Today's Opinions, Tomorrow's Reality
Money Out the Window
By David G. Young
Washington, DC, October 29, 2002 --
The harsh lighting hints at the thick tension permeating the air. A young woman, surrounded by her beautiful children, looks up in anticipation. The husband's shadowed face and somber expression hint of his terrible news: "We didn't get the house," he whispers. As the sad music begins, we contemplate the horror of the young family's situation. They are doomed to continue suffering life in -- heaven forbid -- a rental property.
Such preposterously dramatic commercials illustrate America's national obsession with home ownership. This uniquely American dogma bristles with religious ferocity. The website of the U.S. Department of Housing and Urban Development claims without supporting data that "Homeownership is the single most powerful tool a family can use to improve its quality of life." The formerly government-owned mortgage agency, Fannie Mae, claims, "Our business is the American Dream." Figures from a recent survey show that American home ownership is now at an all-time high of 68 percent.1 In such a climate, it borders on heresy to question the wisdom of purchasing a home. But the harsh reality is that the irrational pursuit of the single-family home has hurt both individuals and the nation as a whole.
For America, the worst consequence of this obsession is urban sprawl and traffic congestion. The construction of homes romanticized in the American dream directly cause sprawl. Large single-family homes are built on the fringes of suburban areas. Here, once rural road networks cannot possibly hope to accommodate the traffic of all the new arrivals. Public transportation is a non-starter. Suburban housing developments lack the density and the pedestrian-friendly layout that makes mass transportation work. In September, sales of new homes hit a seasonally adjusted all time high of over a million.2
As lawmakers engage in futile debate about the solution to America's road congestion, they steadfastly refuse to discuss a sacred cow that has caused much of the problem: the mortgage interest deduction. The country's tax code strongly encourages home purchases through an income tax deduction for mortgage interest. Besides being a real financial incentive to buy homes, this deduction provides a rational justification for the irrational home buying pursuits of Americans. New homeowners are the consumer equivalent of born-again Christians or ex-smokers -- they believe in their cause with an incredibly religious zeal. "Are you still renting?" they preach, "You're throwing your money right out the window!"
The logic behind this argument is flawed. Immediately after buying a home, the vast majority of the mortgage payment is interest. This is a mixed blessing. The good news for middle class homebuyers is that the interest tax deduction typically returns about 28 percent of the mortgage's interest from their taxes. The bad news, however, is that since most of the payment is interest, the homeowner is not appreciating much capital. Paying interest -- even with a tax deduction -- is an expense just like renting. It's "money right out the window!"
The remaining small part of the mortgage payment, the principal, is the essence of the argument offered by the home ownership congregation. It's an investment. But is it a good investment? Despite ample anecdotes of people who made a killing on homes that tripled in value, residential home ownership is a risky investment that offers a poor return. For every person who claims to have made a killing on his home, you can find others who lost their shirts when neighborhoods when bad or real estate markets went bust. The average annual home appreciation from 1980 to 2002 was only 4.8 percent.3 Compare this to the 11 percent annual return on investment in the stock market over the same period.5
The consequences of this difference can be stark. Let's say one man lives in the Washington D.C. area in a typical two-bedroom apartment costing an average $907 per month.6 A friend with an identical income buys a house for the average local price of $229,0007, with a mortgage payment will be about $1523 per month.8 After factoring in the mortgage interest tax deduction, along with average maintenance, property taxes, and lender-required homeowner's insurance, the buyer's monthly net cost is $2560.9
Although the renter is saving money in the short-term, the buyer is building equity. So let's say the renter puts all his relative savings in the stock market, where they appreciate at a typical annual rate of 10 percent per year. Meanwhile, the buyer's house appreciates at the average rate of 4.8 percent per year. At the end of the 30 year mortgage, the renter will leave the buyer in the dust: His stock portfolio will be worth $50,000 more than the buyer's home!10
Of course, this analysis doesn't factor in the extra space enjoyed by the homeowner. The big question is: does the homeowner need this space? While it may make good financial sense to stop renting a one-bedroom apartment in favor of buying a one-bedroom condo, the same logic does not apply to moving from a one-bedroom apartment into a three-bedroom townhouse or an even larger single-family house. Buying a larger home necessarily costs more. Even with 28 percent of the mortgage interest back in the form of a tax deduction, buying more home than you need will absolutely hurt your pocketbook more than if you'd just kept renting a smaller place. Unfortunately, this is exactly what many Americans do. Egged on by aggressive real estate agents and a quest for status, Americans often choose the biggest and most expensive house they can afford, rather than the least expensive house that meets their needs.
It is precisely this irrational thought that has fueled the current real estate boom. Despite recession and a 25 percent decline in the stock market since 2000, the price of homes have continued to climb at record rates of over six percent per year annually.11 This price increase has been exacerbated by new aggressive loan practices that allow buyers with almost no down payment to buy a home. With consumer credit at unsustainable levels and mortgage rates bound to increase from current historic lows12, the risk of a crash in the housing market is all too real.
Of course, buying a home can be a good idea, when done sensibly. The key parts of this statement, however, are "can" and "when done sensibly." Home ownership is not a panacea. It is not a religious matter. It is a merely one practical choice. A far higher percentage of Europeans rent their homes, while somehow managing to achieve a high standard of living. They accomplish this with less congestion, less sprawl, and way more neighborhood charm than offered by America's suburban McMansions. With a little less mortgage incentive and a lot less dogma, Americans might find themselves prosperous and happy as renters, too.
1. The Washington Post, Mortgage Payment or Rent Check, October 27, 2002
2. Ibid., Low Rates Boost Sales Of Homes at Torrid Pace, October 26, 2002
3. Office of Federal Housing Enterprise Oversight, House Price Index Second Quarter 2002, September 3, 2002
5. Dow Jones Industrial Average
6. Metropolitan Washington Council of Governments, Metropolitan Washington Regional Housing Report, March 2002
7. The Washington Times, D.C. Home Prices Jump, May 14, 2002
8. Bloomberg.com mortgage calculator: 229,000 financed, 7 percent interest, 30 year loan, zero points,
9. Analysis by Author, See calculations (Microsoft Excel)
11. Office of Federal Housing Enterprise Oversight, Ibid.
12. The Washington Post, Mortgage Payment or Rent Check, October 27, 2002