house.jpgIf you bought a house in Los Angeles in the early ‘90s, you were “catching a falling knife.” Home values were falling. Thousands of buyers in that period spent most of the decade “upside down”--- owing more than they could get if they sold.

Today, whatever the angst about the current market, all those knife catchers are sitting pretty. The upside-down years are a distant memory.

I thought about that as I read reader responses to a recent column taking a long-term consumption-smoothing approach to the purchase of a pricey San Diego house. The exercise showed that buying such a house could be beneficial even if real estate values fell --- provided the buyer lived in the house for a very long time.

In areas where the monthly cost of owning is a big premium over the cost of renting, a long-term approach still showed that owning produced a higher lifetime standard of living than renting.

Reader reactions ranged from suggestions that I had lost my mind to, well, howls of -excoriation. So this may be a good time to remind ourselves of the one simple reason homeownership has done so much for so many.

Whatever the current market, it remains that people who intend to be in their homes 15, 20, and 30 years from now will do just fine.

This won’t happen because of generous tax breaks. Wild appreciation would make things better, but it isn’t necessary. This happens because owning a house is the easiest way to make inflation work for you rather than against you.

Suppose, for example, that you are a young family thinking about buying a house in Lewisville, a suburb of Dallas. There, you can find relatively new houses of about 2,000 square feet with three or four bedrooms, two baths, and a two-car garage for about $150,000. If you bought such a house with a 20 percent down payment and a 30-year mortgage at 6 percent, it would cost $8,634 a year for the mortgage and about $7,500 a year for taxes, insurance, and upkeep (based on 5 percent of market value). The total out-of-pocket cost would be $16,134 a year.

Long term, this would put you way ahead of a renter even though the same house could probably be rented for about $15,000 a year or $1,250 a month.

How can this be?

It isn’t because of your fantastic tax deductions. They may help the people in Boston and San Diego to buy pricey condos, but they don’t do anything for people with average incomes in most of the country.

Skeptical? Let’s do the math. The mortgage interest is about $7,200 in the first year. The real estate taxes are about $3,000. The $10,200 total is less than the $10,700 standard deduction for a couple filing a joint income tax return. So it’s hard to argue that Uncle Sam is giving this couple a big tax break. They may get a tax break for itemizing deductions, but they’ll have to find some other deductions first.

The benefit comes from the decline in the real cost of the mortgage. Even modest inflation will cut the effective cost of the mortgage dramatically over 30 years. And then the cost disappears. The renter, meanwhile, faces a lifetime of rising rent bills.

If inflation runs at 3 percent a year, the operating costs of the house will still be $7,500 in real terms 5, 10, and 20 years later. Ditto, the $15,000 cost of a comparable rental: It will still be $15,000.

The cost of the mortgage, however, will be $7,643 in 5 years, $6,563 in 10 years, $4,840 in 20 years, and $3,569 in 30 years, when measured in real dollars. After that, it will be zero. The homeowners’ cost is lower than the renters’ in the sixth year of ownership. The homeowners’ cumulative cost is lower than the renters’ in the 11th year (see table below).

After that, it’s all gravy for the homeowner.

How HomeOwnership Overtakes Renting

This table compares the cost of owning a $150,000 home with an 80 percent mortgage at 6 percent for 30 years with the cost of renting a comparable home. It assumes that both rent and home operating expenses, excluding  the mortgage, rise at an inflation rate of 3 percent. All numbers are presented in dollars of current purchasing power.
Year Mortgage Op. Exp. Total Rent Homeowner Advantage
1 $8,634 $7,500 $16,134 $15,000 ($1,134)
5 $7,643 $7,500 $15,143 $15,000 ($  143)
10 $6,563 $7,500 $14,063 $15,000 937
15 $5,636 $7,500 $13,136 $15,000 $1,864
20 $4,840 $7,500 $12,340 $15,000 $2,660
25 $4,156 $7,500 $11,656 $15,000 $3,344
30 $3,569 $7,500 $11,069 $15,000 $3,931
After 30 $0 $7,500 $7,500 $15,000 $7,500

Of course, in real life the actual numbers will differ. But as long as inflation whittles away the purchasing power of the mortgage payment, the odds will favor the homeowner over the renter.

Note that home appreciation has not been mentioned.

Even if the value of the house doesn’t rise, it will compete very well with the return a renter could get on the down payment. The homeowner will pay the mortgage off in 30 years, bringing his equity to $150,000. For the renter, the down payment would have to return 4.22 percent, after taxes, to accumulate to the $150,000 value of the home after 30 years with zero appreciation.

What does this mean for lifetime consumption other than shelter? For a couple with $60,000 a year of income, owning provides only a small advantage while they are working--- but it provides a major improvement in retirement. While the renter and owner would both have after-tax, after-shelter consumption of just over $36,000 a year while working, the homeowners would enjoy a bump up to $44,612 a year in retirement, an improvement of about 24 percent over the renters (this result was calculated using ESPlanner consumption smoothing software).

Does this mean we can spend carelessly on houses?

Sorry, no.

It means inflation will protect us from all but the worst housing markets, if we give it enough time.
On the web:

Sunday, April 7, 2007: The Sublime Beauty of Falling Knives

Check my homeownership tax benefits calculator:

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