October 2010

November 2010: WHAT YOU NEED TO KNOW ABOUT - To Buy Or Rent: A New Paradigm

Author: Lew Wessel | Photographer: Photography by Anne

A shell-shocked Alan Greenspan testified to Congress in the fall of 2009 that a conceptual framework for the economy that had guided him for 40 years had serious flaws and that he was “very distressed by that fact.”

It’s times like these that require us to examine even the most basic of tenets. No belief is more basic in the financial world than the belief that owning your own home is the building block to achieving personal economic success. It is at the foundation of the American Dream.

For decades, the wisest financial advisors urged us to get into a home as quickly as possible with as little down payment as possible, lock into a long-term fixed mortgage and start building equity. Over our careers, we would keep “trading up” to larger and larger homes until our kids left and we turned into empty nesters. At that point, the equity in our home would become a key component of our retirement funds and we would trade down or cash out much of our equity and move into our smaller retirement home.

Our homes not only gave us personal satisfaction, but our mortgages promoted “forced savings” and served as a great inflation hedge.

Somewhere along the line, of course, all this sage advice went on steroids, and our homes were no longer seen as just piggy banks, but veritable ATM’s. We sucked our equity out of them every chance we got through cash-out refinancing and home equity lines (HELOCs). We started to see our homes as our best “investment,” not just a place to live. And then the real estate market bubble popped and we found ourselves in a whole new financial world.

For those of us who are already homeowners, the effects of the real estate collapse are just a reality we have to live with. If we are underwater on our mortgages, we have options ranging from sucking it up and dutifully making our contractual payments to short sales to personal bankruptcy. Those issues are very real, but what I want to focus on is the real estate “virgin” who’s trying to make the life-changing decision of whether or not to go from being a renter to a homeowner. What advice, for instance, should you, as a parent of a young adult, give vis-à-vis homeownership?

First of all, let’s all agree that the decision is no longer a positive no-brainer. Agreeing to that is step one, and frankly, that’s a BIG step—a dramatic paradigm shift from the days of Beaver Cleaver. Now, step two is to figure out what parameters to consider in order to make a wise buy vs. rent decision.

NON-FINANCIAL CONSIDERATIONS

RENTER ADVANTAGES:
• Limited liability. In general, you are on the hook for your monthly rent and maybe utilities, plus your security deposit. That’s it. If the place burns down, you move (Free advice: make sure you get renter’s insurance—it’s cheap.)
• Mobility/Freedom. Once the lease is over, you can move out anytime you want.

RENTER DISADVANTAGES:
• Landlord. You essentially have a boss of your home who can tell you what you can or can’t do with your living quarters. So, call this “lack of freedom.”
• Lack of control. In general, you have less control over your living environment as a renter; e.g. if you have a problem with your homeowner’s association, you’ll probably have to go to your landlord to get it fixed.

OWNER ADVANTAGES:
• Freedom and control. You can generally do whatever you want to the inside of your home and, within reason and subject to covenants, a great deal to the outside as well. Plus, you’ve got a voting seat at the table when your homeowner’s association meets.
• More choices/Better locations. Many desirable neighborhoods in the Hilton Head/Bluffton area have a very limited selection of rental opportunities.

OWNER DISADVANTAGES:
• Total liability. It’s your property and you are responsible for EVERYTHING. Welcome to the world of homeowner’s insurance (make sure you’re covered for wind and hail and flood as well as fire) and homeowner association fees. The refrigerator goes on the fritz—your problem and your expense. This is a major step up the responsibility ladder from life as a renter.
• Lack of mobility. If you decide to or, more likely, circumstances require you to move, you’ll have to do something with your home. You can’t just do the renter thing, i.e. give a month’s notice and say “bye-bye.” A young couple trying to make the own-versus-rent decision needs to focus hard on this issue; it’s not quite at the same level as the having-the-baby decision, but it’s probably above the level of should-we-get-a-dog.

FINANCIAL CONSIFERATIONS

RENTER ADVANTAGES = OWNER DISADVANTAGES
• No equity risk. The real estate market collapsed in 2006 and, per Zillow.com, the value of homes on Hilton Head has decreased about 50 percent since that date. “Ho hum” says the renter. “Not my problem.”

RENTER DISADVANTAGES +OWNER ADVANTAGES
• No equity reward. If the real estate market recovers, the renter will just get stuck with higher rent.
• No tax deductions: Some states actually do allow renter-related tax deductions, but not South Carolina (call your representatives). At the federal level, homeowners get a whole slew of tax incentives from mortgage interest deduction to credits for adding energy-saving material to their homes. UNCLE SAM WANTS YOU TO BUY A HOME!

So, should our “virgin” homeowner buy? The answer depends first and foremost on whether he/she is up to the responsibility of accepting the total liability of homeownership mentioned above. If the answer is yes, then the question is not if, but when.

Is NOW the time to take the plunge? Many personal financial pundits say yes. Prices for homes have, as noted, dropped substantially, and homes are effectively on sale for 30 to 50 percent off 2006 prices. At the same time, mortgage interest rates are at historic lows—between 4.5-5 percent on a 30-year fixed mortgage. That’s an amazing bargain! Think about it. You can quite reasonably expect to pay $350,000 today for a home that in 2006 would have cost $500,000. Assuming a 20 percent down payment in both cases and rates of 6 percent then and 4.5 percent now, the monthly payments for principal and interest would have gone from $2,998 in 2006 to $1,773 today—a savings of 40 percent. So, time to jump in? Maybe.

While it is doubtful that mortgage interest rates will go much lower, home prices could still decrease significantly. Nobody knows for sure.

What’s of more concern is that, whether prices have hit bottom or not, there is still lots of housing inventory on the market, and the time it takes to sell a home keeps getting longer and longer—which leads us to the most important factor in the rent vs. buy decision: time.

Like virtually all asset classes, the average return on homes will be positive over the long run. Even though prices have dropped dramatically in the last few years, you still would have made money on a Hilton Head home (on average, per Zillow.com) if you had purchased your home prior to 2002. As a short-term bet, buying a home is a gamble, but over the long run, it will probably be a decent asset to own and will provide shelter to boot (Ask that of your 401K!). So, if you plan to stay put for 5-10 years or more, buying a home makes more sense.

BUT, WHAT IF I HAVE TO MOVE?
Of course, the best laid plans can often go totally awry. Job relocation, marriage, divorce, etc., can mean that you will be forced to move and obliged to do something with your home. Instead of sticking your head in the sand, you need, as with any investment, to think about your exit strategy BEFORE you close on your new home.

One strategy would be to sell, but, in that event, not only are you at the mercy of the market, but, between brokerage fees and other costs, you are also going to incur around 6 to 10 percent of the sale price in closing costs. If this should happen a short time after your purchase, you are probably going to take a substantial financial hit.

Another strategy would be to rent your home to someone else. My advice, if your “virgin” homebuyer is looking to assess his/her financial home-buying risk, is to compare the home’s potential rental numbers to the amount of the mortgage payment. If the two are fairly close, then this will give him/her an alternative exit strategy that will substantially cut the risk of homeownership.

BOTTOM LINE
There are a number of calculators available online to make rent vs. buy decisions, but all require you make assumptions about future prices, inflation, etc. My advice is to keep it simple: Buy if you are ready to accept the responsibility—financially and emotionally—of homeownership; you think the combination of lower home prices and low mortgage interest rates is pretty much at an optimum level; you PLAN on staying put for five years or longer; and you have a viable exit strategy if that plan doesn’t work out. Otherwise, keep renting.

To comment or for more information, e-mail lewwessel@hargray.com.

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