smackdown: rent v buy

Squawkfox has an interesting article about good debt. Her take? There is no such thing. It's a myth marketed to us by financial professionals.

The most interesting part of the post, in my mind, was the discussion of mortgage debt. Squawkfox joins Millionaire Mommy Next Door in the devil's advocate position of saying that renting frees money for investing, which will earn returns greater than housing equity can. This is a 180 from the American conventional wisdom that home ownership is the path to wealth for the majority of us.

I agree with everyone. (I'm an agreeable sort of girl.) There are many paths to wealth. Some include home ownership. Some do not. But all of them include a strict scrutiny of the real financial picture underlying a decision.

If you decide to rent and invest your money in the cheerful expectation that you will make the stock market's historic average every year, you are gambling. You haven't done the math.

If you decide to buy and expect your home to grow in value at rates outperforming the stock market, you are gambling. You haven't done the math.

Doing the math is a burden and a chore, but no one said that financial freedom was easy and fun. I purchased a home in May of 2007. While it's still early days, I consider it my best financial decision ever. Let me take you through my personal numbers and show you why.

First decision item: Can I afford a home? Do I have the credit to do so?

Despite the ominous rumblings of the mortgage market in early 2007, I had the opportunity to purchase my home under a first-time homebuyer's program with a 1% down payment, closing costs rolled into the loan, and two mortgages at 80% and 20%, thus avoiding private mortgage insurance (PMI.) Deals like this have been recast as a seriously bad idea for both lenders and borrowers, but there were two redeeming features. The non-profit organization did months of financial monitoring and counseling before allowing a home purchase, so we didn't buy more than we could handle. They also financed both mortgages at a fixed 30-year 5.5%.

Second decision item: What is the opportunity cost of a home purchase? What else could I do with the down payment? What would it cost just to rent?

This is where I lucked out. I live in a small and rather remote town. Housing prices are traditionally horrific because there is very little buildable land. (We're surrounded by national part, pueblo land, and federal government property.) But, while the housing market has been irrationally exuberant in other parts of the country, price increases have been fairly restrained in my area due to financial uncertainty for the major local employer.

I also had an apples-to-apples rent/own comparison. There are several hundred homes in town build with the same age, materials, acreage and floor plan as mine. At any given time, there are two or three listed for rent in the paper. The rental cost for a house comparable to the one I purchased is about $1000 per month, not including utilities.

My actual financial outlay to get the home would be minimal: 1% of the purchase price and no closing costs. I knew that 1% would be less than $2,000, so I could use that number as my high number when counting opportunity costs.

My rent v. buy analysis assumed a 7 year horizon.

Renting would cost $1000 per month. $2000 could be expected to double in the stock market in 7 years, resulting in a rough profit of $2000. I could assume a rent increase of 2% per year and rental insurance at $200/year.

The total cost of renting for 7 years and investing the down payment instead would be $88,980 for rent and $1400 for insurance, with $2000 profit from the down payment funds, for a total cost over seven years of $88,380.

Third decision item: What is the home worth now? What was it worth five years ago? Will it maintain or increase its value?

After some intense house-hunting with a realtor, I had an idea of my preferred neighborhoods, home, and budget. I drove around those neighborhoods several days a week. This paid off: I was the first person to see the FSBO sign in front of the home I purchased. I actually signed a contract before the first ad ran in the paper.

Scoping out the neighborhood was an important part of the process. I bought within two blocks of an excellent elementary school. The neighborhood is settled and well-maintained. It's away from major roads. There is a municipal park (check out the photo at the beginning--isn't it rather breathtaking?) within a three-minute walk and a golf course within a five-minute walk. These features stabilize the value of the home. I had the selling prices of all comparable houses within the previous five years, so I knew what the type of home I wanted should cost.

Because I had this information at my fingertips, I knew when I had a good price and I wrote a check for earnest money immediately. Without the research, I might have missed a remarkable bargain. I ended up buying well under the appraised value.

Fourth decision item: What are the added costs of insurance, property tax, and home maintenance?

I am also fortunate to live in an area where my combined yearly property tax and insurance bill is less than 0.5% of my home's appraised value. I know that's unusual. I'm not gloating, I swear. I anticipated about 1% of the home's appraised value in maintenance and improvement costs.

Fifth decision item: Do the math. Do the math, do the math, do the math.

Ultimately, the cost of purchase broke down like this:

7 years at $990 per month for PITI and $130 per month for maintenance, which is assumed to increase at about 2% per year = $94,756.

Actual down payment: $700 (don't laugh), since the owners rented back from me for a month at $1000/mo and I crashed on my parents' couch. So the actual cost of renting goes up by $1300 (remember, we assumed a $2000 down payment invested in the market, instead.) So the real cost of rent is $89,680 over 7 years.

The cost of ownership is $5076 greater over 7 years. If that money were invested in a lump sum at the beginning of the 7 years, it might reasonably become $10,150 over the seven-year period.

However, if I sell the home after 7 years at the same price at which it was appraised when I bought it, I would have approximately $21,000 in equity, of which $8150 would go to brokers' costs, leaving a net profit from the home of $12,850.

After living in the home for seven years, assuming no increase whatsoever in the home's value, ignoring any tax benefit from home ownership, and assuming a generous and consistent market return for invested money, I am still $2700 better off as a home owner than as a renter.

These are excellent numbers for a worst-case scenario. I think they're unusual numbers; I live in a very good market for buying, and it took lots of time and effort to find such a low rate and a cheap house.

* * * * *

Lest I start sounding too self-congratulatory, let me observe that I still shoulder some significant risks as a home owner. If the major employer in this area failed, my home's value would drop significantly. If I had to move after only a short time, I might not be able to recoup the money spent on closing costs and brokers' fees.

One of the unavoidable downsides to home ownership is that it is putting a lot of eggs into a single basket. Investing all your retirement in one company's stock is courting huge market risk. The risk is lower in real estate, because you control many of the maintenance, capital improvement, and timing decisions. But the risk is still there.

To hedge against this risk, I've invested four times as much in mutual funds since buying my home than I've paid in equity. I understand the desire to retire a mortgage early, but I feel that I'm more financially balanced if most of my money is going into diversified investments. I would ultimately like to maintain a 4 to 1 ratio of investment to home equity in my net worth.

The moral of this story is not to buy a home. It's not to rent, either. It's to calculate. Every financial decision has real cost as well as real benefit. Doing something because everyone says it's a good idea is a bad way to run a personal exchequer. Americans lost a lot in the market in 2000 because they followed the leader into tech stocks, and they're losing their shirts in real estate now for exactly the same reason. No one else--no blogger, no financial analyst, no guru--can give an easy answer to investment questions. We all have to get out the calculator and do the math for ourselves.