Renters can acquire wealth as well as homeowners
Renters who save and invest can acquire wealth just as well as homeowners who rely on their house as their biggest asset.
Over the long term, home ownership is superior to renting because homeowners fix their housing costs whereas renters pay an ever-increasing housing cost. In fact, I believe owning a home without a mortgage is the best retirement savings plan available because it provides the opportunity to permanently and dramatically lower an owner’s housing costs.
In addition to the fixed cost of ownership, an amortizing mortgage serves as a forced savings account, providing financial discipline that may otherwise be lacking. Of course, lenders pervert this benefit by offering mortgage equity withdrawal, but the forced savings benefit is still significant, assuming disciplined owners avoid spending their equity.
Further, tax benefits including the home mortgage interest deduction helps owners defray the costs, but one of the biggest advantages of home ownership is a tax break people seldom think about: a large capital gains tax exemption. If a family’s house goes up $500,000 in value, they pay nothing on the gain. If their mutual fund goes up the same amount, they will pay 20% in capital gains taxes, a $100,000 hit.
Despite these advantages, it is not always better to own than to rent. It largely depends on what rate of return a renter can obtain on the money not invested in a home, assuming the disciplined renter saves at the same rate as a homeowner who is forced to save 8% of their income in amortization.
The calculations on this site that display the cost of ownership for every property has a poorly understood adjustment labeled “opportunity cost,” the cost of taking money out of a competing investment to put it into a home purchase.
When renters decide whether to own or to rent, they must consider their opportunity cost; what financial returns would they enjoy if they didn’t buy a house and invested in something else instead. I use a formula based on the mortgage rate that assumes the renter is earning less than the mortgage rate in a safe investment like savings accounts or short-term CDs. While this is the best method for most people, some renters have unique opportunities to earn more.
Some renters may chose to invest in their own businesses (like me), or they may invest in rental properties or other stable investments earning higher returns. Generally, these competing investments are riskier, and over the long term, most won’t earn a higher rate of return than their mortgage rate (if they could, they would be better off borrowing against their house to invest, a strategy most people lose at).
Under most circumstances for most people, buying a house and paying off the mortgage is the best use of money over the long term; however, for a small group with unique investment opportunities, renting may be a better path to wealth.
House of Cards: Morningstar’s HelloWallet Unit Examines How Buying a Home vs. Renting and Investing Affects Wealth Creation
Study finds the median-income household could generate more than 50 percent more net wealth over the next 10 years by renting and investing instead of buying a home.
CHICAGO, Nov. 11, 2014 /PRNewswire/ — HelloWallet Holdings, Inc., a leading provider of online financial wellness and a Morningstar company, today published a new research paper, “House of Cards,” which examines how the decision to rent or buy a home affects wealth creation for American workers. This paper brings a new perspective to families’ unique decisions to buy or rent a home by analyzing the historical tax benefits and wealth-building opportunity costs of home ownership. Aron Szapiro, a consumer finance researcher for HelloWallet, authored the paper.
The paper includes two analyses. The first examines historical home purchase data from the Federal Reserve Board’s 2013 Survey of Consumer Finances. Szapiro compares how much wealth Americans would have created had they rented a comparable home and invested any savings in a portfolio of stocks and bonds over the home ownership period.
With the volatility of the housing market over the last 30 years, particularly in California, the period selected will strongly influence the results. Owning real estate over the last 10 years was a poor investment with a major, unnerving decline. If this same study was conducted in 2006, real estate would have come out as the best possible investment among all other alternatives.
The second analysis looks at two hypothetical households—one earning $50,000 per year and the other $100,000—living in 20 major cities to examine the effect of state and local tax structures on the buy versus rent decision. HelloWallet’s research finds:
- A median-income U.S. household ($50,000 in annual income) could generate more than 50 percent more net wealth over the next 10 years by renting and investing instead of buying a home.
These results will also be sensitive to the cost of ownership and the cost of renting at start up. For example, in San Francisco where it’s already much more expensive to own than to rent, it will take many years of rent increases before the monthly expenditure balance tips back in favor of ownership, but in Riverside County, home owners obtain significant monthly savings over renting from the start.
- Median income homeowners realize no federal tax benefit in 75 percent of major cities.
The tax savings calculations on this site take into account the loss of the standard deduction. For properties under about $200,000, there is no tax benefit at all. The cost of mortgage interest does not exceed the standard deduction.
- More than half of current homeowners, or more than 40 million households, purchased their homes during time periods when average homebuyers would have been better off renting and investing.
This is a direct result of the housing bust. Hopefully the cycle of boom and bust is over (or at least muted), and under normal circumstances households do not benefit by renting over a 10-year period.
- Many popular, free, online “buy-or-rent” calculators inflate the benefits of home buying. The study shows that calculators provide inaccurate guidance to more than 90 percent of renters considering whether to buy a home by overestimating tax benefits and underestimating the returns an individual can earn by investing.
Buy or rent calculators are awful. In fact, one of the main reasons I developed the calculations on this site was to combat the erroneous crap found in these online calculators. Most were developed by realtors or their proxies, and they always overstate the financial benefits of owning versus renting because realtors want to manipulate people into buying rather than renting; their self-serving desires cause them to trample the truth. Many realtors solace themselves by saying the family they cajoled into buying will be better off in the long term, but this is mere rationalization for the agent’s bad behavior.
- Prospective home buyers should calculate their “rent-to-price” ratio, or the ratio of the annual rental costs of a home compared with its purchase price, to determine whether to by a home or rent and invest. If the rent-to-price ratio is 5% or less, people may be better off renting and investing any savings. If the rent-to-price ratio is greater than that, they may be better off buying a house.
“While there is no question that homes have become the most valuable asset for U.S. households, our research finds that homeownership is often not the best strategy for building wealth,” Matt Fellowes, founder and CEO of HelloWallet and a former scholar at the Brookings Institution, said. “Workers need to take a hard look at other investment choices before deciding to buy a home. Employer-sponsored retirement or health savings programs, 529 college savings plans, or even IRAs may be more effective vehicles for families to build wealth and get ahead.”
It’s important to note where home ownership fits in to an overall investment plan. A large portion of a retirement investment portfolio should be in conservative, low-risk investments. Owning a house and paying off the mortgage is in that bucket. However, to have a more comfortable retirement, people have to take on more risk and get better returns, and these alternative investments should be pursued in addition to paying off a home mortgage.