Mental Accounting and Other Errors in Home Buying

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Homeownership –  the American Dream. The one that contributed significantly to the Great Recession and is still responsible for the slow recovery we are seeing. There is some change in this love to own a home, among some demographics,  but not much to call it a shift.

To explain why we still prefer buy vs. rent will take a book, so let us keep it brief and look at the errors we commit in our thought process. There was an article in The Washington Post that wrote about a research that found, “Average American’s don’t think like Economists”.

That explains a lot about our love for buying homes.  I should add, when it comes buying or selling their own homes most economists don’t think like economists.

  1.  The Seller pays all the realtor fees- The first thing any realtor will tell a prospective homebuyer is, “you don’t pay me anything, the seller pays me“. Conflict of interests aside, how does the seller really pay? It does not come from a different pot the seller has. The seller pays by including it in the price of the house.A moment’s reflection will convince  you that the day you sign the 2564th document they thrust in front of you during closing, you are down 5-6%. In other words even if you sold the house the next day you will lose 5-6% of the price you paid.
  2. Rent is down the toilet – Rent is an expense. By extension every expense we make is down the toilet. Besides this ignores the fact that your interest payments, most of your monthly mortgage payments are just that in the first few years, are down the toilet too. Interest is the rent you pay to use the bank’s capital to buy the house.
  3. Interests are tax deductible, rent is not – True and this could be used as a another point to bolster the case, “rent is down the toilet”.  First there are limits on mortgage interest tax deductions. Second, renters indirectly get the advantages of the tax deduction.
    When you rent a home or apartment recognize that they are owned by somebody who is paying mortgage interest on that property. Because of the tax deduction the cost to own is reduced and hence  more are willing to get into the renting business. As more such owners buy to rent it out, the supply of rental properties increases and hence the price decreases. If there were no deductions fewer people may own rental properties and the decrease in supply will push up rent. Either way renters get part of the benefits of mortgage tax deduction.
  4. Prices will always go up –  There is enough data published by Case-Shiller that says prices don’t go any faster than rate of inflation. We all suffer from optimism bias, ignoring the downside and giving higher likelihood to favorable scenarios.
    Even if it did, what does it mean to us to take advantage of the new higher prices? We need to sell the house first. Where would we live then and what would be the costs? If your home price went up so did the whole neighborhood, city,  and state. Unless you are ready to move to a low-cost state there is no upside to the home price increase.
  5. Opportunity cost of down payment – This is huge for those buying houses in Bay Area. When you sink 20% of the price of the home in one illiquid asset you are losing out on the opportunity cost of investing the same capital in any diversified fund.
    While realtors tell you, “when stock market goes down you are left with nothing to show for but even when your home prices go down you have a place to live”, you need to ask
    – will my mortgage payments stop? No.
    – Is my down payment safe? No, that is wiped out with just 10-20% down swing in home prices.
    –  will i still have job in the same neighborhood? Unlikely.
    If the stock market is wiped out, will be home market be any better? They are not completely uncorrelated. At least you get diversification when you invest your down payment in a broader market.
  6. Locking in my “rent” for next 30 years – This is usually stated as post-purchase rationalization, “at least I know what my payments will be for the next 30 years”.  If the economy goes south, you are liable for the same level of payments even if the market prices for rent are lower.
    If indeed rent goes up, then you need to realize that you are maintaining the same quality of life at a higher cost even though there is no additional money flow. In other words you could rent the home out to take advantage of higher rent and reduce your standard of living by renting a lower quality place for you.  The net is there is no advantage in locking in payments.
  7. Unlocking  equity - Homeowners repeat this phrase as if it were a self-evident truth. They speak as if they sold part of the house and cashed out without really giving up that part of the house. The basic accounting equation is
    Assets = Liabilities   + Equities
    When you buy the home it is added to the asset column at the price you paid and the mortgage you took is added to the liabilities. The down payment is added to equities column. The two sides of the equation are matched.
    When market price for homes goes up it does not really do anything to the asset side unless you are doing mark-to-market accounting (which we don’t). If we did that then the assets column will go up. The increase in left side of the equation is balanced by adding the same amount to the equities column.
    What you do when you take out a home equity loan is move some or all of that increased equity to liabilities column.
    The net is, you are liable for the additional loan you take out.  It is not like you are issuing new stocks to convert the asset class to cash.

There you have it, the seven errors in our thinking that leads us to prefer buy over rent.

Other articles:

  1. Home Staging - Why our willingness to pay is higher with staged homes?
  2. Ignoring the downside – Prices will always go up
  3. Slow decline in home prices – why prices are slow to fall
  4. Home Prices – Value gap

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