Conventional Wisdom
People can decide to rent or buy a home based on a detailed financial analysis, or a careful consideration of preferences, or both, but in fact they often make the decision based on belief or commonly accepted notions of what makes the most sense in a given situation. (Most people, in fact, first decide to buy a home then carry out an analysis of where and what to buy.) As it happens, this has not been a bad way to decide, since conventional wisdom has established rules of thumb that have pretty much worked, at least in the United States since the second world war: if you think you may move in a few years, rent, otherwise buy, particularly if you are a young family with children.
Why It Works
The conventional wisdom generally works because it reflects the preferences and experiences of a majority of people: most Americans have simply preferred to own their own homes, and economic trends and policies have rewarded that decision. Whether people have been fully aware of this or not is beside the point: it's worked. To put it in terms of the financial analysis described above, appreciation in home values plus tax considerations have more than offset any lost income from other investments. This is particularly the case because it is only recently that the average person has had easy and cost-effective access to more profitable, if more risky, investments, and for much of the post-war period other investments, such as stocks and bonds, had mixed success (anyone remember the '60s and '70s?).
Ownership as Inflation Insurance
The conventional wisdom also incorporates other, indirect financial benefits. One is the value of ownership as insurance against inflation. Home prices and rental values both tend to increase with inflation, as do such ownership costs such as maintenance and taxes, but the chief ownership cost, the mortgage and its interest or the cash and its foregone interest, remains nominally the same regardless of any increase in housing costs or general inflation. By owning your home you lock in your housing costs. In fact, in real terms your housing costs fall with general inflation, because the share of your income spent on housing goes down, assuming your income increases with inflation. (But note that inflation erodes the value of the mortgage interest deduction just as it erodes the value of the mortgage: assuming your income increases the deduction will be worth less.)
But ownership costs are also locked in when deflation occurs and housing prices and rents fall. This means owners can find themselves paying more for housing than necessary, because their costs remain the same while housing costs in general have gone down. And if incomes also fall, owners' real cost of housing goes up, because they then are paying a greater share of income for housing.
While on the whole deflation and declining housing prices have not been a problem in the United States since the second world war, housing markets are intensely local, and some areas have seen considerable declines in housing prices even as other prices have gone up. Note too that timing is critical: inflation and housing markets are volatile: while prices may increase steadily over say 10 or 20 or 30 years, there can be considerably sharper increases and decreases over shorter periods. This is particularly true of local housing markets and economies. For example, housing prices in the San Francisco Bay Area increased for much of the late 1970s and 1980s, but fell during the 1990s, then rebounded sharply from 1995 through 1997 (with prices in some areas increasing in 1997 by 20 percent, compared with a national inflation rate of less than three percent).
Ownership as Savings
Another indirect benefit of home ownership is it forces owners to save. While paying for a home is almost always far more burdensome than renting, because initially a larger share of income goes to housing, that money is buying an investment that should appreciate and increase the owner's net wealth. While a renter could take the same share of income and invest it (and that is assumed in the financial analysis), in practice that is much harder without the compulsion of a mortgage payment. And the mortgage interest deduction and capital gains exemption make home ownership a tax-advantaged savings plan.
But notice the words "should appreciate": just because housing prices have appreciated in the past does not mean they will in the future. Homes are not savings accounts: there is no guarantee of how much or whether they will appreciate. Furthermore, owning a home is a highly illiquid form of savings: it is usually difficult to shift money out of a home to invest in any other, better paying, investment that comes along. (But home equity loans are making this easier.) And it is the availability of better paying investments that makes some people advise against spending money on owning a home. As it is usually put, there is a risk of not making as much money as possible.
Other Investments
The risk that other investments would be more profitable than buying a home is a real one, which is why our financial analysis includes an opportunity cost, which should reflect the interest paid by other investments of similar risk, duration, and tax treatment. Adjusting for these factors is critical, because investments that are riskier, longer term, or more taxed should always be more profitable to compensate. (But it is another commonplace that investors should hold a variety of investments with different risk factors, balancing security and low returns in some with greater risks and higher returns in others.)
Also, historically, other investments, such as stocks and bonds, have been less accessible to the broad population because transaction costs were high (with brokers almost always necessary), financing difficult (it is considerably easier to borrow money to buy a house than to buy stock, and easier to borrow against a house than stock - ever hear of a stock equity loan? well, yes, buying "on margin"), and government support lacking (a wide range of policies has long supported the buying of homes; it is only recently that there has been support for other investments). Finally, whatever the profitability of other investments, most people in the past were not comfortable with them, especially after several stock market crashes from after the Civil War to the Great Depression, and did not understand them.
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http://www.mindspring.com/~wheiser/RentBuy/rb08.htmLast updated March 20, 1998
Wayne Alan Heiser, wheiser@mindspring.com
Copyright 1998