Should you rent or buy your house? I’ve always answered this question using an arbitrage relationship that should obtain between a house’s rental rate and the real rate of interest. The rental rate is the ratio of the annual cost of renting a comparable house to the price of the house.
profitability = rental rate + appreciation rate – interest cost
For example, if a house rents for $12,000 a year ($1000 a month) and sells for $240,000, then the rental rate is .05. If it appreciates at a rate of .01 (one percent per year) and the interest rate is .06 (6 percent), then profitability is zero.
When profitability is positive, the economic cost of buying is less than the economic cost of renting. When profitability is negative, renting is less expensive. The rental rate is the ratio of rent to price, which is the inverse of a house’s “P/E” ratio.
Here are three pieces that discuss the price of housing from the standpoint of the P/E ratio:
A story from CNN/Money
A piece from the San Fransisco Fed economics letter
an article by econometrician Edward Leamer
In his paper from a year ago, Leamer said that the P/E ratio is higher than its historical average, although not by much: house prices were 11 percent above the value indicated by the historical norm. However, in my view, the real interest rate may well be below its historical norm by an amount that is at least as large. In that case, the arbitrage decision still favors buying over renting. It seems that Leamer reached a similar conclusion, by a slightly more roundabout means. writing
Nationally, there is thus no bursting housing bubble in the immediate future. But this index could turn around rapidly if Mr. Greenspan decides to increase short-term interest rates. A flattening of the yield curve, rising mortgage rates, and weaker appreciation could all add up to a significant drop in housing.
For Discussion. Are housing prices out of line with rents, and if so, is the discrepancy sufficient to be labeled a bubble?
READER COMMENTS
Eric Krieg
Jun 25 2003 at 10:07am
Renting may not be as bad a deal as it is made out to be. Because interest rates have been so low for so long, the supply of available renters has been decimated. Everyone that could possibly afford a home has bought one.
Thus, the price of homes has been bid up, while the dearth of renters has pushed down rents (usually in the form of discounts, i.e. first month of rent is free).
I guess you would have to decide if there is something better you could be doing with the money. If you think the stock market is ready for a run, being a renter would be a better option than tying your money up in housing.
JT
Jun 25 2003 at 12:13pm
You also need to factor in property taxes (on an after-tax basis) into the rent/buy decision.
Eric Krieg
Jun 26 2003 at 7:44am
The tax issue is a good one to analyze. Housing is a great tax shelter. You deduct interest and property taxes from you federal income tax.
But you only do that if you have enough income to itemize! This little technicality is often lost when talking about housing. With all the tax cutting going on lately, the number of people who itemize is dropping.
There is a whole corner of the welfare system devoted to getting poor people to buy houses. The logic is that home ownership is good for the middle class, so it must be good for the poor as well.
Of course, the poor are very different than the middle class. Their income isn’t stable, for one thing. They have no savings, for another. So home ownership for the poor can literally put them a couple of paychecks away from bankruptcy.
I don’t think this fetish over home ownership over renting is neccessarily a good thing. There are many people who are ill suited to home ownership, but the financial and real estate industries (as well as liberal housing “activists”) are pushing many of these people into ownership. The rising bankruptcy rate is one result.
JT
Jun 26 2003 at 8:32am
Eric: I wouldn’t describe efforts to increase housing ownership among the lower-income brackets as “welfare” — I think that’s not quite accurate and also is needlessly inflammatory — but I think is, let’s say, “problematic.” Buying a house with a mortgage is properly viewed as assuming a large liability, not acquiring an asset. Put in that perspective, the efforts look different.
Eric Krieg
Jun 26 2003 at 9:27am
What do you call a program that gives people money for a downpayment, with no requirement that it ever be repaid?
That’s welfare.
What do you call a progam that grants an interest rate far below that the person could get on the open market?
That too is welfare.
But that’s just my opinion, extremist as it may be. Rather than argue semantics, let’s discuss the implications of this home ownership fetish.
At the very least, with apartments going begging and homes for sale at a premium, it looks to me that almost by definition homes are over-valued, and a renter who does not itemize would do better to stay a renter, rather than get into this overheated market.
