Rent or Own Your Home? New Rules

Until the housing market began to collapse back in 2006, the decision to buy a home versus renting one was simple – as long as you were staying put at least four years, buying was nearly always better, primarily for three reasons:

1. Appreciation: Historically houses have gone up in value by an average 5 percent to 7 percent annually.
2. Tax benefits: For most people mortgage interest is tax deductible, and providing you meet IRS restrictions, when you sell, you don’t have to pay taxes on up to $500,000 of the profit.
3. Equity building: Paying rent is an expense. Paying a mortgage means building ownership.

These days, it’s a lot different because over the last several years, houses have been going down – not up – in value. The Case-Shiller Housing Index of 20 major metropolitan markets reveals that housing prices declined nearly 33 percent from their peak in July 2006 to their trough in the first quarter of 2009 – a greater decline in housing prices than our nation suffered during the Great Depression. (Better news: through May, the same index reflects price appreciation of just under 5 percent for 2010.)

In addition, due to factors like maintenance and insurance, buying often costs more than renting: The rule of thumb is 30 percent more per month. So if you bought a house back in 2006, you’ve been living a nightmare – paying extra every month to own an asset that’s dropping in value.

Rent vs. own calculators

Read most “rent vs. own” articles, and you’ll typically see advice like, “Normally it’s better to own than rent. Here’s a calculator to help you decide which is best for you.” Then they’ll show you a calculator like one of these:

• New York Times Rent Vs Own Calculator
• Smart Money Rent Vs Own Calculator
• Motley Fool Rent Vs Own Calculator

But there’s a problem with these calculators. As with many online calculators offering easy answers to complex questions, in order for them to work, you’re required to know the unknowable. For example, you’re supposed to supply the future price appreciation of real estate, annual maintenance costs, initial fix-up costs, what you expect to earn on your savings, your future tax bracket, future property taxes, future rent increases – lots of key variables that virtually nobody can possibly know.

Had you used any of these calculators back in 2006, you’d have bought a house and made the worst investment decision of your life. Maybe it’s time to understand a few fundamentals when it comes to deciding whether to rent or own. Get these down before using any calculator.

Rule No. 1: Leverage is a double-edged sword

Putting up a little of your own money, then using someone else’s to pay for an asset, is called leverage. Leverage only makes sense in one circumstance: when the value of what you’re buying is going up by more than the interest you’re paying. So if you’re paying 5-percent interest on a mortgage, the transaction makes sense if the house you’re buying appreciates by more than 5 percent a year.

The income tax advantages of owning a home alter this equation somewhat – if you’re in a 25 percent tax bracket, for example, and qualify to deduct your mortgage interest, your after-tax cost of that borrowed money drops by 25 percent. So you’re effectively paying not 5 percent interest but 3.75 percent. As long as your tax bracket and the mortgage interest deduction remain unchanged, the house would only have to rise in value by that amount to break even.

But using leverage never makes sense if what you’re buying is falling in value. That’s why financing a vacation, clothes – even cars – is a bad idea. These things already fall in value the instant you buy them. Paying interest simply makes the loss greater. That’s why you can’t decide whether to rent vs. own unless you first determine if housing prices are likely to increase.

Rule No. 2: See if prices are likely to rise by measuring supply and demand

As I said in my recent story, Why You Should Buy Stocks and Houses Now, I believe we’ve seen the lows in housing prices and stocks and now is a good time to buy. But even if I’m right, nationwide, housing – unlike stocks – is often influenced by local conditions. It’s possible that the Miami market goes down while the Rapid City market goes up. So you’ve got to look at the local market where you’re considering a purchase and make this determination yourself.

The price of virtually everything – including houses – is determined by demand and supply. How do you determine the demand for housing? One simple way is jobs. If jobs are abundant, the population should be growing and the demand for housing should also grow, leading to higher housing prices. According to the Bureau of Labor Statistics, the unemployment rate in South Florida is about 12 percent – 20 percent higher than the national average. In Rapid City, unemployment is only 4.3 percent – less than half the national average of 9.6 percent. Providing that trend remains intact, housing prices in Rapid City should be more stable and more likely to grow than those in Miami.

Another way to measure demand is to contact a local real estate office and ask how long houses are staying on the market in the neighborhood you’re interested in and how close actual sales prices are to listing prices. The closer asking prices are to sales prices and the shorter the time houses sit on the market, the better.

As for supply, you can ask a real estate agent about the inventory of unsold homes in the area you’re considering. You can also contact a local Board of Realtors (here’s a list of state and local associations). The lower the supply, the better.

What you’re looking for in all these numbers isn’t just today’s numbers – it’s the trend. Is the unemployment rate improving? Is the population trend upward? Is the days-on-market gradually declining? Is the local inventory of unsold homes shrinking?

Rule No. 3: Consider that tax advantages of ownership may decline

I started this article with three reasons owning a home is better than renting. The first was appreciation – what we just discussed. The second was tax benefits. As with appreciation, the tax benefits of owning have historically been regarded as a given. But as our nation’s ballooning deficit becomes the center of Washington’s attention, that may not remain true. According to the Congressional Budget Office, total government subsidies for home ownership were $230 billion last year – a tempting target for Congress.

While it’s unlikely that the deduction for mortgage interest is in danger (at least for the foreseeable future) there are other critical elements of public policy that could change. For example, 30-year, fixed-rate mortgages are largely dependent on government guarantees. With taxpayers on the hook for billions in losses from mortgage guarantors Fannie Mae and Freddie Mac, it’s possible that these mortgages may ultimately be shorter, carry higher interest rates and require bigger down payments. Should changes like this occur, getting in under the wire may help you buy a house today but reduce the demand for housing when the time comes to sell.

It’s still early in the game to worry about what could happen with the tax benefits of home ownership. The point, however, is that this wasn’t even a consideration when “buy v.s rent” calculators like those above were developed. Now it is. Keep your eyes peeled for articles that might offer a hint as to which way the wind is blowing, starting with this one at USA Today.

Rule No. 4: Really compare renting vs. home ownership

In some cities – notably bubble markets where prices appreciated the most – rents have come down a lot as formerly foreclosed homes flood the rental market. In others, foreclosures have pushed housing prices down so much that it’s much better to buy than rent. So now more than ever before, it pays to really evaluate what you could be renting with the same money that you’d use to buy – especially in markets where future appreciation may be more in question due to high unemployment and large inventories of unsold homes.

Trulia.com recently began a rent vs. buy index for top metropolitan markets that offers some insight. But wherever you’re planning to live, don’t just look at houses for sale. Really look at the rental market. Unless you’ve determined that prices are about to take off based on supply/demand factors, if you can rent something for significantly less than the cost of owning it, it may pay to do so. At least until market conditions begin to change.

Bottom line? This isn’t your parent’s real estate market any more

Many of the factors that made home ownership a part of reaching adulthood are on shaky ground. I stand by my assertion that now’s a good time to buy. But in the 30 years I’ve been buying real estate, there’s never been a time when it’s been more important to really think it through.