By Chris | April 17, 2010
I have two friends in the graduate program who were on the market this year and accepted jobs. Both have been house hunting. One has already purchased a home. The other intends to soon. Home ownership is something I’m looking forward to. I’d love to have a library, a fireplace, and maybe even a secret passageway. However, I have no desire to saddle myself with a 30-year mortgage, annual property taxes, and the obligation to pay for maintenance and repairs anytime soon. When my toilet breaks, the refrigerator stops working, or the water pipes freeze, it’s nice to just call my landlord.
So, I asked my friends why they were so eager to own. Here is the response I got:
- Paying rent is throwing your money down the drain
- A mortgage is forced savings
- The house will appreciate and I will be able to live rent free
I was dismayed. These are economists! In fairness, one of my friends owned a home in graduate school and it did appreciate quite a bit. Nevertheless, after the recent housing bubble, it’s quite clear that housing values don’t always go up.
Anyway, I was pleased to see this article on the Mint.com blog by home ownership critic Matthew Amster-Burton:
We’re not so different, Joe Homeowner and me. I rent property from a landlord. He rents money from a bank.
Every month, I write my landlord a check. The money gets spent on orthodontia for the landlord’s kids, and I will never see it again.
Every month, Joe writes his banker a check. The interest portion of the payment–for Joe, that’s well over half the payment, more than I spend on rent for a similar home–gets spent on polishing the banker’s yacht, and Joe will never see it again.
Matthew provides some great evidence that housing prices don’t rise much faster than inflation. I’d like to take a different approach, and start from the assumption that if markets are competitive, it should be equally expensive to rent or own something. Owning things often seems cheaper, but that is because it is easy to ignore depreciation and opportunity cost. When is the last time you gave someone a ride and they offered to offset your opportunity cost of owning the vehicle? By opportunity cost, I mean that if you had $20,000 instead of a car, you would be earning a return on that money. But, I’m getting off track.
In theory, why might renting be more expensive than owning?
1. Asymmetric incentives. Renters don’t have an incentive to maintain property. I live in a college town, and renters trash places. They throw parties and break things and pour grease down the drain. They don’t have an incentive to do otherwise. If I rent a car, I don’t check the oil and I don’t worry about wear and tear on the brake pads. Therefore, it should be cheaper to own. But, this becomes less of an issue the more easily you can vet tenants and and punish those who damage the property.
2. Tax rules that favor buyers. This is only true to the extent that those tax benefits do not also accrue to owners who rent out their properties. The interest deduction for mortgages isn’t relevant for most people because they take the standard deduction anyway. However, it may be cheaper to buy if you qualify for a limited time home ownership credit.
3. Houses are a risky asset and landlords are compensated for carrying that risk. As a renter, you are not subject to the vicissitudes of the market. If most people are risk averse, landlords must be paid a premium for carrying the risk of a mortgage. I don’t find this argument too convincing because landlords can purchase homes across the country diversifying the risk away.
What about the fact that most Americans have a strong desire to own their own home? At first I thought that this should make rentals cheaper. Used furniture and clothing is a bargain because people like new things. But, the same concept does not apply here. In this case, it is the renting, not the house itself, that is considered inferior. The price shouldn’t depend on the popularity of renting. However, since most Americans would prefer to own a home, renters are signaling that they are unable to purchase a home. People that are unable to purchase a home may be more likely to damage property that they don’t own. Or, they may be more likely to use drugs or engage in criminal behavior. Ultimately, the preference for homeownership leads to a selection bias of tenants that exacerbates #1.