David Thomson
Jun 26 2003 at 10:33am
“At the very least, with apartments going begging and homes for sale at a premium, it looks to me that almost by definition homes are over-valued, and a renter who does not itemize would do better to stay a renter, rather than get into this overheated market.”
To be blunt: if you are filing a mere 1040EZ IRS return—you might want to think twice before purchasing a home. I know for a fact that in Houston a family with terrible credit can still buy a house. There is indeed something weird about individuals who can get a mortgage on a house who cannot even obtain a standard credit card. Unfortunately, I do not know how high is the default rate.
Eric definition of welfare is most accurate. Distorting the English language does not get around the reality that free money from the government is always a form of welfare. This is true whether the recipient is an individual person, or a corporation. I might also add that the Democrats are making fools of themselves claiming that the recent tax breaks ignore the very poor—even though the latter don’t even pay taxes!
Chris
Jun 26 2003 at 3:19pm
Of course, home ownership is not a completely financial decision. How do you put a price on the peace of mind you get from not worrying about rent increases, your landlord selling out to condos, etc? Also, here in the US, there is also a cultural status attached to home ownership. Rightly or not, its a sign of maturity, stablity, etc. I think issues are more important to home buyers than the pure economics of the buy versus rent decision.
Another thing – and somethng I try to warn my friends about (especially here in DC, where a starter home starts well over $200K) is that the down payment is the easy part. It’s the hundreds you sink into the house ever month in the form of grass seed, fertilizer, paint, new appliances, ceiling fans, the water bill, home owners associations, etc that kill your budget. It probably just about balances out the tax break every year.
Eric Krieg
Jun 26 2003 at 4:00pm
Chris, I think that a good part of the push by the do-gooders to increase home ownership is based on the premise that home ownership in and of itself makes people more mature. They see the stability of middle class suburbs, and attribute that to the high level of home ownership.
And to some degree they are no doubt right. But again, I caution against applying a middle class rule of thumb to the poor. The finances are different, and the outcomes will be different.
Bernard Yomtov
Jun 26 2003 at 4:13pm
“Buying a house with a mortgage is properly viewed as assuming a large liability, not acquiring an asset. Put in that perspective, the efforts look different. ”
Isn’t it BOTH assuming a liability and acquiring an asset?
Eric Krieg
Jun 26 2003 at 4:41pm
>>Isn’t it BOTH assuming a liability and acquiring an asset?
Bernard Yomtov
Jun 26 2003 at 6:23pm
Eric,
I was making an accounting point which is plainly true. The asset may ultimately be worth less than the liability, but it’s an asset all the same. Putting some of your own money down makes no difference.
David Thomson
Jun 26 2003 at 6:52pm
“Isn’t it BOTH assuming a liability and acquiring an asset?”
It all depends on the circumstances. You cannot in any way describe this as a general rule. Also, your argument unwittingly could justify a lot of wasteful spending. One could go out and throw around a lot of money and simply point out the alleged “assets.” Oh well, at least the bankruptcy attorneys will appreciate your remarks.
Jim Glass
Jun 26 2003 at 10:58pm
If you buy any thing, X, with a fair market price of $100k using a loan of $100k you emerge with balance sheet entries of: assets +$100k; liabilities +$100k. You acquire both an asset and an equal offsetting liability of $100k.
If your lender makes you put up 20% down of your own cash money, the balance sheet entries then are: assets -$20k (cash) +$100k (house) net +$80k; liabilities +$80k (mortgage).
Again your assets and liabilities increase by equal offsetting amounts, now $80k.
“One could go out and throw around a lot of money and simply point out the alleged “assets.” ”
Well sure, but that doesn’t change the accounting for assets and liabilities by a whit. It just points to another line item on the sheet: equity.
Eric Krieg
Jun 27 2003 at 8:09am
OK, I get it. Don’t mix up assets and equity.
In any case, if you DO put people into a home where they have put no money down, and then the home depreciates in value, you have done them no favors. While homes generally increase in value in the suburbs around big cities, the same cannot be said of small cities, inner cities, old inner ring suburbs, rural areas, and other areas where the poor tend to congregate.
