The Home Equity Fallacy
Building home equity can increase your financial security, but it isn’t necessarily the best way to maximize your net worth. That is, building home equity quickly isn't necessarily the right choice for everyone, not even those who have the financial wherewithal to do so.I’ve frequently heard two statements relating to home ownership that hold true for some people, but I consider them to be fallacies when applied to everyone.
It is always better to own than rent.
If you own, you should pay off your mortgage as quickly as possible.
There are definitely people, including me, for whom one or both of these statements are true. However, in the current mortgage interest rate environment, neither is true for people whose primary financial goal is to increase their net worth!
In this post, I’ll talk about the theory behind how rent is determined, provide a simple framework for comparing options for ownership and renting, and apply that framework under a number of different scenarios to see what happens to your net worth.
Your Priorities and Situation
Before digging into the analysis below, you’ll want to identify your priorities. The analysis below assumes that your primary financial goal is to maximize your net worth. It also assumes that you are indifferent between renting or owning from a lifestyle perspective. And, it assumes you have the ability to handle the risks of home ownership. All of these considerations are discussed in more detail in this post. You'll need to consider the extent to which these assumptions apply to you before you use the findings below to inform your decisions.
In many situations, the analysis suggests that either renting or paying down your mortgage (i.e. building home equity) slowly will maximize your net worth. However, many people, including me, prefer to have as large a home equity as possible. Characteristics that might put you in the same category as me are that you are:
Living off your investments and a preference to eliminate a monthly mortgage payment from your cash expenses.
Averse to risk, leading you to not want to find that your investments have decreased in value at the same time you need to liquidate them to make mortgage payments.
Someone who likes the comfort of knowing that, in all but the most extreme scenarios, you have a place to live.
Planning to use the equity in your home as collateral for a reverse mortgage to finance retirement expenses.
Because I have all three of the characteristics, and because my first few home purchases happened when mortgage interest rates were between 9% and 17%, I paid off my mortgages as quickly as possible. I also paid cash for my most recent two residences with the proceeds of the sales of their predecessors.
Finances Rent vs. Owning, in Theory
In theory, the economic cost of renting should be more than economic cost of owning. First, the owner needs to make a profit to cover opportunity cost of owning the property. Second, the owner is taking on risk from the uncertainty in their ability to find renters and the cost and timing of repair costs for which the owner needs to be compensated.
An important consideration, though is the difference between the economic costs of ownership vs. renting and the cash flows of both options. Specifically, your down payment and the portion of mortgage payments that go towards principal are not part of the economic cost of owning your home. The principal portion is a transfer from cash to equity in your home. As such, from a cash perspective (as opposed to an economic perspective), you will often need to pay more in cash to cover the costs of home ownership than to pay rent.
The economic cost of the equity in your residence is the opportunity cost of not being able to invest it elsewhere. This amount differs from the amount of your down payment and mortgage payments. The value of your home may increase, so your opportunity cost is the difference between the return you would earn if you invested your money in a different asset, such as the stock market, and the appreciation in the value of your home.
Appreciation from Ownership
When I was young, most people assumed that the price of houses went up every year. Reality has shown that not to be the case, both when looking at regional and local conditions and also when looking at US nationwide housing price changes. The chart below shows the average price changes by year from 1988 to 2019, the length of the period available for the Case-Schiller US National Home Price Index on the Federal Reserve website.
As you can see, in most years, the price of houses went up. However, in 1992 and from 2008 through 2012, the prices went down with the worst year, 2009, reporting a 12.6% decrease in home values.
Other Considerations
A comparison of the financial aspects of renting and owning also has to consider what you are willing to rent as compared to what you might buy. The inferences above apply only if you are renting and buying the same residence. If, on the other hand, you are willing to rent an apartment but are only willing to buy a house, the rental option can become much more attractive. There are economies of scale gained from running an apartment complex that aren’t available to owners of single family homes. Also, you might be willing to rent a residence that is smaller than one that you might buy. Again, if that is the case, the rental option might be more attractive.
Rent vs. Own – Simple Illustration
To help you understand the finances of renting and owning your residence, I’ll start with a simple illustration. In it, I compare three options:
Buy your residence
Rent the same residence
Rent a smaller property
Key Assumptions
Here are the key assumptions for the three options.
Buy Your Residence
I selected a 1,500 square foot house in Des Moines, Iowa for my illustration. A typical house that size there has a current market value of about $240,000. The countrywide annual average appreciation is 4% every year. I have assumed that you pay 15% as a down payment and have a 30-year fixed-rate mortgage at 3%.
Utilities are assumed to be $200/month and property taxes and homeowner’s insurance total 1.5% of the market value each year. In addition, I’ve included 2% per year for maintenance and repairs and 0.5% per year for updates. These costs are assumed to increase with inflation at 3% per year.I’ve assumed $1,000 of closing costs at both purchase and closing plus a 5% sales commission when you sell.
Last, I’ve assumed that you leave $10,000 in cash in an emergency fund at all times.
Rent the Same Property
The same house rents for about $1,400 a month, including utilities. I’ve added renter’s insurance at $120 per year. Both of these costs are assumed to increase at 3% a year for inflation.
Under this strategy, I assume that you invest the down payment plus emergency fund money at a 7% return per year. The mortgage payments plus other costs of home ownership are more than rent and renters insurance, so I’ve assumed you also invest the difference at 7% per year.
Rent a Smaller Property
If, instead of a house, you choose to live in an 1,100 square foot apartment, your rent is only $1,100, including utilities, increasing with inflation. As with the previous strategy, differences between the costs of home ownership and the cost of renting the smaller property are assumed to be invested at 7% per year.
