After 8 months of personal finance blogging, I’ve come to a realization: most personal finance bloggers favor renting or at least, think that the benefits of homeownership are overestimated. It’s my opinion that some facets of homeownership, like building net worth, are overstated. Yet, for the most part, the benefits of homeownership are mostly understated.
Since the buy/rent decision is heatedly debated in the blogosphere, I thought it was time for Smart Family Finance to add some salient points to the discussion. That’s why my posts for this week and next will all be part of a series: Should Families Buy a House or Rent an Apartment. We’ll deal with a number of concerns and issues that get to the heart of the finances behind buying and renting. I hope that you find these posts helpful and at worst, unique.
Today’s post covers the risks of buying versus renting. I also plan on talking about the effects of inflation, the myth of “hidden” costs when buying, costs of housing over a lifetime, why net worth from ownership tends to be overvalued, the fallacy that renting is more flexible, and an accurate look of the cost/benefits of homeownership over renting.
Homeowners and Renters Risk Losing The Initial Investment
There is definitely a risk to homeownership, although I suspect it is far less of a risk than most people realize. While the total amount risked might be greater for homeowners, the type of risk for homeowners and renters is the same; loss of your initial investment.
To simplify this assertion, assume that the costs of renting are exactly equal to the costs for owning a home. For now, we’ll ignore whether or not one option costs more and deal with it in another post. However, we can assume that if homeownership has greater costs compared to renting, it will have greater risk.
Homeownership and rent both require an upfront investment. Renters usually pay at least one month rent for a security deposit. Homeowners have to pay a down payment and closing costs to purchase. If for some reason either renter or homeowner defaults, they will lose this initial investment. However, homeowners almost always pay much more to buy a home.
In the early years, the only real loss a homeowner can suffer is the closing costs and down payment.
Homeowner’s Don’t Risk Losing Equity Compared to Renters
It may come as a surprise, but homeowner’s don’t risk losing equity when compared to renters.
Housing is a necessity and unless you are moving in with a friend or relative for free, your choices are either to rent or own. Remember that renters don’t earn any equity. In our example, costs are the same to rent or buy. This means that you aren’t any worse off if you lose all of your equity.
Think of the homeowner and renter as two gamblers. The renter decides to bring $100 to the casino, but losses every game he plays. At the end of the night, he lost $100. The homeowner also brings $100 to the casino and wins a few thousand dollars at first, but by the end of the night, he goes broke. They both started the night, risking only $100. While the homeowner lost thousands in winnings, he isn’t any worse off than the renter gambler.
Essentially, the worst case scenario for a renter is eviction and loss of their initial investment (security deposit). The worst case scenario for a homeowner is foreclosure and loss of their initial investment (closing costs and down payment).
Homeowner Has Short-Term Risks, Long-Term Advantage
The big take away is that homeowners have a larger initial investment and that difference makes homeownership more risky in the short run.
Let’s say that you are never able to make a mortgage payment, you’d lose all of the money you paid to close on the house. Your risk is greatest at the very beginning.
Now let’s say that you can’t make your final mortgage payment. The rules of foreclosure grant the bank the ability to sell your home and recoup their costs. However, at your last payment you have almost all your equity. You also have had many years of home value appreciation. There is a good chance that there will be leftover proceeds that is paid to you after foreclosure.
Homeowners do have a better alternative than foreclosure; they could file for bankruptcy instead. Bankruptcy law favors homeowners and reserves a portion of equity for the homeowner even if they lose their home. This reserved equity can be up to tens of thousands of dollars, provided that selling the home is a necessary part of the bankruptcy. Renters do not get the same benefit from bankruptcy court.
While homeowners risk losing the large chunk of money used to purchase their home, over time, those risks do vanish. In time, homeowners get an advantage over renters.
Renting is Not Risk Free
It’s also important to note that renting is not risk-free either. By paying a security deposit, renters also can lose their initial investment. However, there are other risks as well.
Let’s say a renter saves up to buy a house, but changes his mind and invests the money in the stock market instead. The renter is still facing potential loss of the initial investment should the stock market collapse. The renters risk is smaller so long as stocks are diversified, but he is taking on the same risk, just less risk.
Potential Homeowners Can Lower Risks
Before buying it’s important to understand the risks of home ownership and potential losses associated with those risks. Just like any investment, your home buying decision should be considered with your risk tolerances in mind.
Understanding the risks of home ownership can also help you implement strategies to reduce those risks. You can buy a smaller home, find loans with the smallest down payment or seek seller paid closing costs before you purchase. These strategies will lower your initial investment and risk of loss.
Erin from The Dog Ate My Wallet points out that there is one other potential risk for home ownership. If there is a serious loss to the bank after foreclosure, some state’s allow the bank to seek a deficiency judgement. A deficiency judgement allows the bank to come after you for the difference between the principal owed in your mortgage and what the bank received in foreclosure.
This is definitely something more common if your mortgage is underwater at the time you faced foreclosure.