view my home as a home that I purchased and gain emotional sense of well-being from. I never felt that as a renter and I don't have a dollar figure to place on it.

  • Report this Comment On May 20, 2011, at 2:43 PM, drborst wrote:

    Rent vrs buy... 20 years ago, I came really close to buying the house I was renting in Detroit. If I did, I might still live there (and I checked it a few weeks back, its still there, but about half the nearby neighbors aren't, looks like a community garden on Google Earth).

    The point I'm trying to make is that buying a house is a good investment in the community, but a lousy financial move. Allocate your assetts accordingly.

  • Report this Comment On May 20, 2011, at 5:46 PM, DJDynamicNC wrote:

    TMFGalagan, I'm going to counter your anecdotal evidence with some of my own. Living in upstate New York has provided me with ample opportunity to rent single-family dwellings for the past decade or so, and I've had next to no trouble finding excellent accommodations at great prices. The amount I've spent for rent has most assuredly been a great deal lower than the amount I'd have paid for mortgage/taxes/maintenance/fees, and for the last few years I've been renting apartments in the heart of Rochester, a pleasant, walkable, urban environment.

    I know that many of my friends have had similar living arrangements in cities all over North America, but again, just as in your post, the evidence here is anecdotal, so I can't make any sweeping generalizations about the state of the market as a whole. I'd be interested in seeing some systematic measurements on this front.

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Morgan Housel
TMFHousel

Economics and finance columnist for Fool.com. Analyst, Motley Fool One.

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