The Farce that is "Don't throw your money away on rent"

Jun 25, 2010

I graduated from college in 1999, near the apex of the tech bubble. I moved back up to the bay area, which was experiencing a really unique historical period - jobs were aplenty and it seemed like everyone was getting rich off of internet stocks. Free drinks were everywhere throughout the city as tons of companies threw parties to try to find new employees to build web sites that would destroy the old brick and mortar businesses.

Fast forward a year and a half later and the bubble had burst. My company, Ask Jeeves, laid off over 25% of our workforce, and other companies were following suit or even folding. Americans, frightened by the crashing stock market (the tech heavy nasdaq lost over half it's value - see chart below) decided to plow their money into housing.

And why not? For as long as I can recall my parents have always told me that "buying a home is the only/best way to build equity". Many of my friends happen to be Asian, and for some reason Asian parents seem to believe that renting is "throwing your money away". Better to rent as the home will always retain it's value. This advice may have been true in my parent's generation. But now, in the bay area, it's complete bullshit.

The reason why is because housing prices, at least in the bay area, are completely out of wack with rents. When my parents bought the home I grew up in in Berkeley in 1977 they paid $40,000 (that's $144,000 in 2010 dollars per the BLS inflation calculator - don't make the mistake of thinking that $40k then is $40k today!) their mortgage was roughly equivalent to their rent. In 2010 this is just not the case.

I had lunch with a friend of mine today. He told me that he had planned to move out of his parent's house recently and rent, but his parents told him that he was throwing his money away by renting, and that he should buy a house with them. Let's take a look at whether this is a good idea. First off, he went ahead and bought a condo in the silicon valley area, and he ended up paying around $800,000 for the 2 bedroom unit.

Let's take a look at how this transaction will work for him using the New York Times excellent rent vs. buy calculator. Any of these calculators have to have some assumptions built in. I'm going with these assumptions:

  • I generally don't think housing prices in the bay are are going to increase in the next 5 years, but I'm going to be generous and say that perhaps we'll have 3% increases (I think this is high)

  • that the opportunity costs of the down payment are 4.5% (ie that if he invested his down payment he could get a 4.5% return)

  • that his home owners association fees are $300 (that's pretty low in the bay area)

  • that he puts 20% down (standard down payments these days)

  • and that he could rent a comparable apartment for $3000 a month (I think he could, but I'm not 100% sure).

With these numbers the calculator tells us that buying a home is better than renting after 21 years!

Why is that? Because:

  • The mortgage itself is over $37,000 a year (~3k per month alone)! Granted he can deduct this via his income at his marginal rate, but that still will put him at around $2,000 on the mortgage alone

  • His property taxes, at the 1.25% California rate, are $9500 a year (or around 800 a month). Many people forget that property taxes are paid by the landlord in your rent

  • 20% down on an $800,000 house is $160,000. You can invest that $160,000 a lot of ways and make money on it

  • The home owners association fees on a condo aren't deductible from your taxes, so this can be looked at similarly to rent

So on this condo it would take 21 years for buying to make sense! In addition to the pure financial argument against buying let's also consider:

  • He doesn't need a 2 bedroom home now. He could rent a smaller unit now and upgrade to a larger one when his space needs change

  • Moving is considerably easier when you aren't encumbered by a mortgage. Many people argue that you can always rent the house if you need to. This is true, but you won't be able to get back enough in rent to cover your mortgage, property taxes, and home owners association fees - so you'll be losing money every month!

  • If he meets someone and decides to move in with them his options are much more flexible

  • If his income situation changes he can downsize to a smaller place (or move in with his folks!) or upgrade to a larger place without the threat of a financial disaster in the form of closing fees and selling into a down market hanging over him

There are many upsides to home ownership including a stable place to live and the ability to customize your residence, but you are definitely not throwing away your money by renting!