A lot of these housing programs are just setting people up for financial ruin, all because renting has been given a bad name.
Bernard Yomtov
Jun 27 2003 at 9:03am
“In any case, if you DO put people into a home where they have put no money down, and then the home depreciates in value, you have done them no favors. ”
Maybe not. But I don’ see the down payment as the key to this, except from the lender’s point of view. If I put down 20% to buy a house , and it declines sharply in value I’m not going to be real happy either. But my lender is better off than if I had made no down payment because:
1. I have less reason to walk away – my liability may still be less than the house’s value.
2. If there is a foreclosure the lender will recover a greater percentage of what is owed.
How I gain from having put money down is not clear.
I think we’re overlooking two important aspects of home ownership here. The first is economic. Owning a home, as opposed to renting, is in fact a hedge against rising housing costs. Given the strong tendency for housing costs to increase over time this is quite valuable.
The other is vaguer, and more in the nature of a positive externality. It can be argued that owners take greater pride in their homes and neighborhoods than renters. So a high level of ownership tends to improve an area quite apart from any direct benefit to the owner.
Is there evidence for this? I know that lenders are more willing to lend for a condo purchase, for example, when a high percentage of the units are owner-occupied, and that many condos and coops have rules restricting the rights of owners to rent out their units. This is surely suggestive.
So maybe this second sort of effect does justify some government effort to help people acquire homes.
Eric Krieg
Jun 27 2003 at 9:21am
>>How I gain from having put money down is not clear
You simply owe less money on the house! Your liability is less. You are less leveraged. It’s all about leverage. It helps you when prices rise, but it kills you when they drop. Ask a commodities trader.
>>Given the strong tendency for housing costs to increase over time this is quite valuable>It can be argued that owners take greater pride in their homes and neighborhoods than renters
Bernard Yomtov
Jun 27 2003 at 11:07am
Of course you owe less on the house. But you owe more somewhere else, or give up an investment opportunity. You yourself point this out in an earlier post.
Putting money down does not affect the value of the house.
What you have to be careful about is the size of the payments, and the ability to meet other costs. So don’t overspend. But you can overspend with a down payment just as well as without one. Then you have no reserve for emergencies, etc.
Someone buying a $150,000 house with little or no down payment may well be making a more prudent decision than someone buying a $250,000 house with a 20% down payment.
Jim Glass
Jun 27 2003 at 1:49pm
Bernard is right that the down payment requirement really is imposed to protect the lender to keep the borrower from walking away if the home loses a percentage of its value. That’s why historically it’s been *imposed* by lenders, and its average size has diminished over time as lenders have been able to reduce default risk by selling loans in the secondary market. He’s also right that if a house drops in value the borrower takes that loss whether he’s made a down payment or not. And that the money that goes into a down payment must come from somewhere else, and so in that sense is a wash.
But Eric is right too in that there is risk involved in borrowing 100%, and that for some borrowers this matters. It gets to the question: Why do people pay down their mortgages at all, and sometimes even pre-pay them? Why not keep refinancing to be fully borrowed at 100%, and have all that extra money as cash available to spend? The problem is not that the house might drop in value below that amount and you’ll lose it, because as long as you keep making the mortgage payments you won’t.
The thing is that most people think of their home payments as savings. What if I lose my job, or get sick, or have to pay a big college tuition bill for the kid, etc.? *Then* I will tap my equity in my home. And if I never have to do so, I’ll use it to have a wealthier and maybe earlier retirement.
(BTW, this is a big difference from renting — if you rent you’d better provide for extra savings another way. But for a lot of people some kind of “automatic saving” like a mortgage payment or payroll deduction is necessary, they won’t save any other way.)
What happens if I borrow 100% on a home purchase, have no savings or equity, and lose my job or get sick? *Then* I lose my home because I can’t make the payments — and maybe I’m Chapter 7 too.
