Are you better off buying or renting a home? If you've listened to the traditional advice, you're likely to believe buying is the better choice, providing tax benefits and giving you a leg up on long-term wealth. However, a new study by HelloWallet contends that the buy vs. rent equation has been tainted by bad assumptions.
Many buy-vs.-rent calculators overestimate the tax benefits of buying and underestimate the amount investors could earn on other investments, according to the study. In reality, median income families -- those earning roughly $50,000 annually -- got no federal tax benefit from homeownership in 75 percent of the cities studied.
On average, these households would build 50 percent more wealth over a 10-year period by renting, according to the HelloWallet research. Moreover, more than half of U.S. homeowners purchased their homes during a time when they would have been better off renting and investing the difference, according to the report.
"Workers need to take a hard look at other investment choices before deciding to buy a home," says Matt Fellowes, founder and CEO of HelloWallet. "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."
The conclusion of HelloWallet's 25-page study is that the best way to determine whether you're better off buying or renting is to calculate your "rent-to-price" ratio. If that ratio is under 5 percent, rent. If it's over, you should buy.
In other words, if you could rent a $500,000 home for less than $2,083 a month (or $24,996 a year -- just under 5 percent of the home's value), renting is likely to be the best deal. If renting would cost more -- say 7 percent of the cost of buying, or $2,900 a month -- buying is likely to be the smarter economic choice, particularly when you factor in that rents are likely to increase over time.
Of course, the biggest challenge of looking at the buy vs. rent equation is that it involves a lot of variables -- like how long you'll stay in the home, home price appreciation over that time, the returns you could earn on alternate investments over the same period, the relative cost of rent vs. a mortgage, and whether you will be able to make full use of tax deductions provided to homeowners. Making even minor changes in these assumptions -- such as assuming that someone won't itemize deductions after buying -- can swing the math.
Moreover, real people don't necessarily act like mathematical calculations assume they will. The calculators all assume that renters and buyers "invest" the same amount of cash in a home or another type of investment.
For example, if the buyer puts $50,000 in a down payment and spends $3,000 a month on his mortgage, property taxes, insurance and maintenance, the formula will assume the renter plunks $50,000 in an investment account and then spends, say, $2,000 on rent and invests the remaining $1,000.
These assumptions allow for apples to apples comparisons of investment returns and results. But on a personal level, the renter and buyer are not in the same position.
The buyer must make those "investments" in his house or risk foreclosure (or the wrath of tax authorities). The renter, on the other hand, has to pay his rent to keep a roof over his head. But he's not compelled to invest the rest. In real life, he may decide to live a little better -- go out more, travel, buy a nicer car -- instead of putting the entire $1,000 a month into an investment account.
"If I had had an extra 300 or 400 a month that I didn't have to put into the mortgage, I might gone out to dinner a few extra times instead of sinking it into investments," says Geoff McIntrye, a Long Beach realtor who owns 15 rental properties as well as his home. Owning real estate forced him to invest, he says.
That said, the vast majority of homebuyers say they bought because they thought their home was a great investment. But, in many cases, they could have done far better investing in a diversified portfolio of stocks and bonds. Moreover, for the average homeowner it's not even an effective "forced savings" plan, Fellowes says. That's because HelloWallet's research found that the average homeowner moves within 9 years. Over that time, the vast majority of mortgage payments go to interest, not principal.
A look at a loan amortization table shows the bitter truth. Consider a hypothetical buyer who borrowed $400,000 at 4.5 percent to buy a $500,000 home. His monthly payments amount to $2,027 per month. Over 10 years, he's paid $243,240. But his mortgage balance has declined by just $80,000 to $319,532. Because he's likely to pay 5 or 6 percent of the sales price to a realtor when he moves, even more of that forced "savings" evaporates.
To be sure, if the home appreciates, he'll walk away with a fair amount of cash -- the down payment, the price appreciation and the amount he's built in equity. But all too often, he'd have far more if he invested in, say, diversified mutual funds instead.
It's worth noting that HelloWallet's study isn't aimed at discouraging home ownership -- just looking at the numbers more critically, says Fellowes, who is also a homeowner. If the goal is to put down roots in a community and decorate your living space so that it suits you, home ownership may be a reasonable way to invest. But if the goal is to build wealth in the most expedient fashion, homeownership may not be the smartest choice.
"Most people think buying a home is a great investment and the online rent vs. buy calculators encourage that mindset," Fellowes says. "We are interested in finding the best path for people and that requires a lot more critical thinking."