Fact #1: People and companies generally adapt a herd mentality and follow each other blindly.
For well over a hundred years the US credit system had refined how it determines the credit worthiness of prospective borrowers. Politicians, due to political expediency, supported Fannie Mae and Freddie Mac in pressuring banks to loan to highly marginal buyers. As banks (initially in New York) began lending to this previously untapped market segment other banks quickly jumped onto this seemingly lucrative band wagon. These loans were bundled into mortgage backed securities and sold abroad, resulting in the inevitable market crash that came as marginal home owners began to default in mass.
The pendulum quickly swung the other way and banks began to deny even highly qualified borrowers. Money became tight and the government went into overdrive to get banks lending again.
“Leverage is how you make money.” Prior to the market crash I constantly heard clients expressing the need to leverage their money to get it working for them. I witnessed many individuals with no money for a down payment buy homes far beyond their means under the false premise that real estate can only go up in value.
“Cash is how you protect yourself.” The trend now on many blogs and with some financial columnists is to rent and save with the idea of safely buying your home outright or amassing a huge down payment that will keep your monthly payments to a minimum.
Fact #2: Trends oscillate around the center line of truth.
“High leverage is a foolish risk.” Being highly leveraged means you are living beyond your means. You may not have an adequate down payment or your income marginally supports the home you purchased. You become house poor! All of your income is tied up in making your monthly payment. There is no money left for the trip to grandmas or for the kids’ music lessons. You are living with no buffer should you have a hiccup with your income or you are faced with an unanticipated expense.
“No leverage can be a waste of resources”. On the other hand, no leverage can be equally negative. Paying cash for a house absorbs significant resources that could be working for you elsewhere. Not buying a house while you rent and save fails to leverage the US tax laws which encourage home ownership by making interest payments tax deductable.
“Reasonable leverage is the truth!” A balanced approach to leverage is usually the best solution. If you can leverage your money for higher interest-yielding returns without taking on a high deal of risk it is often sensible to do so. Over a hundred years of credit history taught lending institutions that buyers with a 20% down payment, good credit history, and a steady income were an excellent credit risk and were highly unlikely to default on a loan. As I’ve watched many lending institutions swing wildly from one end of the lending spectrum to the other I’ve had to question their apparent disregard for this history.
Fact #3: If you have a 20% down payment, good credit history, a steady income, and you live in an area that has NOT seen radical property appreciation (Texas), it may be more advantageous for you to buy than to rent.
To demonstrate the comparison I will use a “rent vs buy” calculator created by Dave Ramsey, arguably the most respected financial advisor in the country today. The analysis compares the 5 year costs associated with renting or buying the same home in Circle C, Austin’s largest master planned community. The home in question was built in 2007 and is for sale and for lease. Comparison data shows that this home should sell at $400,000 and should lease at $2500/month. Assuming an inflation rate of 3%, investment returns of 8%, a current 30 year fixed interest rate of 4.5%, a 20% down payment, and a home appreciation rate of 3%; it is $20,000 more beneficial to buy this home than to rent it. If, however, home appreciation remained at zero or decreased it would be $44,000 more beneficial to rent than to buy.
The same analysis of a home selling for $200,000 and renting for $1600/month shows a $28,000 benefit to buying over renting at 3% home appreciation. With no appreciation there is no significant advantage either way.
Finally, we look at paying cash for a home. With cost of borrowing money as low as it presently is this is the most conservative and the least beneficial alternative (assuming you can make a reasonable return on your money in another market). This alternative may be attractive to retirees who want to eliminate all risk and don’t need their money working for them.
The best solution is specific to you, your situation, and where you live – Don’t be a trend follower! Take some time to input your specifics into the “rent vs buy” calculator and see what it tells you. Weighing the different scenarios will help you to make an educated and informed decision on what may be the largest investment of your life.