So from the buyer’s point of view there’s really no one right answer as to how much in debt to go buying a house — either for the cost of the house or the amount of the price that’s mortgaged. It depends on the person’s entire sitiuation. It’s easy to borrow too much — but a lot of people borrow too little and wind up being “house rich cash poor”. And if one is going to sell a house and move in a couple years it really doesn’t make much sense to prepay the mortage, though I know people who do.
Bernard Yomtov
Jun 27 2003 at 4:22pm
Ah, the behavioral economist is heard from. Reasonable points, though I wouldn’t go so far as to say “most” people use their houses as savings vehicles, though some surely do.
Paying down the mortgage isn’t really such a bad idea if you’re looking for a safe investment. Not as good as paying off credit cards of course.
Eric Krieg
Jun 30 2003 at 9:13am
Have you guys ever gone to get a mortgage?
The first time I did, the banks were willing to lend me over $250k, despite having a household income of maybe $60k. My monthly payment would have been huge. I would have been putting all my money into house payments.
The point is that, if you have no down payment and max out on your mortgage, you are taking a huge risk. Everything must go right for you. No layoffs. No illnesses. No divorces.
To be in poverty, almost by definition, you have some problems: teenage pregnancy, out of wedlock births, substance abuse, divorce, etc. This is NOT the group that you want to grant the riskiest loans!!!
With a downpayment, you have less risk because your payment is lower. You can afford for some things to go bad. Your threshold for when you walk away from the home or file for bankruptcy is higher.
Bernard Yomtov
Jun 30 2003 at 10:17am
Eric,
You are correct that it is important to leave yourself some safety margin when taking out a mortgage. The point is that this is not the same as making a down payment. What you should avoid is buying a house you can’t reasonably afford, down payment or not. You should also not assume life is going to go perfectly smoothly. But this is true of everyone, not just poor people.
It’s the amount you borrow that is critical. As I point out out above, buying a $150K house with no down payment is more prudent than buying a $250K house with 20% down. The P&I payments will be less, as will insurance and property taxes.
So the issue is one of avoiding excessive debt, not of making a down payment.
Look at it another way. If you stretch to make a down payment you may leave yourself with inadequate reserves to meet financial emergencies, such as a period of unemployment. That’s not smart.
Eric Krieg
Jun 30 2003 at 11:08am
>>You should also not assume life is going to go perfectly smoothly. But this is true of everyone, not just poor people.
Bernard Yomtov
Jun 30 2003 at 11:44am
“Seriously, the libs get incensed at “predatory lenders” who target the poor with things like payday loans. Where’s the outrage when government housing programs cause just as much, if not more, financial havoc?
Once again, liberals give government programs a pass because they value intentions higher than results.”
There is a vast difference between payday lenders and government housing programs. Just look at the rates, for starters, and then look at what the loans are used for. Government housing programs have included things like VA and FHA loans, which have opened the housing markets to many. They have included FNMA and GNMA, which have reduced home financing costs for almost everyone. To say that they have caused more havoc than payday lenders is absurd. ( as long as you’re not claiming the predatory lenders cause less because they are smaller).
Do you have any evidence at all about the results of these programs, or are you just incapable of believing they might actually be beneficial?
Besides lacking facts you lack logic. Why should private inducements to excessive borrowing do more harm than government inducements, assuming even that govt housing programs are as bad as you think.
Eric Krieg
Jun 30 2003 at 12:54pm
Facts? How about common sense? How about personal experience? Go to any low income area, and check out the HUD foreclosures. That’s all the facts I need to back up my opinion.
Here’s some more background, these guys come to the same conclusion, that low income people don’t get the benefit of housing because they don’t itemize:
http://www.housingamerica.org/docs/RIHAwp01-02.pdf
Bernard Yomtov
Jun 30 2003 at 1:05pm
“Facts? How about common sense? How about personal experience? Go to any low income area, and check out the HUD foreclosures. That’s all the facts I need to back up my opinion.”
Classic, absolutely classic.
Eric Krieg
Jun 30 2003 at 1:13pm
What would you prefer? A NBER paper, perhaps?
Social scientists won’t believe anything without a paper. And the flip side is that you can convice people with masters degrees of anything as long as you have “studies” “showing” that it is so.
