The need for shelter is basic, often closely followed by the desire for community. In the United States, this often translates into a desire to take on a very large mortgage to buy real estate. These basic human emotions drive much of the activity in real estate markets. Most people buy because it is the right time for them. Their career, age, family circumstances all come together to push people toward ownership at different times. Some are fortunate and buy at the bottom of the real estate cycle. Some are not so fortunate and buy at the peak.
The most damaging aspect of our current system is the price volatility. It capriciously rewards some and destroys others. Home price volatility creates a culture of Ponzi borrowing and dependency. The goal of government policy should be price stability, but lately it seems their goal is price maximization. The end result of their policies is an endless series of market stimuli and manipulations which creates even more volatility.
Reasons to buy a house
Many people choose to rent to avoid the negatives associated with home ownership, and many more rent because they can’t meet the down payment or credit requirements to qualify for home ownership. However, most people who hold down productive jobs have a choice. Anyone who chooses not to buy is making a choice to rent by default. There are many different reasons people chose to buy homes to live in, some of them are good reasons, and some of them are not.
Have a place to raise a family
The primary reasons to buy a home are emotional, not financial. At the top of the list is the desire to provide a safe and comfortable home to raise a family. It’s a primal urge. Although it shouldn’t make a difference, there is an emotional quality to home ownership that is not replicated by renting. Satisfying one’s emotional needs is an instinctive drive, and this compels many people to buy houses. Unfortunately, some people turn this emotional satisfaction from home ownership into a reason to feel superior to their renting brethren, a group they perceive as being less involved with family, neighborhood and community.
Be a part of a neighborhood and community
As people grow and develop during their life cycle, they first learn to take care of themselves, then their families, then their neighborhood and community, and finally the whole world. Being part of a broader community one can work to build and improve is a basic human need. Most people see this as a natural extension of buying a house. They dream of watching the children play with the others in the neighborhood, enjoying block parties, and participating in organized events. All things being equal with the house, people will chose to locate in neighborhoods with others of their same demographic with whom they can make friends and socialize.
Following parent’s advice
Many people buy homes simply because their parents did. People grow up, get married, buy a house, have children, and become part of a community because that’s what their parents did, and often this behavior is strongly encouraged by the parents who will even help with down payment money to get started. There’s nothing wrong with this. Parents generally have good advice due to their broader life experience. Unfortunately, parents can sometimes be mistaken as many were that pushed their children into home ownership at the peak of the housing bubble.
Build equity and hedge inflation
Houses tend to go up in resale value over time as workers in a community earn higher wages. The inflation of wages translates into more buying power that allows potential buyers to bid up the price of residential real estate. There is a strong connection between local wages and local house prices. The rising value of real estate serves as a hedge against the ravages of inflation preserving the value of an owners investment.
Also tied to the growth of wages in a community is the cost of rent. People who chose to rent rather than own face the likelihood of rising rents over time as they compete against other renters for available properties. There is no way for a renter to fix their cost of ownership. Sometimes they may find a landlord content to leave their rent alone for years at a time despite the rising rents around them, but once the renter wants to move, they bear the full brunt of increases in local market rents.
As wise homebuyers use fixed-rate mortgages, the loan amortization serves as a forced savings account. Fixed-rate amortizing mortgages are the best tools for retirement savings available to most Americans. The gradual increase in value and the gradual retirement of mortgage debt combine to create equity for homeowners. It is the primary benefit of long-term home ownership.
Acquire an asset to pass on
Many people buy homes because they are a tangible physical asset to pass on to heirs. Since these assets appreciate over the long term, houses become a reservoir of value and a great vehicle for passing wealth from one generation to the next.
Gain a tax deduction
Many people buy a house to obtain a tax deduction on the mortgage interest. As a general rule this is not wise because the borrower is incurring a dollar in expense to obtain a quarter in benefit. However, since most people finance real estate, and since the alternative to ownership is renting, which has its own costs, many people take on a mortgage because they save money on taxes for an expense they would have incurred anyway. Unfortunately, the mistake many borrowers make is to over-borrow to the point that the after-tax cost of home ownership is higher than a rental. Perhaps they believe they are throwing away money on rent, but they are throwing away even more money on interest. It doesn’t make much sense. However, if the net cost of home ownership after the tax break is positive, then the tax deduction has value. Whether the deduction has value or not, many perceive it does, and this motivates them to buy houses with very large mortgages.
Reasons not to buy and rent instead
Between 35% and 40% of Americans chose not to buy and rent their primary residence instead. This is generally a lifestyle choice although during the housing bubble it also became a wise financial move. The reasons vary, but they all generally relate to commitment and finance. It’s said that the decision to own is emotional whereas the decision to rent is financial.
