Summary: One of the great myths about buying property is that it is an excellent way of ensuring disciplined saving of income. This is known as the "forced savings" argument for buying a home: that even if financial calculations indicate you would be better off renting and investing your surplus income elsewhere (e.g. superannuation, shares), mortgage payments are a more reliable way to accumulate wealth. In reality, paying off a mortgage is not equivalent to building up actual savings as your debt payments do not accumulate like a normal savings account. Instead, whether you actually come out ahead in the end is dependent primarily on how much your property ultimately sells for and what happens to interest rates - things that are outside your control and are quite a risky gamble. The only guaranteed winners from large mortgages are banks which capture your savings for decades. In return, what you get is a big bet on future house prices. The current very high property prices in most Australian cities make this a very risky bet.
Details:
1. How an actual savings plan works
Real, sensible, long-term savings have nothing to do with taking on a massive amount of debt to buy a single asset and then hoping interest rates don't get too high and house prices have risen sufficiently when you sell. Not to mention crossing your fingers that nothing goes badly wrong over the years, like losing your job or being forced to sell early (e.g. relocate, relationship splits).
As an example, if you rent close to work, you might save around $1,000 per month compared to taking out a mortgage on a similar home. If you were to actually save this money in a savings account paying 5% interest* you would have $155,000 guaranteed after 10 years. Those are real, accumulated savings. (*Current interest rates might be very low but one of the advantages of term deposits is that you can lock in decent rates for up to 5 years. P2P lending also offers much better rates than 3.5% term deposits).
2. A mortage-related "forced savings" plan is just a leveraged gamble on house price growth, interest rates and not having to sell early
For our example, I'll use the real case of 13 Mary St, Preston which sold for $700,000 on 11 April 2015 and is listed for rent at $420/week in June 2015. We'll compare two scenarios representing good luck and bad luck with interest rates, home price appreciation and rental increases.
Good Luck Scenario:
Average loan interest rate: 5%
Home appreciation: 5% per year (Westpac default)
Rental increases: 4% per year (Westpac default)
Sell after 10 years and Buying ($598,448) beats Renting ($376,346) by $222,000.
Sell after 30 years and Buying beats Renting by $1,148,611.
In this scenario, renting is only better if you're forced to sell after 1 year. After that the high home appreciation rate and low interest rates result in a massive speculative windfall when someone buys the property off you for hundreds of thousands more than what you paid.
Bad Luck Scenario:
Average loan interest rate: 7% (Possible according to Aussie banks themselves)
Home appreciation: 0% per year (This is possible average over several years if the bubble pops)
Rental increases: 2% per year (More accurate based on current growth)
Sell after 3 years and Renting ($198,275) beats Buying ($122,244) by $76,000
Sell after 10 years and Renting ($376,346) beats Buying ($123,943) by $252,000
Sell after 30 years and Renting ($1,420,385) beats Buying ($53,665) by $1,366,720
This is a huge reversal of $474,000 over 10 years. All it takes is for home price growth to be minimal or go backwards over several years and for interest rates to be higher than their current historic lows. A home buyer could end up with less money after several years than what they started with plus still be trapped with a large debt to keep paying off.
Conversely, any real savings plan can only go in a positive direction (no matter how slowly) as the regular savings accumulate and also earn interest.
3. A mortage-related "forced savings" plan involves paying a lot of interest to a bank in exchange for a leveraged bet on house price growth
Part of the deception of the "forced savings" myth occurs because it seems like real saving: setting aside a large amount of income each month and sending it to a bank. However, those considering taking out mortgages should take a look at two key parts of their loan repayments table - the Total Interest Payable and the amount of their Principal they are paying off in the first 7 years.
Using our example of 13 Mary St, Preston you can see that a 30 year loan at a 5% interest rate would require paying total interest of $522,232. And in the first 7 years you can see why this massive amount accumulates - the annual mortgage payments are mostly interest.
These "forced savings" plans turn out to be guaranteed transfers of hundreds of thousands of your hard-earned savings to a bank in exchange for getting the chance to gamble on house prices increasing by more than 3% a year. If they don't average at least 3% growth, you're likely to have your wealth go backwards by being a property owner.
4. Ultimately the entire model of building wealth through housing rests on whether future long-term, property price growth will follow past growth
I'd call this wealth building strategy a complete fraud if it wasn't for the fact that over the last two decades it has actually worked out well for most long-term home owners in most countries. Over the last two decades, house prices have averaged gains at more than the rate of inflation and so as long as you didn't sell too soon, it was a pretty reliable way of building wealth. Inflation and interest rates are also very likely to remain at lower levels given the state of the economy.
The big question since the Global Financial Crisis is whether the broad housing market will continue to perform so reliably in developed economies given lower population growth, lower economic growth, stagnant wage growth and high levels of debts (government and especially household). Also some countries and cities have massive oversupply (e.g. Spain, Detroit) while others are still very expensive (e.g. Australia, Canada).
The key assumption in Westpac's Rent vs Buy Calculator which all potential Australian home buyer's need to consider carefully is this presumed average home appreciation rate. Most lenders and firms that make money from property think rates of 3-6% average growth are eminently reasonable. On the other side are sceptics that think property prices will go nowhere or backwards over much of the next decade.
I can only point out that for our example of 13 Mary St, Preston at a 5% home appreciation rate after 10 years the $700,000 house would need to be sold for $1.14 million. This means the new purchaser would need to have saved a deposit of $228,000 and stamp duty of $63,000. On a loan amount of $912,000 they would have monthly mortgage payments of $5,166 (annual payments over $60,000) and pay $948,000 just in interest over 30 years. In total: paying off a $1.86 million loan in addition to the upfront costs.
Given the current state of the economy and medium term outlook, these are absurd presumptions about the future capacity to service such massive loans. Developed economies like Australia's face significant challenges for the next few decades. I expect it to be challenging to obtain high-paying jobs and that wages for many workers will be stagnant; 5% average wage growth would be a fairytale.
I would argue that even 3% average house price growth from current levels is very high and is only predicated on speculation, not an economy expecting growing wages for decades. The problem with speculation and treating property as an investment is that expectations can shift rapidly. When the next slump starts, it is likely to become entrenched as people factor in future price falls or price stagnation rather than rises.
Further Info:
Get Rich Slowly
Does Renting Make Sense?
NY Times
As Home Prices Drop Low Enough, a Committed Renter Decides to Buy
In Defense of Home Ownership
Stockspot
Rent or Buy? We do the sums
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