Common sense, my friend. It goes a long way. Personal experience doesn’t hurt, either.
Bernard Yomtov
Jun 30 2003 at 2:16pm
I would prefer data.
An NBER paper would be nice, but just some data would be helpful.
Gee, it really is idiotic of those social scientists to insist on evidence for factual claims.
Is that the way you do your engineering work, Eric?
“No point doing any calculations, common sense says the bridge will hold up. Besides I saw one like it somewhere and it was fine.”
Eric Krieg
Jun 30 2003 at 3:00pm
Bernard, the Romans built bridges that are still around today. They knew nothing of the math behind structural engineering.
Experience is a powerful tool.
There is very little research into the outcomes of these government housing programs aimed at the poor (at least, not much on the Internet). However, anyone with any experience with HUD forclosures knows that you don’t find many in middle class, suburban areas. Poor neighborhoods are full of them.
Habitat for Humanity has a very low default rate on its loans, on the order of 1%. They require a down payment of a different sort: sweat equity. They realize that getting the poor to have a stake in their home is key to stability.
Bernard Yomtov
Jun 30 2003 at 9:25pm
“…the Romans built bridges that are still around today. They knew nothing of the math behind structural engineering.”
And they built some that fell down.
In any case, the issue is not whether poor people default more often than middle class borrowers. I think this is probably true. What I question is your statement that somehow government housing programs cause “more havoc” than predatory lenders.
Do you have any assessment at all of the harm and benefits of these programs? Since they do benefit some people on what basis can you say they “cause havoc” at all, rather than providing a net benefit?
If you have reasons, other than what you call common sense – really just your own ideological bias – post them.
Eric Krieg
Jul 1 2003 at 7:37am
http://www.hud.gov/homes/index.cfm
Go to your state, and take a look at where these homes are located. See the sheer number of homes in certain towns.
It’s a scandal.
Net benefit? Since when does a liberal use net benefit as the yardstick? Even payday loans are probably a net benefit to the people who get them!
Bernard Yomtov
Jul 1 2003 at 10:34am
“Net benefit? Since when does a liberal use net benefit as the yardstick? ”
In other words, since you have no idea as to the net benefits you decide to fling an idiotic insult to cover the flaws of your own argument.
Do YOU think net benefits are important? If so, explain why you think there aren’t any.
That the poor have realtively high mortgage default rates proves nothing.
When you say something sensible, Eric, I’ll think about it. Until then, spew all you want.
Eric Krieg
Jul 1 2003 at 11:14am
I don’t know if there is a net benefit or not. I don’t think anyone knows, because I don’t think that it has been looked at in any systematic way.
I’m just saying that, looking out there across the country, there are a lot of bankruptcies and there are a lot of these HUD homes in poor neighborhoods. I don’t think the basis for these programs (that home ownership for the middle class is good, so it must also be good for the poor) has been well thought out.
Can I point to a NBER study “proving” these points. No. I can’t point to one disporving it either. The research has not been done.
I have said before in other posts that one thing I dislike about economists is their worship of economic utility (under which net benefit falls). There is more to life than mere utility. That’s why I’m not a libertarian or an objectivist.
Bernard Yomtov
Jul 1 2003 at 4:37pm
OK Eric,
That’s sensible. You have reservations about the value of these programs. You think they have some bad effects and aren’t sure whether they are beneficial overall or not. You have no definitive information that points either way, but based on your observations and experience you are dubious.
We disagree, but I understand your point. No need for the “libs are all stupid” rhetoric.
Eric Krieg
Jul 2 2003 at 7:50am
Bernard, how can one come to any other conclusion? For a bunch of people who think that they are so smart, liberals consistantly choose to ignore the law of unintended consequences. What does that say about their intelligence?
JT
Jul 2 2003 at 10:05am
I’ll jump back in since this thread seems to still be alive.
