Wednesday, March 14, 2007

Rent Money

“Its like throwing money down the drain”

There is a misconception in America, one that may be partially responsible for the large and still slightly increasing housing bubble in a few of the nations costal cities. Rent, they say, is like throwing money down the drain. You get nothing in return! All of your money goes to the landlord and at the end of the day you have nothing.

Buying on the other hand, is an investment. Well, sort of. It turns out that most banks today demand that you invest money when you take out a loan. Before the Great Depression is was common for people to take out interest-only loans. In this case they weren’t investing at all.

They were buying the house all right, but they were renting the money.
Interest on your mortgage is the rent you pay on money. Without the funds to buy a house outright most people are left with only two options – rent the house or rent the money. However, after the defaults of the Great Depression banks became wary of renting money to people with little security. They demanded they you rented-to-own, not the house but the money.

That is, along with your monthly rent payment (the interest), the bank asked that you repay the original debt little by little (the principal). They figured it up so that you would repay the loan in about thirty years. Thirty years is a slightly mystical timeframe in finance. It turns out that from a payment standpoint, thirty years is really close to never. The payment on an interest only loan, for which the principal will never be repaid, is very close to the payment on a loan that will be paid off thirty years from now, so long as the interest rate is not too, too low.

The bank does this because with an interest-only loan, if you end up not being able to sell your house for as much as you paid for it, too bad – so sad, it’s the bank that takes the loss. However, if the bank makes you pay in a little in equity then it’s your equity that goes down the drain first. This is a much safer deal as far as the bank is concerned.

So, buying a house means renting money. Is that better than renting the house itself? To figure that out start by looking at what the interest-only payment would be. That’s a fair comparison between renting and buying. Then, correct for taxes.

The federal government subsidizes home buying by allowing you to deduct the rent on money (interest) from your taxable income. Sadly, the government is not so generous to those who rent the home instead. Whatever your tax bracket is, that’s what you knock off you interest payment to account for taxes.

However, there is bad news for money renters too, you have to add back in insurance and property taxes because landlords take care of those things for home renters. When you compare the figure you’ve got to the cost of renting a home you have a reasonable comparison of the two.
For those who live in the middle of the country the numbers should be pretty close. Those who live in a costal boom zone will probably see that renting the money is a lot more costly. However, there are a few additional things to consider and this is what really makes it a choice.

First, renting the money forces financial discipline on you. The bank (if its doing its job) is not going to let you be very irresponsible. It’s going to make sure that your house could be appraised for what you are paying. It’s going to make sure that you can afford the monthly payment given your other debts. Most importantly, it’s going to force you to save. If you are not a good saver then this one is key for you.

As we said before the bank is not keen on you leaving it with a principal sum of money outstanding that is worth more than the house. They are going to force you to repay the loan little by little. This is exactly the same as saving. This is the only saving many Americans do.

Second, there is the more complex financial issue of going short vs. going long. There are risks and rewards to both. Renting the house gives you lots of options. You can move easily. You can always have the right house for you. If you change jobs even within the city you can change to a closer house. You are totally mobile and totally free. If you have a mid-life crisis you can pack up and leave for Patagonia and you don’t have a debt hanging over your head.

This is the freedom of going short. Its something you give up if you go long. On the other hand going short has its risks. You could be evicted. The house you love could be bulldozed to put a sparkling new condominium. Most importantly, your rent could go up. This is the real risk you face. Going short means you owe nothing-to-no-one, but it also means that no one owes anything to you either.

This can be particularly scary when you’ve picked a great place to live. Once everyone else find out about it you could find yourself on the downside of an increase in demand.

Going long secures you from that. You never have to move if you don’t want to. This is your home and you can do what you want with it. However, you may never get to move if you need to. Selling during a downturn could destroy your equity. If you work for a big company then you are likely to get laid off when everyone else does too. That doesn’t bode well for your ability to sell your house.

All in all, it looks as if most people on the coast have looked at their options and thought that going long is a good idea. The big cities for the most part are getting bigger. The most dynamic job markets are there. Middle America retirees might enjoy life on the coast. There are reasons to think that going long, in general, might be a good idea.

However, with prices as high as they are in some places one has to wonder how much higher they can go. Is the premium to rent the money really worth it when you could be adding more to your 401K? At this point it’s hard to think the answer is yes. Rent is money down the drain and the rent on the money needed to buy a house in some places these days is stratospheric.


dWj said...

Quibble: you didn't really mention appreciation among the benefits of home-ownership. In fact, with an interest-only loan, you will generally be increasing equity, because housing prices generally go up. Generally.

To the extent that we can estimate rental values of the house and carrying costs, it's not too hard to generate forward prices for a house, at least ones that go a few years out. I think they generally increase with time, i.e. you need some anticipated appreciation in order for it to be worth buying. It depends, naturally, on where and when.

The only reason a house has value is because you can live in it on an ongoing basis. If it didn't have rental value, it wouldn't have purchase value. I find it easier to think of it in these terms; the purchase value of a house is an effect of the future rental value (and, in fact, is a net present value of future rental values minus future current costs). It seems strange to me that so many people work the other way, deriving rent from the value of the house rather than vice versa.

Your "going long" argument can be slightly recast in a similar way as above; if local rental values turn out to be higher than expected, the value of the house will prove to be more, and vice versa. You have to live somewhere, and it's likely, depending on your situation, that the cost of living where it is you're likely to live is going to be well correlated with the cost of living where you live now. Buying the house is a way of making assets match liabilities; you're ultimately going to be liable for the rental payments, and buying a house allows you to lock in their price now.

Karl Smith said...

In fact, with an interest-only loan, you will generally be increasing equity, because housing prices generally go up. Generally.

The question, however, is whether or not you equity is increasing faster than your interest payments.

Home prices have on average risen about 6% a year. Mortgage rates are typically above that.

So you are paying more in interest than you are getting in equity. Thus buying a house solely for the appreciation generally will not payoff.

Now of course, you get the "dividend" of living in the house while its appreciating.

However, it may or may not be the case that Interest + Taxes + Upkeep - Appreciation > Rent.

Furthermore, you take on the risk that housing prices could stagnate. In the long run they won't fall, but they could be flat for quite a while.

This is why I say buying vs renting is like going long vs going short. Its about the type of risk you are willing to take on.

dWj said...

Actually, my point isn't that the house will itself appreciate at the rate of interest. It's that expected appreciation is positive, and I felt that some of your post read as though it could be ignored as a benefit of ownership.

I think Interest + Taxes + Upkeep - Appreciation = rent in a perfect neoclassical world with no uncertainty, no agency costs, etc. Let's rearrange that to expected appreciation = taxes + upkeep + interest rate the value of the property - rent. This is where I'm getting my forward price on a house. If taxes + upkeep are equal to rent, then I need my house to appreciate at the interest rate. I expect rent is usually higher than those, so the expected appreciation being priced into houses is less than the interest rate.

As for the question of accounting equity, I can be paying 6% interest with 1% appreciation and my equity is still increasing. For a $100,000 house, 100% LTV, I pay $6,000 the first year and the house goes to $101,000 while my loan is still $100,000. I now have equity of $1,000. That is the nature of interest-only loans: the outstanding balance holds still. A $1 increase or decrease in the value of the house translates directly to a $1 increase or decrease in home equity, with no change with time if housing prices stay constant -- with a traditional mortgage, you still see increasing equity when house prices flatline.

Global Private Partners said...

Great Article

Thanks and do keeping writing it's another one of your "callings"