Something really strange happened in the housing market over the last decade. Interest rates went down thanks to the massive stimulus of central banks, and suddenly mortgage payments were cut. People took home slightly more money at the end of the month, allowing them to pay off debts and spend a little more on other services.
The government achieved its goal: get the economy back on track (even if it did take a long time). But something strange happened in the housing market. Lower interest rates ultimately didn’t make paying the mortgage any cheaper. Instead, it allowed banks to lend more against property, forcing the price of homes back above their long-run price trend. The absolute value of loan repayments for the average family stayed roughly the same, despite the cut in interest rates, because the amount of money borrowed on the mortgage was much bigger.
The good news is that the mortgage market seems to be more sustainable overall than it was before the financial crisis. Although prices are still high, the average family is paying about the same proportion of their disposable income to service the debt as they were in 2000, which isn’t bad.
The question, though, is whether this situation will last forever. Should people be buying their homes and taking on mortgages? Or is renting a better option, given the precarious state of government policy?
Conditions In The Economy May Change …
The most significant risk to homeowners at the moment is a rise in the rate of interest. Central banks around the world, led by the Federal Reserve in New York, have hinted that interest rates will soon be returning to their historical norm, somewhere between 3 and 5 per cent. Currently sitting at around 2 per cent, central banks are already raising rates, hoping to calm inflation on the broader economy.
Rising rates may be bad news, at least in the short term, in the housing market. For starters, mortgages are large, about four times the average annual income, and therefore higher than the historical norm. Large mortgages mean that any increase in interest rates will lead to large increases in monthly payments on debt. Consumers, already struggling to get by, may need to foreclose to prevent bankruptcy. Existing homeowners who have already paid off their mortgage may also suffer if an increase in interest rates forces house prices down. House prices could fall if high-interest rates prevent banks from lending so much to borrowers.
Homeowners also need to keep an eye on inflation. Should inflation rise too high, perhaps because of a booming economy, central banks will have no choice but to use the policy levers at their disposal and try to prevent a boom by increasing rates still further.
Is Renting The Answer?
One way to protect against the fluctuations in the housing market is to rent. Sure, rents might go up or down following turmoil in the overall market, but these payments are usually fixed for a 12 month period and can be renegotiated. Importantly, there’s no debt involved when renting, so renters don’t need to worry about interest rates, at least not directly.
But renting may offer some other advantages over buying a house outright. It’s a widely held conception that purchasing a home makes more financial sense over the long run than does renting. But it turns out that renting can sometimes work out cheaper, especially when you consider the full cost of home ownership.
How many times have you heard somebody say “renting is money down the drain?” It’s often assumed that when you rent, you’re throwing your money away. However, that’s not entirely true. For starters, you’re getting shelter for yourself (and your family), which isn’t free. And secondly, even when you buy a house outright, you’re still “throwing money away” because you have to pay additional property taxes, interest on the mortgage, and other legal fees.
On top of that, there’s also the fact that homeownership comes with many expenses besides the obvious repayments on the mortgage. Homeowners must take responsibility for all the little costs associated with running a home whereas renters don’t usually have to bother. Data from Forbes suggests that these additional costs may sum to as much as 50 per cent of the overall cost of the mortgage, meaning that owning a home could carry a massive premium. Insurance costs, taxes, maintenance fees, and utilities can all make a severe dent in one’s finances.
Rent For The Short Term, Buy For The Long Term
Another reason people love to buy houses is that they see them as an investment. But there’s a problem with this idea: homes are not productive assets and, therefore, probably shouldn’t be considered an investment, especially if they aren’t being rented out.
Robert Schiller, famed macroeconomist and scholar of the property market, says that for most families, their home is not an investment. Instead, it’s a money sink: somewhere they pour the majority of their financial resources. He’s gone as far as to say that only a few wealthy people at the top of the income pyramid should own their own homes – the rest should rent.
There’s a rational reason for this. Schiller says that most people invest too much of their capital in property. Their overall portfolio of assets is skewed towards housing rather than other forms of investment, and they end up being overexposed to the volatile property sector. Renting, he says, is probably better, since it reduces overall risk, and allows people to spend their spare money on other investments that can generate returns over the long term.
With that said, some people can benefit from buying their own home: those who want to live in a specific location for a long time. Not only can they benefit from rising house prices, but they also reap the rewards of rent-free living once they pay off the mortgage.
Is Buying Too Risky?
Not all arguments are in favour of renting. In fact, there’s a lot that homeowners can do to reduce their risks when buying outright, making it more appealing.
First off, buyers can reduce their risks by insuring against default. As you discover more about owning a home, you soon find out that it can be a risky business. The primary income earner can get sick or die, leaving the rest of the family saddled with unaffordable repayments. Insurance products, however, can not only provide payouts if somebody dies but help to keep a family in their home by meeting mortgage expenses should the worst happen.
Second, buyers can reduce risks by sticking with fixed-rate mortgages. Although they have higher rates than variable mortgages, fixed-rate products protect homeowners against the seemingly inevitable interest rate hikes coming down the pike.
The only way to really find out whether renting is cheaper than buying overall is to use a “rent versus buy” calculator. These calculators take into account the basics, such as the cost of rent or mortgage over a fixed time interval, but also many of the costs involved in running a home. The best calculators provide a present value estimate of the total cost of renting versus ownership, giving you a figure in today’s terms for how much either option will cost you.
As with any calculator on the internet, renting versus buying calculators depend on accurate inputs. They need you to have a good grasp of the costs that you expect to incur when owning a home, some of which we’ve discussed here. If you don’t know these, then any estimates you get out of them will be nonsense.
Once you’ve got an output from the calculator, check to see how much the overall costs differ from one another. In theory, they should be reasonably close if the market is working correctly, but not always. Different areas can have different markups for renting and owning, so it’s still a good idea to check.
The Psychic Benefits Of Home Ownership
The biggest flaw in Schiller’s argument is that he assumes that people are only concerned with financial matters, and not with other psychological benefits. But for many, there are intangibles, such as social status, associated with home ownership, which may explain why so many people work so hard to achieve it.
People associate home ownership with success and raising a family: important life goals. And so the very notion of owning a home might have value above renting. It all depends on the kind of person you are. Owning a home might make you less mobile, but if you don’t mind about that and just want to settle down with a family, then it may be the right option for you. Yes, there will be hassles along the way, such as a broken down boiler, but renters have to face the same issues too. Homeownership might be riskier than renting, but it also gives a person a sense of belonging and purpose. And ultimately, that’s what makes for a fulfilling and joyful life.