Bernard: of course, I agree with your point about my comment that taking on a mortgage involves assuming a big liability. It’s really a difference in emphasis: while many people view buying a house as acquiring an asset, I was underlining the fact that to actually end up owning the asset free and clear, one has to make regular mortgage payments and this is not an easy test for lower income households which are particularly prone to income disruption. The real question is whether mortgage, property tax and maintenance costs are in the range of the equivalent rental payments such lower-income households would make. If the costs of owning a home are actually quite a bit higher than rental costs, then we are doing these households no favor at all.
Eric Krieg
Jul 2 2003 at 10:28am
>>If the costs of owning a home are actually quite a bit higher than rental costs, then we are doing these households no favor at all.
Jim Glass
Jul 2 2003 at 11:35am
You folks mentioned the tax deduction for mortgage interest but you missed the big tax shelter — up to $500,000 of gain on a home can be taken totally tax-free as often as every two years.
So the mortgage and property tax deductions provide a current tax subsidy towards financing future tax-free income. You don’t get that in many other places in the tax code. In fact it’s generally prohibited.
(For only two years $500,000 of gain may seem like a lot — but here in Manhattan I know people who’ve done it. People also use this break serially, if over the years they’ve accumulated at home, and a vacation home, and an investment property, they sell them off sequentially taking the gain on each tax-free.)
“If homeownership was such a great thing in and of itself, the government wouldn’t subsudize it through the tax code.”
Oh, come, I hate to sound cynical by being realistic, but these tax breaks for homes are nothing but vote-buying payments from politicians to the upper middle class. There’s no non-political rationale at all for allowing $500,000 of tax-free gain on homes but nothing else — plus tax susbidies for financing such gain while tax subsidies are barred from being used to generate other kinds of tax-favored income.
If you go down the budgetary list of “tax expenditure items” — (their loopholes, my well-deserved deductions) — all the biggest ones, hundreds of billions of dollars worth, go to the upper middle class. Not to “the poor”, nor to “the rich”, but to the upper middle class.
Eric Krieg
Jul 2 2003 at 12:32pm
Jim, regardless of why the subsidy is there, it is NOT there for those who do not have the income to itemize.
I still don’t see the rationale for why, say, a single mother on welfare should be buying a home.
Bernard Yomtov
Jul 2 2003 at 2:41pm
Eric,
Get over it. If you just hate liberals, fine. I’m trying very hard to maintain a polite converstaion with you. But if you can’t make a post without saying “liberals are all stupid,” then I’ll quit and let you go back to reading Ann Coulter.
Look, suppose the default rate on FHA loans is 25%. That means the non-default rate is 75%. So the question is whether the harm done by the defaults outweighs the benefits of enabling the other 75% to buy homes. It may not be not foolish to think, as you do, that the harm does outweigh the benefit. But it is extremely foolish to think, as you do, that it’s so blindingly obvious that only a moron could fail to see it.
Eric Krieg
Jul 2 2003 at 3:02pm
Why doesn’t the same logic apply to payday loans?
Because there is something unseemly about an industry that profits the way payday loan operators do.
FHA loans are different in that they have a more noble purpose, perhaps. But in the end, they’re far more damaging.
BTW, with all the talk about Fannie Mae recently, did you see that Fannie makes FEWER loans to the black community than commercial lenders do? The corporation chartered by the government to combat redlining is itself redlining?!?
Bernard Yomtov
Jul 3 2003 at 10:16am
FNMA does not lend to individuals, as I understand it.
It was not established to “combat redlining” but to provide a secondary market in mortgages.
Eric Krieg
Jul 3 2003 at 1:32pm
It’s portfolio contains less loans to black homeowners. Is Fannie Mae racist or what?
By lowering borrowing costs by creating a secondary market, it was thought that minority access to morgages would increase. But not if Fannie Mae doesn’t buy their loans!
Bernard Yomtov
Jul 3 2003 at 8:10pm
FNMA has no way of knowing whether a particular loan is to a black borrower.
Eric Krieg
Jul 3 2003 at 9:48pm
Come on, Bernard. Fannie knows where they live! Thus the term “redlining”! They won’t buy loans from certain neighborhoods, which are predominantly black.
Or are you saying that it is possible to achieve a racist outcome by chance?
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