I generally lean towards the rent side of the Buy vs. Rent debate.  However, this mostly because I think people often rush into a buying a property without really thinking about how long they actually plan on living in a house.  There are other reasons as well, but in general buying a home is mostly not a financial decision.  It’s a decision about where and how you want to live.

What is a financial decision is the mortgage.  Many proponents of buying like to cite how leverage is one of the single best reasons to buy.  For those who aren’t familiar with leverage, leverage is the ability to control X dollars with Y dollars which is less than X dollars. In the case of home purchase, it’s the basically the ability to put 20% down, and be exposed to 100% of the property value. Leverage magnifies gains AND losses.  It’s great in a bull market, and disastrous in a bear market.

However, in all this debate about leverage, sometimes the discussion loses sight of the basic benefit of the leverage equation – the ability to borrow.  Unlike a corporation, I can’t issue commercial paper, or corporate bonds.  My only options to issue debt are: personals loans, credit cards, using brokerage margin, mortgages, and now propser borrowing.  Of all these, a mortgage is by far the best; better rates, flexibility with length and amount.  I realize that many personal finance gurus rant against debt, and rightly so.  However, debt can also be a very useful part of someone’s investment and planning.  Most corporations would not succeed if they were unable to issue debt.

The ability to borrow money against housing allows an individual to both lock in current inflation views, and to make other investments.  Given that mortgages these days generally have limited prepayment penalties, a borrower is not locked into any given rate.  The flexibility that borrowing allows can be quite useful if executed properly.

Everything in the chart above uses 1975 as base year. 1975 was the first year that I could find data for a Housing Index Price as published by the Office of Federal Housing Enterprise Oversight.  I’ve used the Massachusetts Housing Price Index.  The CPI data is from the Bureau of Labor Statistics, and the 30 year fixed rate mortgage is the December rate from FreddieMac.  The SP500 data is from Yahoo, and is the adjusted index that is inclusive of dividend reinvestment.  The one item that needs to be explained is what I call Relative Affordability.  This is simply a ratio of the mortgage payment given the prevailing interest rate and housing price divided by the CPI.  It basically tells us how affordable relative to everything else mortgage payments are.   I’ve dimensioned it so it can be appear on the same axis as interest rates on the right.  Not surprisingly it tracks interest rates quite well. 

The ability to borrow, and lock in an interest rate has everything to do with inflation. Embedded in interest rates are really three different components. 1) Time Value (A dollar today is inherently worth more than dollar tomorrow) 2) Default Risk 3) An expectation for inflation. Because a 30 year fixed rate mortgage allows us to lock in rate for 30 years, we can lock in that inflation expectation. So even if housing prices only appreciate at the rate of inflation, the ability to borrow allows us to be better off. This would’ve been the case for a housing purchase made in the mid 1970s, as inflation skyrocketed and housing prices merely kept up.

Now as we move to the high interest environment of the 80s, the relative affordability index shoots through the roof reflecting the high cost of borrowing.  However the nice thing about mortgages is that you can always refinance.  Had you borrowed in this period, you could’ve later refinanced to a lower rate.  Of course timing this can be a tricky and expensive proposition.  As rates declined, the relative value of housing boomed, and if one had purchased in the early 80s and refinanced later, a handy profit could’ve been made.  Of course you would’ve lost your shirt if you didn’t time it right.

The late 80s and 90s represent an era of stable housing prices, and benign interest rates. With perfect hindsight, one would’ve borrowed against the home equity and thrown the money into the stock market as the market shot through the roof.

The first half of the 1st decade of the 21st century, housing prices have gone up while the stock market has gone way up and then way back down. Borrowing to buy property has been effective because it has allowed one to enjoy the price appreciation on a backdrop of stable inflation. Now we’re in the middle of the decade and it looks like we’ve rounded a corner. Where that corner leads is anyone’s guess. Will the U.S. Housing market look like Britain’s? - Experience a hiccup and keep on soaring.  Will we return to an era where housing which is naturally more like a commodity return to behaving like a commodity and just track inflation? Will housing crash as many expect?

I for one don’t know the answers to these questions.  What I do know is that that a house gives me ability to cheaply borrow at a fixed rate.  In the least I can use this ability to hedge inflation.  If I am more bold it allows me invest in other assets, potentially higher interest rate bonds if inflation starts to rise.  Even though this ability to borrow can be easily abused it is an ability that is in itself worth something.