Flexibility to move
The primary reason people chose to rent is to have flexibility. Selling a house takes time and effort, and with real estate commissions and closing costs, considerable expense. Renters face none of these issues. For a renter, at the end of their lease, they simply pack up and move, and they have no further financial obligation to the property. Owners don’t have it so easy.
As a general rule, it costs an owner about 8% of the resale value to move (6% commission plus closing costs). If houses appreciate 3% to 5% per year, it takes two or three years of ownership before an owner can reasonably expect to get out at breakeven. Most people who recognize their current living situation is not likely to last more than two or three years generally chose to rent, and wisely so. Unless they want to become landlords or take a loss, people who must move within two or three years of buying a house give up their freedom of movement.
No money spent on upkeep
Homeowners must pay all the costs of upkeep on their properties. If a dishwasher or water heater goes out, if the roof springs a leak, or any of a number of other maladies strike, the homeowner must pay for it. Renters don’t face these unexpected and sometimes costly expenses. Renting eliminates the unknowns. Renters know how much their housing is going to cost and they know what they will leave with, at best their deposit. Owners face uncertainty as to the costs of ownership, and they don’t know how much they will leave the property with. Sometimes it’s a gold mine, and owners obtain a significant equity check at closing. Sometimes, the end up with nothing but bad credit after a short sale or foreclosure. Ownership is a giant lottery.
Monthly payments exceed comparable rental
One of the best reasons to rent is to save money. In volatile markets like California, prices often get bid up so high by the kool aid intoxicated that the monthly cost of ownership greatly exceeds the cost of a comparable rental. This is also the telltale sign of a housing bubble ready to pop. Rental rates establish where property values should be. Rental Parity is a balance point where there is no financial advantage to choosing renting or owning; a point of theoretical indifference.
If we had a group of theoretically indifferent people who always acted rationally based on perfect information, prices would always be at Rental Parity; any price below rental parity would be perceived a bargain and bid upward, and any price above rental parity would be perceived as too high, and there would be no bid interest. Of course, we all know that people are not indifferent; in fact, they can become very emotional about buying and selling real estate. When they participate in a market, they get caught up with the herd and move prices without regard to fundamentals; short-term price movements become accepted as the market’s long-term trajectory. Trees really can grow to the sky.
Rental parity becomes a baseline — a fundamental. Prices are loosely tethered and may depart for long periods, but prices always manage to return to rental parity in time because as a logical point of indifference; it is the natural resting point for a market purged of kool aid intoxication.
Take on too much debt
Another reason many opt not to buy houses is due to their total cost. Even if very low interest rates make the payments affordable, people get uncomfortable borrowing five or six times their total yearly gross income, and rightly so. Many people blithely take on this debt believing they will not have to pay it off, their future buyer will take care of that. The folly of that attitude became apparent when people discovered that real estate does not always go up in value.
Ties up too much savings
Many people do not buy homes because it ties up a substantial amount of their personal savings. Money tied up in a down payment has an opportunity cost. For people with attractive investment opportunities, it may be wiser to invest that money rather than sinking it into a house. Money put into a house reduces the mortgage payment, so the return on that money is equal to the mortgage. If other investment opportunities provide a greater return than the current mortgage interest rate, then putting money into a house is counterproductive.
Mistakes and fallacies about renting or owning
Sometimes people buy for the wrong reasons. People make rational purchase decisions based on faulty reasoning and irrational beliefs. Most of these center around false assumptions on the financial rewards of owning real estate.
Buying for rapid appreciation
Buying a home for rapid appreciation is a fools game. Most would-be Donald Trumps base their opinion of long-term home price appreciation on short-term market trends. By the time the general public becomes convinced house prices will go up forever, they have already been rising in an unsustainable manner for far too long and most likely ready to crash.
Real estate investors during the housing bubble put their money to work on faith. There is no logical reason to believe house prices only go up. In fact, there have been two prior periods in California’s recent history where house prices did, in fact, go down. However, with kool aid intoxication, otherwise known as faith-based investing, reality is ignored.
For investors who truly believe house prices only go up, no price is too high, and they don’t have to worry about a backup plan if house prices don’t go up. There is only one viable backup plan when a speculative play on appreciation does not pan out: renting the property until they get out at breakeven. For most people, this was as far as they take their analysis. A glib idea of renting it out gives them all the assurance they need to pull the trigger on a foolish deal. If they stop to do the math, they would quickly realize rents would only cover a portion of their monthly cost of ownership. A wise person would recognized this risk and pass on the speculative bet. Investors during the housing bubble were not very wise.
Everyone who participated in the housing bubble claims a collective ignorance; “Nobody could have seen the crash coming” or some other such nonsense. Any investor who bothered to consider their plan B would have quickly realized the risk of an extended period of negative cashflow was an unacceptable risk. Prices didn’t have to crash to make this risk a pocketbook-burning reality. Even a flattening of prices for an extended period would have been a problem.