Net Worth Comparison
This section contains a simple comparison of your net worth under the three options described above – own your home, rent a similar home or rent something smaller. For this illustration, I’ve assumed you own your home for ten years.
Ownership Cash Flows
The chart below shows your annual cash flows using the assumptions above if you buy a home and sell it in ten years.
The dark blue bar on the left is your down payment, buyers’ closing costs and the $10,000 of cash you set aside for an emergency fund. The subsequent ten bars show your mortgage expense (orange), property taxes and homeowner’s insurance (gray), utilities (yellow) and maintenance, repairs and updates (light blue).
After ten years, under the simple assumptions, you can sell your home for $355,000. From that, you pay 5% in real estate agent commissions and $1,000 in seller’s closing costs. In addition, you don’t need the $10,000 in your emergency fund. Thus, at the end of ten years, you get $346,000. From that, you need to re-pay the remaining $150,000 of mortgage principal, so your net worth is $196,000. Of that $196,000, $106,000 is from appreciation in the value of your home and $40,000 is from the principal portion of your mortgage payments.
Annual Cash Flow Comparison
The chart below compares the annual cash flows from the three options over the ten-year time period.
The blue bars show the total of the cash flows in the previous chart from owning your home. The yellow bars show your cash flows for renting the same home and the gray ones for renting a smaller residence. These last two sets of bars include rent and renter’s insurance. I note that the blue bars are taller than the yellow bars because they include your down payment and the principal portion of mortgage payments, both of which allow you to build equity in your home.
Net Worth Comparison
If you own your home, your net worth increases from the appreciation in the value of your residence. Because you have borrowed some of the money to pay for your house, your percentage growth rate of your home equity is higher than the appreciation rate of the house itself. This result is called leveraging, as you get the dollar value appreciation of your house while investing only a portion of it yourself.
If you don’t own your home, you can invest the difference between the cash flows represented by the blue bars and those represented by either the yellow or gray bars. For this simple example, I’ll assume that you earn a 7% annual average return on your money by investing it in the stock market. To further keep the example simple, I ignore income taxes.
The chart below compares your net worth under the three strategies at the end of ten years.
In the Buy Your Home option, your net worth is equal to your home equity after you sell.In this illustration, you have a higher net worth if you buy your home than if you rent the same home. However, your net worth is much higher if you rent the smaller apartment than if you buy your home.
Rent vs. Own – More Realistic Illustration
In the simple illustration, I ignored risk. All four of mortgage rates, inflation, home appreciation and stock market returns vary widely from year to year. In the more realistic illustrations, I use the actual values of these economic variables for each period starting in 1987 and ending in 2019 to introduce volatility. I’ve looked at this time period because 1987 is the oldest year for which I could find home appreciation values. Had I used even older time periods, mortgage interest rates would have been outside the range of what is shown here, so the probabilities should not be considered representative of all possible results.
I show four sets of comparisons to increase the likelihood that one of them is close to your situation. In the first comparison, I use the same assumptions as in the simple illustration other than the economic variables. I increase your down payment from 15% to 50% and 100% of the purchase price in the second and third comparisons. In the fourth comparison, I retain the 15% down payment assumption but change only the time period you own the home from ten years to two years.
10 Years; 15% Down
The box and whisker plot (described in this post in case you aren’t familiar with reading one) below compares the simulated values of your net worth (i.e., your home equity) after you sell your home if, under the Buy Home strategy, you own it for ten years and put 15% down.
Because I used ten years of inflation and stock market return data, the data used in the graph include 23 ten-year periods, those starting in each year from 1987 through 2009. The boxes represent the range from the 25th percentile to the 75th percentile of your net worth under each strategy. The line in the middle of the box is your average net worth. The whiskers that stick out of the boxes range from the 5th to the 95th percentiles.Using these assumptions, the range of ending net worth values from renting the apartment (gray box) are almost always higher than either of the other two strategies. At the average (solid line in the middle of each box), you have a very slightly higher net worth if you buy your home (blue) than if you rent the same home (orange). The range of your net worth is wider if you rent the house and has a higher upper end, due to the possibility of attaining high investment results. Over a ten-year period, the average return on an investment in the S&P 500 is very rarely negative, so you never have a lower net worth from renting as compared to buying the same home based on this time period.
10 Years; 50% & 100% Down
The higher your down payment, and therefore the higher your equity in your home, the higher your net wroth from renting as compared to buying, as shown in the two charts below.
The higher ending net worth values when you rent in the comparisons with bigger down payments emanate from the larger amounts that you have available to invest. That is, if you are comparing your net worth after renting to the option in which you pay for your house in one lump sum of $240,000, you have the full $240,000 available to invest for the entire ten years. But, when your down payment was 15%, you had only $ $36,000 (15% of $240,000) to invest for the full period plus the amounts that you paid in principal each month.
2 Years; 15% Down
Another scenario in which your net worth will be higher from renting than from buying is if you plan to own your home for a very short period of time. For illustration, the chart below compares your net worth if you own your home for only two years and put 15% down.
Your ending net worth is generally higher under the two rental options than the buy your home option. However, the difference is not as clear as when you pay cash for your house. There is much more volatility in stock market returns when looking at only two-year periods as compared to ten-year periods, so the range of results under both rental options (in which you are investing your extra cash) is much wider than in the ten-year scenarios.
Conclusion
These analysis show that, in many cases, your net worth will be higher if you rent than if you own. However, as noted above, maximizing your net worth is not everyone’s priority when it comes to their residence. As such, you'll want to consider your priorities and preferences along with these findings in making your decision to buy or rent.
