Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Effectiveness of Homeownership in Building Household Wealth

Academic journal article Economic Review - Federal Reserve Bank of Kansas City

The Effectiveness of Homeownership in Building Household Wealth

Article excerpt

The recent economic and financial crisis and the current slow recovery highlight that homeownership plays a critical role in the U.S. economy. The estimated "equivalent rent" implicitly paid by homeowners accounts for more than 8 percent of gross domestic product (GDP). Investment in single-family housing also represents a significant share of GDP and is closely tied to the business cycle. Over the past decade, such investment has ranged from as little as 1.3 percent of GDP during recessions to as much as 3.4 percent during expansions. The associated large fluctuations in demand for owner-occupied housing play an important role in driving the business cycle. In addition, demand for owner-occupied housing is especially sensitive to intermediate-term real interest rates and hence to inflation and monetary policy expectations.

Homeownership also plays an important role in determining household saving, which has implications for national saving and investment. Some aspects of homeownership increase household and national saving. For example, renters intending to purchase a home have an incentive to save to make a down payment on their first home. In addition, new homeowners must promise to save far into the future by making monthly mortgage principal payments. On the other hand, homeownership typically requires large house-related payments and so can reduce household cash flows available to invest in financial assets such as stocks and bonds.

For decades, conventional wisdom has viewed homeownership as an effective way to build household wealth. However, the recent fall in house prices has caused some observers to question this belief. This article examines whether homeownership effectively builds household wealth. It develops an analytical framework to compare the wealth that homeowners have historically accumulated by building equity in their houses with the wealth they could have accumulated by renting an identical house and investing the resulting saved cash flow in stocks and bonds.

The first section describes the analytical framework. The second section uses the framework to compare building wealth by owning and by renting an identical house for ten-year occupancies beginning in 1970 through 1999. The article finds that for ten-year occupancies beginning during most of the 1970s and 1990s, homeowners built more wealth than renters. In contrast, for ten-year occupancies beginning during most of the 1980s, renters who invested their savings from lower house payments (than owners) built more wealth. For other periods (about a quarter of the ten year occupancies), it is unclear whether owning or renting built more wealth. This ambiguity arises from the difficulty of measuring the market rent and purchase price on identical houses.

I. ANALYTICAL FRAMEWORK

Comparing the wealth built by purchasing and building equity in a house with the wealth built by renting an identical house and investing any saved cash flow in stocks and bonds requires a framework that tracks the many cash flows associated with owning and renting. These flows include both one-time items, such as making a down payment on a house, and recurring payments, such as monthly mortgage and rent payments. Such a focus on cash flows is needed because the many costs, investments, transfers and taxes associated with owning and renting a house are together too complicated to allow a simpler comparison of net present values.

This section details the framework for this flow accounting-specifically, the framework for taking account of the many cash flows that affect the wealth accumulation of owners and renters. In particular, it describes the cash and financial flows associated with owning and renting a house, the saved cash flow that the renter can invest in stocks and bonds, the breakeven rent-to-price ratio at which owners and renters accumulate equal wealth, and the market rent-to-price ratio at which households can rent or purchase an identical house. …

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