The people who ignored this risk and bought properties are now bagholders. They own property consuming their income and providing no benefit to them whatsoever. Many still cling to their denial and hope for rapid appreciation to bail them out, but many others capitulate to the market and sell. As they sell they keep prices from rising and discourage others. One by one, each market participant moves from denial to acceptance and capitulates by selling at a loss. Such is the fate of most who buy for rapid appreciation.
Renting is throwing away money
There are two legal ways to obtain the beneficial use of real estate; owning and renting. Since most people borrow money to buy homes, people are actually choosing between renting money to “own” real estate or renting real estate directly. Both forms of rentership have a cost. Owners pay the cost of renting money in the form of interest payments, and renters pay the rental rate in their lease agreement.
There are many forms of money rentership, some have fixed payment rates and some do not. The primary advantages of owning versus renting over the long term are the ability to lock in a fixed cost of ownership, and the ability to accumulate equity through loan amortization and appreciation. Of course, most people overestimate the benefits of appreciation, and this causes many of them to overpay or use adjustable-rate mortgages which negate the advantage of a fixed cost of ownership.
The key point here is that renting is not throwing away money. A renter does not participate in the change in value of the property, which in the long term is generally a benefit for a homeowner. However, if the homeowner pays far more in interest than a renter pays in rent, the renter gains a substantial short-term advantage. Further, if the owner buys at the wrong time –something often tied to paying far more in interest than in rent — the owner may participate in a decline in property values that makes their decision to buy even more costly. Renting is an insurance against a decline in home prices, and it’s a particularly valuable policy when owners are paying a premium to own near the peak of a housing bubble.
Owners are better people than renters
One of the most galling fallacies in the owning versus renting debate is the smug belief among homeowners that they are superior human beings, mentally, emotionally, spiritually superior. Their children do better in school, they demonstrate greater financial control and sophistication, they take better care of their property, and they are more valuable members of their neighborhoods and communities. Of course, the fact that they believe these things is the proof that none of it is true. Some renters do not meet the necessary qualifications for home ownership because they have emotional and behavioral problems, but the majority of renters are either young people just starting out who are on the path to home ownership, or people later in life you enjoy the freedoms of rentership. People who choose to rent are just as valuable to God and society as those who chose to buy.
The former owners of today’s featured property were very consistent. They consistently borrowed and spent every penny of appreciation the moment it appeared. The put very little down, and they more than doubled their original mortgage.
- This property was purchased for approximately $214,000 on 8/5/1999. The original first mortgage was $212,240 and there was a $5,000 stand-alone second. It’s likely the purchase prices is understated in the public record.
- On 7/30/2002 they refinanced with a $224,0000 first mortgage and took out a $32,646 stand-alone second.
- On 7/21/2004 they obtained a $310,000 first mortgage.
- On 12/1/2005 they refinanced with a $375,500 first mortgage.
- On 12/7/2006 they obtained a $65,000 stand-alone second.
The foreclosure seems to have been conducted quickly, but the outstanding mortgage balance was almost $75,000 larger than the original first mortgage which suggests they were squatting for quite a while before the foreclosure proceedings began.
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Proprietary OC Housing News home purchase analysis
$409,900 …….. Asking Price
$214,000 ………. Purchase Price
8/5/1999 ………. Purchase Date
$195,900 ………. Gross Gain (Loss)
($17,120) ………… Commissions and Costs at 8%
$178,780 ………. Net Gain (Loss)
91.5% ………. Gross Percent Change
83.5% ………. Net Percent Change
4.8% ………… Annual Appreciation
Cost of Home Ownership
$409,900 …….. Asking Price
$14,347 ………… 3.5% Down FHA Financing
3.41% …………. Mortgage Interest Rate
30 ……………… Number of Years
$395,554 …….. Mortgage
$108,045 ………. Income Requirement
$1,756 ………… Monthly Mortgage Payment
$355 ………… Property Tax at 1.04%
$25 ………… Mello Roos & Special Taxes
$102 ………… Homeowners Insurance at 0.3%
$412 ………… Private Mortgage Insurance
$140 ………… Homeowners Association Fees
$2,791 ………. Monthly Cash Outlays
($259) ………. Tax Savings
($632) ………. Equity Hidden in Payment
$15 ………….. Lost Income to Down Payment
$71 ………….. Maintenance and Replacement Reserves
$1,986 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$5,599 ………… Furnishing and Move In at 1% + $1,500
$5,599 ………… Closing Costs at 1% + $1,500
$3,956 ………… Interest Points
$14,347 ………… Down Payment
$29,500 ………. Total Cash Costs
$30,400 ………. Emergency Cash Reserves
$59,900 ………. Total Savings Needed
The property above is available for sale on the MLS.Contact us for a comparative market analysis, a cost of ownership analysis, or information on how you can make an offer today!