One of the great myths of American culture is that buying a home is a "great investment" and is financially better than renting which is often derided as "throwing your money away" or "paying for someone else's mortgage". I'm sure if you're American, you're familiar with this line of thinking and might even believe it yourself (perhaps not if you're from a country like Germany or Switzerland where home ownership rates tend to be far lower). I see it crop up on this forum frequently in topics about buying a house.
I want to use this post to try to dispel this myth. On average, buying a home is worse for you financially than renting.
To be clear, it's not always a bad idea to buy a house. It's often a great idea to buy a home for lifestyle-related reasons. Perhaps you place great psychological value on the freedom home ownership gives you to repaint, remodel, install a pool, etc. Maybe you don't want to be forced to move if your landlord kicks you out. Maybe you want a certain type of home that's difficult to find as a rental, or have many dogs or strange hobbies that landlords shun. These are all entirely valid reasons to buy a home. But they are lifestyle-based, not financial.
"But I/my friend/my parents/my barber bought a home in 2009 and now it's worth 4X as much!" -- Yes, I'm sure that's true. Sometimes people buy houses and they appreciate significantly in value. Sometimes they sell them and make a lot of money. Also, sometimes people play the lottery and make millions of dollars.
Not everyone who buys a home is going to make a lot of money, just like not everyone who plays the lottery is going to make a lot of money. There are far fewer lottery winners than there are successful house flippers, but on average, most people don't make much money on their house. And many people lose a lot of money.
If you look at historical data on housing prices, you see that prices appear to rise steadily year-over-year. But this doesn’t take into account inflation, or the fact that the average house has been getting larger over time. If you adjust for these factors, you find that on average, house prices have only increased about 1% per year over the last 100 years, and on average, house prices experience a crash about every 10 years. Now some markets have done a lot better than others. If you bought a house in the Bay area 50 years ago you’ve probably made a small fortune. But if you bought a house in a place like Detroit, you may have lost everything. You might try to convince yourself wherever you're buying a house is the next San Francisco and not the next Detroit, but you're not a psychic. The future is inherently uncertain -- you just can't know.
On the other hand, the S&P 500 -- the most general stock market index -- has risen nearly 10% on average over the last 100 years. In other words, if you had put the money you spent on your down payment into a low-cost stock index fund, you would’ve done much better.
What’s more, buying and selling a house is very expensive -- you often pay a realtor 6% of the price. Stocks can be purchased for just a few dollars in commission (depending on your broker, maybe for free) and can be bought through tax-advantaged accounts (for most people, a Roth IRA is ideal). If you need the money, you can sell a portion of your stock portfolio. If you need to take money out of your house, you either have to sell it or borrow against it which is often expensive (you can refinance if the house has gone up a lot in value, but that's not always the case).
Will this continue in the future? What determines house prices?
House prices are a function of rent. A house is worth about 25X what someone would be willing to pay to rent it for one year. In other words, if you could rent it out to someone for $10,000 per year, the house should be worth about $250,000. In high growth markets like San Francisco, this ratio is closer to 40X, and in low growth markets like the rust belt, it’s closer to 15X. But the key idea is that the value of your house is determined by the potential rent.
Another thing people often believe is that the price of rent must reflect the cost of owning -- that the rent has to factor in the mortgage, taxes, maintenance, etc. This is not simply true. A landlord may have bought the house many years ago, paid it off, and have much lower costs than someone who is buying today. They may be renting it out at a loss. They may own hundreds of homes and have lower costs because of economies of scale (for example, a dedicated maintenance team). Rent is a function of what people are willing to pay. Not a function of what it costs to provide the home. Rents determine house prices. Not the other way around.
Some people say it’s a good idea to buy a house because rents keep rising, and they don’t want the risk. It’s true -- rents do rise over time. Sometimes they rise sharply, and they rarely fall. But they don’t rise as much as people think. Again, on average, only about 1-2% per year. And rents are highly correlated with the economy in a particular city. If you live in a city where the economy is booming, rents will rise in lock step with the boom. But that’s because the income in that area is also rising, so people can afford to pay more for the rent.
If you live in Houston, and the price of oil is high, rents are probably going to rise. But your income will probably rise, too. That’s not true for everyone. If you’re on a fixed income or have a job that’s not so closely linked to the economy (say you work for the government) you might end up getting priced out of the market, and be forced to move. This is a legitimate risk as a renter, but ignores the fact that owning a home is even more risky. If the boom ends, your income may drop -- you might even lose your job -- but now you’re stuck with a mortgage you somehow have to find a way to pay or go into foreclosure.
In the short-term there can be fluctuations, but in the long-run, the stock market should always outperform the housing market. This is because if companies are not doing well, people are not going to be able to afford to pay high rents.
There are some exceptions to all of this. US veterans, for example, can get very favorable mortgage terms. Some people have jobs that gives them money towards housing, or other similar perks.
But for the average person, the ideal financial strategy is to rent something where the monthly rental payment is about the same as what you would’ve spent on a mortgage. Then take the money you would’ve spent on a down payment, taxes, and maintenance and invest it into a low-cost stock market index fund. After 30 years, it’s likely you’ll have a lot more money than your neighbor who bought a house.
Again, this is not to say no one should buy a house. There are a lot of legitimate reasons to buy one. And sometimes you can make a lot of money if you happen to get lucky. But don’t believe the people who try to tell you buying a house is such a great financial decision. It’s simply not true. Incidentally, there’s an entire industry dedicated to making you believe this myth -- the national association of realtors is one of the largest lobbyists in the United States.
