February 29, 2024

Economix: Building Wealth Through Renting

Buying a home rather than renting may not be the best financial strategy, a Fed official says.Reed Saxon/Associated PressBuying a home rather than renting may not be the best financial strategy, a Fed official says.

You have probably heard a version of the idea that renting a house is tantamount to flushing money down the toilet, while buying a home is building equity for your future. Well, it’s wrong, at least much of the time.

You don’t have to listen only to me on this point. Here is Jordan Rappaport, a senior economist at the Federal Reserve Bank of Kansas City, in a paper published last year:

Conventional wisdom has long suggested that homeownership is an effective way to build household wealth. Consistent with this belief, homeownership is often considered to be a key part of the American Dream….

[Yet the] analysis in this article shows that while homeownership often builds more household wealth than renting and investing the saved cash flow, it also often does not. More specifically, for most ten-year occupancies beginning during the 1970s and 1990s, homeownership unambiguously built more wealth. In contrast, for most occupancies beginning during the 1980s, renting and investing unambiguously built more wealth. Renting and investing is also likely to build more wealth than homeownership for many of the occupancies that started in 2000 through 2009. These results suggest that either homeownership or renting and investing can be reasonable strategies for building household wealth.

In other words, the conventional wisdom that homeownership is usually the better strategy is probably too strong. For many households in many years, renting and investing the saved cash flow has built more wealth than homeownership…

[Emphasis added.]

I also had a nice exchange yesterday with a reader on this issue. He asked:

As a soon-to-be first time homebuyer [in Manhattan] still debating the merits of renting vs. buying, the idea of throwing tens of thousands of dollars in rent down a hole for the next few years is very unappealing — that is, when the alternative is to pay a bit more each month in mortgage fees and taxes, but to at least have substantial equity at the end of the day. Am I thinking about this too simplistically?

I replied:

Yes, building equity is a good thing. But the advantages of it are exaggerated.

For one thing, how do you know you’ll be building equity, as opposed to making an investment that will lose money? People who bought in Florida, Las Vegas, Phoenix and much of inland California in 2006 thought they would be building equity. I interviewed some of them. But they did not. In many cases, they lost all of their equity. There is definitely some downside risk in the New York market today.

Second, by buying a house, you’re making a decision to tie up your capital in a specific sector — real estate. It’s entirely possible that the money you spent on a down payment would have earned more money in the stock market, for instance.

Finally, buying also involves throwing thousands of dollars down a hole: in mortgage fees and interest, in property taxes, in repairs and renovations, in tens of thousands of dollars of closing costs. Renting doesn’t involve the huge up-front costs that buying does. Owning also involves some continuing costs (e.g. repairs) that renting does not.

Living somewhere is always going to involve costs, just as education, health care and food involve costs. Financially, the decision to buy is basically a decision that your investment will increase in value by an amount sufficient to make up for all the additional costs of buying. (Put it this way: you’d never buy an apartment if you were staying in a city for just a week, in an effort to build equity. You’d rent — a hotel room.)

Sometimes — often — the decision to buy works out. But it does not work out far more often than is commonly understood.

Article source: http://feeds.nytimes.com/click.phdo?i=a80ef465514c8c1814526a115fb01455

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