I recently read this article on Smart Money, making the argument that renting a home, and using money saved each year to invest in stocks, was a smarter financial decision than owning a home. He brushes off pro-ownership arguments as clever uses of emotional language "throwing money away," "pride of ownership," and so on, claiming that stripped of emotional considerations, it's actually homeowners that are throwing money away.
His argument basically boils down to stocks having a real return of 7% annually over the long term while houses only match inflation. Factoring in that homeowners have maintenance costs that significantly offset the rent saved by owning, this makes renting the superior financial decision.
This clearly flies in the face of conventional wisdom, and reading his argument, I was unconvinced. So I've spent the last couple of days thinking on it and trying to determine the fallacy in the argument - I was pretty sure it had something to do with the way he threw away inflation - and I think I've nailed it down.
So I ran my own analysis using his numbers, but this time adding inflation back into the mix. My world works like this:
- Average annual inflation: 3%
- Average annual stock returns: 10% (7% real return)
- Increase in house prices and rents: 3% (0% real return)
- Each year the homeowner must lay out 2% of the current value of his home in upkeep costs and property taxes.
- annual rent paid is 5% of the current house value
- A 4.3%, 25-year mortgage interest rate (ING Direct's current 5 year fixed rate)
- Any money saved in a given year will be put into the same stock investments regardless of which party saves it
- $1000 in closing costs for purchasing the house.
I looked at the 40 and 50 year time horizons, figuring that these represent the years around retirement, when you are most likely to be interested in your equity.
Okay, so using these numbers, it turns out that the renter will indeed finish richer. Interestingly, though, the homeowner will have more equity during years 2-6. If homes generate even a modest 1% real return, this homeowner advantage lasts to year 19.
But, I tried some tweaking of my admittedly simple model. Here's some situations where the homeowner will be wealthier than the renter:
- High inflation. If inflation is equal to the real return on stocks, (7% in my model), the homeowner has an advantage up until year 39. 1% more than stocks' real return, and the advantage lasts the full 50 years that I'm looking at.
- Rent is more than 5% of purchase price. If rent is 6.6% of purchase price, the 50 year mark is in the owner's favour. This represents a 15:1 ratio between rent price and purchase price. I consider this to be the most likely situation, since the 5% used in the article is kind of a bait and switch - he uses long term averages for the maintenance cost relative to purchase price, but only the rent to purchase price achieved during a market peak.
Effect of interest rate
My model wasn't well set up for dealing with changes in interest rates. Notably, I was kind of lazy about setting up the annual payments. Should I feel like revisiting this, version 2 will have better handling of interest rates.
There's of course lots of other factors in here. Aside from the emotional decisions - stability, pride of ownership, etc - there's also some variables in terms of people's ability to manage their money. Most people, having made the decision to be lifelong renters, will not figure out what owning a place would have cost them, and then put whatever savings they have over than into an investment account. Most people will wind up increasing their standard of living instead, so some of my assumptions about growth on money saved each year don't translate well in the real world.
Even if stock markets continue to match historical long term averages - which is by no means certain - it's unlikely that average individual investors will exactly match this performance. While index funds make this easier, they have small but still material management fees that over the long term may kill the homeowner's advantage.
I haven't independently researched the ratios used in the original article, and just accepted them as truth. Logically, I've having trouble with the idea that house prices and rents have both matched inflation, but the ratio between the two has more than doubled.
The decision to buy or rent is not as clear cut as most Canadians believe. Deciding between the two, even if we stick purely to a financial calculation, requires making a lot of assumptions about how the world is going to behave in the future. The difference between the two can be significant in one model, but making a small change to one of the many variables involved, come out showing the exact opposite.
Myself, I'm still happy to own a home, and don't think I much want to sell in the near future. But this project has, I think, shown that I obsessed too much about home ownership, that delaying home ownership doesn't necessarily put you behind.