September 24, 2007

Why I Won’t Buy a House (and You Shouldn’t Either)

Posted in Uncategorized at 10:12 pm by Ian

This is a bit of an “I-told-you-so” post to the many people who have suggested, in the past few years, that I should buy property. For those of you who have been hiding at the bottom of a well, the news is full of the sub-prime implosion, real estate decline, and continually repeated assertions, mostly by those with a financial incentive in the selling of houses, that we’re just about near the bottom.

We’re nowhere close.

In real terms (say, converted to ounces of gold, or to some stable currency, like $ Canadian), I predict that the price of houses in California will continue to decline for the next three years, at least. Maybe much more.

I assume you’ve seen this chart.

A little while ago, a friend of mine bought a condo here in Santa Barbara. Now, he’s in a different financial situation than I am, so he has some different priorities. At the time, I made a spreadsheet to chart out the financial impact of buying or renting. You can plug in whatever values you want for size of down payment, interest rate, inflation rate, alternate investment rate, house appreciation rate, marginal tax rate, property tax rate, maintenance costs, commission, etc.

I made a few assumptions. When necessary, I tended to err in favor of buying a house.

  1. You would rent a comparable place to what you would buy. This favors the buyer because generally, you can rent much cheaper than you can buy, if you have to. This gives you more flexibility and enables you to live on the cheap during a period of lower/no income rather than cashing out a 401K because you have to make your mortgage payments.
  2. You would never sell the house you buy. Favors the buyer because most people move houses every few years. Comissions suck.
  3. Standard income tax deduction never changes. Mostly because I didn’t feel like researching how it changes. Favors the buyer.
  4. Renters invest a sizeable percentage of the difference between buying and renting in some other investment. This one definitely favors the renter, human psychology being what it is. Most people are likely to only invest a portion of the difference, and live high off the rest. (Actually, most people aren’t likely to have enough money to buy in the first place, but, obviously, this calculation isn’t about them. They have to rent.) Arguably, the best reason to get a mortgage is that it works as a forced savings plan.

I plugged in some reasonable numbers (3% inflation, 5% housing return, 8% investment return, 10% down, etc.) and prices for Santa Barbara. Bear in mind that 8% is a very conservative return for a stock index, and that, historically, housing has returned less than 2% above inflation.

Want to guess how long it takes for the Owner to outpace the Renter, financially? How’s never strike you? Using the fairly conservative estimates above, with an 80% renter investment rate (and our own rent/estimate of the house we rent’s cost), the renter comes out ahead by 10% at the end of the 30 year mortgage. After that, the renter continues to pull ahead, because his assets are appreciating at a faster rate than the owner’s.

You can see a static version of the spreadsheet online at Google Docs here. Or you can download your own copy here.



  1. Matt said,

    This is certainly interesting, if not exactly news to me. I did pass along some of the sound bites to my brother and parents who just bought a condo for my brother to live in while he goes to dental school. Yeah, wtf? Well, they came up with another idea that seems to be working out pretty well — why pay for a mortgage when you can get someone else to pay it for you? Renting prices in the Seattle area are such that my bro would probably have to have a room mate no matter what. And really, if he could get a room mate who was also a dental student, a study buddy might actually be a bonus. Anyway, rather than instantly looking for someone to room with, he ran the numbers and figured out that he (or rather, my parents) could do much better buying a condo and having a room mate pay you rent compared to just paying your half of the rent with a room mate. Now, not everyone wants to live with a room mate, but buying a duplex and renting out the other half is along the same lines and doesn’t involve sharing your living room. Now, this isn’t as profitable as just going with the market, sure, but since they’re going to have to pay for my brother to live somewhere, somehow until he begins his own career, it’s a pretty good alternative. While people talk about this decision as “rent vs. buy,” there’s another option to keep in mind.

  2. Ian said,

    why pay for a mortgage when you can get someone else to pay it for you?

    That’s the general idea of rental property. If you can buy something at a low enough cost that the rent you receive will pay for the mortgage (and maintanence, property tax, etc.), then great. But, you know, it only works when rents and purchase prices aren’t totally out of whack like they are now.

    That said, I’d be very surprised if rent on half a condo was even half the mortgage payment (unless the market wherever he’s going to school is very different than the one in CA). It sounds to me like your brother/parents are probably paying 70% of the cost and the renter is kicking in 30%. It’s not clear that that comparison will end up any better than the one between, say, buying a smaller condo and renting space in one.

  3. Dad said,

    Interesting analysis. But I think you are comparing apples to oranges in the tax deduction column.

    For renting, you are considering ALL of the standard deduction is applied to rent. But in the ownership column, you are considering only the deduction due to mortgage interest. The most important thing that mortgage interest does is to put you over the “itemizing deductions is better” threshold. Once that is done, the property taxes are deductible (which you have included), you get personal exemptions on top of the interest, you can deduct other taxes like value portion of vehicle registrations, and charitable contributions (including those boxes of stuff you take to Salvation Army), and well, a bunch of other stuff. None of them is huge (except property taxes in your model), but they do add up.

