Buying versus Renting

Real Estate Basics - It's Smarter to Buy than Rent

The tax benefits help somewhat, but it's the long-term gain in value that's crucial to building real wealth.

Yup, the cliché is true: Buying a home is one of the smartest financial decisions most people will ever make.

Don't take my word for it. Take the Federal Reserve's. Its Survey of Consumer Finances has consistently found a huge gap between the wealth piled up by homeowners and that accumulated by renters.

Average net worth of homeowners vs. renters
Annual Income	Owners	Renters
$80,000 and up	$451,200	$87,400
$50,000 to $79,999	$194,610	$25,000
$30,000 to $49,999	$126,500	$10,600
$16,000 to $29,999	$112,600	$4,240
Under $16,000	$73,000	$500

Source: VIP Forum, Federal Reserve Board

Homeownership builds wealth in two ways: through the "forced savings" of paying down a mortgage, and through appreciation -- the rise in the home's value over time. The earlier you get in the game, the quicker you can get that appreciation working for you. The longer you wait, the consequences can be stiff. "If you rent, you'll always be poor," declares real-estate cheerleader and bestselling author David Bach, author of "Smart Women Finish Rich" and the upcoming "The Automatic Millionaire Homeowner." "The longer you rent, the less likely you are to buy. You fall further and further behind." Bach may be indulging in a bit of hyperbole, but he has a point. Those who wait for the current housing boom to crash may be waiting a long time. Prices even in the most overheated markets could plateau or just rise more slowly in the future, maybe even returning to the 6% average annual gain the National Association of Realtors says is the norm nationally.

Still, even Bach acknowledges buying a home isn't always the best choice. Sometimes you're smarter to hold off and rent, postponing the day when you graduate to the ranks of homeowner. But how do you decide if you're being prudent or chicken? Don't expect most "Buy vs. Rent" calculators you find on the Internet to be much help. Outlays for maintenance, repairs, insurance and utilities almost invariably will be greater for a homeowner than a renter, yet many calculators fail to consider the full impact of these expenses. And some expect you to predict events -- like future appreciation or how much your down payment would earn if invested in stocks instead -- that you can't possibly know.

It's a crapshoot: When I bought my first house, for example, Southern California was experiencing its worst-ever real-estate slump. The property, purchased with two friends, lost about 10% of its value in my initial years of ownership, then recovered to post a 20% price gain. Not bad, huh? Except after considering all my outlays for maintenance, repairs and insurance, and factoring in the tax benefits, I determined that I had barely broken even when compared with the rent I would have paid during those six years. Had I invested my down payment in an index fund that matched the Standard & Poor's 500 instead, I could have tripled my money in the same period. The case has been almost exactly reversed with our current house: The stock market has basically been treading water for the past five years. But our home in the insanely hot Southern California market has more than doubled in value. There's no way I could have predicted the performance of either market -- stock or real estate -- in advance. Tax benefits help, but not for long Besides asking for the impossible, many "Buy vs. Rent" calculations -- and most discussions of home ownership benefits in general -- exaggerate the potential tax benefit. Here's a dose of reality: At least half of the nation's homeowners get no tax break. Some own their homes outright, but many don't pay enough mortgage interest and/or property tax to be able to itemize.

If you do get a tax break, it's probably less than you think. What matters isn't the total amount you pay in interest but whether all your deductions added together exceed the standard deduction amount. The standard deduction in 2005, for instance, gives married couples who file a joint tax return $10,000 in "free" deductions, even for those who don't pay a penny in mortgage interest. If you're a homeowner with mortgage interest and other deductions totaling $11,000 last year, the only advantage you would have over a renter who paid zero interest is an extra $1,000 in deductions. If you're in the 25% tax bracket, the $11,000 you spent garnered you a tax break worth just $250 -- so your write-off is worth about 2% of what you paid. Even if you get a decent deduction now, that tax benefit will tend to shrink over time. Most mortgages are front-loaded so that you pay less interest, and more principal, with each passing year. At the same time, the standard deduction keeps getting adjusted upward, squeezing your tax break from both directions.

4 keys to profitable home ownership

You're most likely to win by owning, rather than renting, if the following are true:

You plan to stay put at least three years and preferably more.

In most markets, it can take three to six years for a home to appreciate enough to offset the costs of selling and moving. (Bach thinks anyone who knows he or she won't be moving in the next year should roll the dice and buy; I'm a little more cautious, particularly in overheated markets where you may need to stay put even longer than five years to ride out a real downturn.)

You're psychologically prepared.

Homeownership means dealing with whatever comes up from noisy neighbors to clogged plumbing. You can't just call the landlord for help or pack up and move as easily as when you were renting.

You have some extra savings.

Home buyers who spend every dime they have buying a house inevitably are blindsided by repairs, maintenance and all the other costs of owning a home. Then they go into debt trying to keep up their current lifestyle. Smart home buyers make sure they have an amount in savings at least equal to two mortgage payments after the deal closes, and preferably much more.

You manage your money pretty well.

That "forced savings" aspect I discussed above works only if you can keep your hands out of the cookie jar. Otherwise, it's too easy to drain away your wealth with home equity loans and lines of credit. If you're the kind of person who lives on credit cards and doesn't know where the money goes, you'd be smart to clean up your financial act long before you go hunting for a house.

Article written by Liz Pulliam Weston: Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.