Is it Really Cheaper to Buy Than Rent?

Recently news stories indicate that in some cities it is much cheaper to buy a home than rent. The reason why that may be is that perhaps a fifth of the population may have needed and still needs to use “Easy Qualifier” mortgages to qualify for a loan. These borrowers can’t play the housing game so they have to rent. Or some potential buyers lost their equity after going into foreclosure and have no down payment money.

Recently lenders started offering Easy Qualifier loans but at junk bond spreads instead of offering loans at the same rate as fully documented loans which was the custom before 2009.  One lender charges 3% more than a full doc loan and an extra three point loan fee, which if amortized over four years would boost the Annual Percentage Rate (APR) another 0.75%, for a total marginal spread of 3.75% over the rate for a full doc loan for an “A” paper borrower.

This means that if a borrower can’t qualify he might be able to get a loan by paying a junk bond-like spread of 3.75% over what full doc “A” paper grade borrowers pay. So if a home costs $300,000 outside of California the extra 3.75% per year cost of capital would be $11,250 extra  a year. (Assume that the borrower has a hypothetical cost of equity capital that is the same as the cost of debt capital, so multiply the rate times the purchase price instead of the loan amount to see what the true cost of capital is). In the Bay Area it would be double or triple that. This higher cost of capital explains why some potential homebuyers don’t see ownership as cheaper than renting.

Add other closing costs such as title and escrow fees and amortize over six years and that might add another $500 a year. Add to it the cost of selling at 6%, which if amortized over six years would be another $3,000 a year cost. So some unfortunate people in rural areas may feel the true cost for them personally might be $15,000 a year more than the “A” paper cost of a mortgage, and double or triple that in coastal California. Thus an unfortunate California buyer using a “B” paper Easy Qualifier loan might be paying a margin extra annual cost of $45,000 a year. At that rate it is cheaper to rent.

Regarding the tax deduction for mortgages and property tax that tends to benefit those with jumbo loans rather than conforming loans and then the jumbo borrowers also have a problem with Alternative Minimum Tax limiting property tax deductions. Jumbo borrowers may encounter the Pease limitation restricting the ability to deduct mortgage interest even if it is not limited by AMT.

To qualify for a loan a self-employed or commissioned person needs two years of stable income and the lender uses the net profit not the gross revenue. In modern times self-employment has become more volatile thus increasing the risks that a borrower may have had a bad earnings year in recent years and thus has to wait another two years until his two year average (that's two years in a row) is high enough and stable enough to qualify. This problem didn’t exist during the recklessly easy era of Easy Qualifier loans from 1984-2009. Today the only lenders who offer Easy Qualifiers charge a high 300 basis points spread on the “Note” rate over “A” paper mortgages, plus the higher points fee for an all-in higher APR of about 3.75% over the "A" paper APR.

I don’t expect the rate spread on Easy Qualifier loans to come down. I anticipate that for a long time there will be people trapped in no-equity homeownership situations who can’t participate in move-up transactions. Banks hold a shadow inventory of homes (that they are not spending money on to maintain) which cost them nearly nothing as they get Fed Funds at 0.25%. These homes will eventually be sold, increasing the supply of rental units and the supply of homes for sale.

Investors need independent financial advice about hidden anomalies in real estate markets. I wrote an article “Why is real estate overpriced?"

About the author

Don Martin, CFP®

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