    Or, looked at the other way, paying rent impacts your taxes 0. You pay the same taxes whether you pay rent, or mooch off your parents, or sleep in your car. So the tax deduction for renting is 0.

    Anyway, if one adds a $3300 annual personal deduction, and 5000 in other itemized deductions, the difference narrows markedly. And if it’s a 2 person family, the personal deduction doubles, and it’s essentially break-even.

  4. Ian said,

    I could definitely stand to improve the deduction column. I’ll add an “annual additional deduction you could take, if you itemized” field, and let people do what they will.

    My reasons for doing it the way I did were:

    1. I made this for myself, and I have very few additional deductions I could take. I calculated it out one year, and it was less than $1000.
    2. The vast majority of mortgage calculators assume that you can count the mortgage interest deduction fully in the accounting of buying, but ignore the fact that only the increase over the standard deduction should be considered.
    3. Originally, I didn’t consider the standard deduction at all (ignoring point #2), and it made only a minor difference. While preparing the spreadsheet for public view, I made an error in one of my calcuations that made buying look a lot better (I basically let the buyer have a downpayment materialize out of nowhere), and, desperate to not have wasted all that time writing a scathing blog post only to produce a spreadsheet that disproved it, I started refining the assumptions in favor of the buyer. Later, when I discovered my original error, I figured that there was no point in removing the refinement.

    I’m either not familiar enough with the tax code or I don’t understand what you’re saying about an “annual personal deduction”. You get this as part of itemizing?

  5. Patrick said,

    Your dad is right on about the deductions bit. Not being terribly familiar with the IRC myself (phew!), there is a litany of deductions that one can take under the auspices of “property improvement.” This includes purchases of durable goods like the snazzy Dewalt circular saw ($600), or that beater truck ($3,800) you’re using to haul lumber for the redwood deck you want for next summer ($1,300).

    Ultimately, the tax code strongly favors the home owner as a tool for increasing existing wealth, and getting a piece of that wealth through income and property taxes.

  6. Ian said,

    Anyway, if one adds a $3300 annual personal deduction…

    Ok, I looked at this again, and it appears that you’re talking about the personal exemption, which you get for yourself and each dependent you have. But that’s separate from itemized deductions. You get it even if you take the standard deduction.

    Patrick, I totally agree about the tax code strongly favoring the homeowner. I’m saying that it probably doesn’t favor them enough to make it a good deal. You can deduct costs for property improvement, but I’m pretty sure that deducting an entire vehicle because you use it to haul lumber once or twice is more properly called “tax fraud”.

  7. Dad said,

    Ok, It’s been many years since I used standard deduction. At one time, personal exemption deduction was rolled into that. I see it is separate now.

    That makes a difference.

    I’m going to have to play further.

  8. Matt said,

    Well, there’s a difference between making someone else pay the mortgage because you’re renting and making someone else pay because you’re renting to them: namely, you have something to show for it at the end. Having crunched a lot of numbers for this, I guess it’s clear that the Seattle housing market isn’t quite as whacked as the CA market seems to be. With the market in Seattle, the monthly payments on mortgages must be closer to rental rates for comparable qualities of residences. It’s always a good idea to run the numbers no matter where you live, and cluing people into the fact that renting sometimes does work out to be the better option is a good PSA.

  9. Ian said,

    I don’t know Seattle well enough to make a meaningful prediction. What kind of profit are your parents predicting on the condo for the 3? 4? years that dental school takes?

  10. Ian said,

    Wow, this post is already attracting targeted blog spam.

  11. Gina said,

    This is far from my area of expertise, so I just have a question or two…

    1. Does the inflation rate influence the rental costs over the years?
    2. What is the outcome if you look at it 35 or 40 years in, on a 30 year mortgage, while the renter is still renting?
    3. Are you assuming that the renter would be investing, so that they would have enough income to continue renting long after retirement and in the case that they live to be 85-ish?

  12. Ian said,

    1. Yes, assuming I wrote the spreadsheet correctly. Rent increases at the rate of inflation (note that the rates are all APRs compounded monthly, because that was easier. That means you should actually set them slightly lower to get the proper annual rate. I might add fields for that in the future.
    2. Generally, the renter continues to pull away from the owner. Even though the owner no longer has a mortgage payment (he still does have taxes/maintenance), the renter has more assets and they’re appreciating much faster. By the time 30 years has passed, the monthly investment return for the renter tends to be greater than the monthly investment return + old housing payment for the buyer.
    3. Yes. The presumption is that the renter will invest (some percent of) the difference between rent and owning expenses every month. Note that once the house is paid off, the renter will probably be drawing down his investments with respect to the buyer. Note that the difference between the two amounts is the only valid data point. The renter probably won’t all of a sudden lose his income and have to pull his rent out of the stock market at 30 years, it’s just that he will no longer be investing net over the buyer at that point.

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