Saturday, 27 October 2012

Why Do Too Many People Buy Houses?

Josh Barro and Noah Smith made the point today that housing is a pretty bad investment for most people to make, and it seems pretty clear that houses are overvalued. The problem is that for many people there’s something special about home ownership – people don’t see taking out a mortgage to buy a house as just any old investment. If they did, they would do a lot less of it.

Compare buying a house to investing the deposit, plus the money which you would have spent on mortgage payments above and beyond what it costs to rent, in a global stock market fund. In simple terms, housing probably offers a worse return than the stock fund would. Barro notes that it’s also much more strongly correlated with unemployment. Your savings are most important when there’s an economic downturn – you stand a higher chance of losing your job and needing to rely on those savings. But house prices are also likely to drop sharply in a recession. Because house purchases are so highly leveraged, the effects of a decline in value can be disastrous – losing your job means you can’t pay your mortgage, and suddenly the savings you had in the form of your house have been repossessed. Housing is a savings vehicle that becomes worthless as soon as you need to access it. You’d be much better off if you had your savings somewhere that isn’t likely to collapse at the same time as you lose your job, like China.

Another cost to housing as an investment is its inflexibility. If you need to tap those savings, because you’re between jobs or your car breaks down or your son really needs you to e-mail him a plane ticket back from Thailand, it’s really hard to get money out of your house. You might be able to refinance over a longer term, effectively reducing your payment, or with a higher principle, but remortgaging is time-consuming, expensive, and is subject to the whims of your bank. Equity-release schemes, meanwhile, are risky and charge exorbitant rates. It’d be much easier to sell some of a stock portfolio.

However, this inflexibility might also explain why housing is attractive. Comparing buying a house to investing in stocks assumes that you invest the same amount of money either way. If you rent, though, you’re going to have a lot more disposable income, and it’s going to require a much greater effort of will to save that money. ‘I would have to put less money into my portfolio this year’ is a much less likely to persuade Future You to forego the family summer holiday than ‘I wouldn’t be able to pay the mortgage.’ In this sense, you’re entering into an inflexible commitment to save.

You might have very good reasons for doing this. Perhaps you’re worried that Future You will be seduced by the allure of the Costa del Sol or a V8 penis substitute, and won’t save enough to finance the retirement you have in mind. By entering into a big inflexible mortgage, you force Future You to save that money. It’s the same logic as that of the dieter who puts a lock on the fridge door at night, or the blogger who pays someone to slap him when he checks Facebook. By increasing the costs of a lapse in self-control, you can make it more likely that you get the long-term outcome you want – in this case, adequate savings for later life.

Publicly forcing yourself to commit has implications for relationships, too. Home ownership is inevitably tied to the institution of marriage – and its importance is increasing as the traditional social attitudes to divorce weaken. Getting a mortgage with your partner is an explicit commitment to your long-term relationship. It makes leaving the relationship costly, forcing you to expend a lot of effort trying to make that relationship work when you might otherwise be impetuous. It’s also an important signal that you are the kind of person who places value on the importance of commitment, in the same way that the dieter’s girlfriend might be impressed by the lock on the fridge door. If, on the other hand, you extoll the virtues of your highly portable global stock index, your partner might start to worry about your motivation for trying to minimise the impact of divorce on your savings. And so you have an incentive to commit.

People don’t treat buying a house like they would other investments, but it’s not enough to say that this is simply irrational. There are a lot of good reasons why people might not be indifferent between owning and renting, and why they might want their chosen savings vehicle to be highly inflexible.

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