To Buy Or Not To Buy?
The 5% Rule
A new way to look at the rent vs buy decision
The 5% Rule
Housing is most people’s largest financial expense. We must make sensible decisions when it comes to our housing choices. To complicate matters housing is much more than a financial decision. There is a huge emotional component that goes into our decision of where we live.
For decades there has been a stigma against renting. As a result, many people decide to buy a home rather than rent a home. This may or may not be a good financial decision. The problem is that many homeowners decided to buy based on the notion that “owning is always better”. Most people do not have a comprehensive framework to evaluate the rent vs buy decision.
Measuring the costs of renting and buying
I recently watched a fascinating video Ben Felix who is a Canadian investment portfolio manager. Ben argues that the rational way to decide on whether to rent or buy is to compare the cost of renting with the cost of buying.
The monthly cost of renting a home is simple. It is equal to how much you pay in rent.
The monthly costs of owning a home are more complicated. Homeownership costs can be broken down into three categories.
- Property tax
- Maintenance costs
- Cost of capital
The 5% rule
Ben has come up with a simple calculation to help evaluate the rent vs buy decision which he calls the “5% rule”, which compares the monthly cost of owning to rent. The 5% rule is an estimation of the three costs that homeowners face that renters do not.
1. Property tax is generally assumed to be 1% of the value of the home. This is the first part of the 5% rule
2. Maintenance costs are also assumed to be 1% of the value of the home. This is the second part of the 5% rule.
3. The cost of capital is assumed to be 3% of the value of the home. This is the final part of the 5% rule.
Let me expand on the cost of capital.
- To buy a home you put down a down-payment in cash. This is typically 20% of the value of the home which means you need to finance the remaining 80% with a mortgage.
- The down-payment is your equity
- The mortgage is your debt
- Together your debt and equity make up 100% of the value of your home.
- Cost of capital = cost of debt + cost of equity
The cost of debt is measured by the interest you pay on your mortgage. Ben looked at the data and concludes that most mortgages currently being issued in Canada have an interest rate of 3%. Therefore, your cost of debt is 3%.
But what about your equity in the house, how can that be considered a “cost” of homeownership? The cash you put down to buy a home has an opportunity cost. This is the difference in returns between the global stock market and real estate.
- Ben’s firm projects a 3% annual return for real estate and a 6.57% annual return from the global stock market.
- The difference, 3.57%, is the annual opportunity cost of investing in a real estate asset (buying a house) compared to investing in the stock market.
For example, if you put down $100,000 in cash to buy a house your annual opportunity cost of investing in real estate vs the stock market is $3,570 (3.57%).
To be conservative, Ben reduces the projected opportunity cost down from 3.57% to 3%. Assuming a mortgage rate of 3% (cost of debt) and the opportunity cost of equity at 3% the total cost of capital for homeowners is 3% per year. This makes up the final piece of the 5% rule.
- Property tax: 1%
- Maintenance: 1%
- Cost of capital: 3%
The buy or rent breakeven point.
Here is how the 5% rule works in action.
- Multiply the value of your home by 5%.
- Divide by 12.
- The result is the break-even point where renting is financially equivalent to buying.
This is best illustrated with an example. Let’s say you are considering whether to buy a $500,000 house.
- Multiplying the value of the home by 5% = $25,000
- Dividing that number by 12 = $2,083.
- $2,083 is the monthly break-even point for owning that home
If you could rent an equivalent home for less than $2,083 you are better off renting.
If it would cost you more than $2,083 to rent an equivalent home you are better off buying.
What I like about the 5% rule
Ben admits that the 5% rule is an oversimplification and will not provide the exact costs. However, adopting this framework forces you to consider all the costs, including the opportunity cost of owning a home.
The 5% rule will provide an obvious outcome in overpriced real estate markets. Consider the case of Toronto where the average home price is around $1 million. Putting 20% down would require you to come up with $200,000 in cash and STILL require an $800,000 mortgage.
The 5% rule would tell us that you would be better off if you could rent a home for less than $3,333 per month. The average cost of rent in Toronto is $2,260. From a financial perspective, you are better off renting if you live in Toronto than buying.
Tilting the numbers in your favor
When you own your home you have complete control of who lives in that house. Typically, renters do not have that type of control.
This allows you to earn income by renting out rooms in your house. Going back to the example of a $500,000 house.
- Let’s say that is a 3 bedroom house.
- If you could rent the other 2 bedrooms for $1,000 per month that will generate an additional $24,000 per year in income.
- This would heavily tilt the math in favor of owning.
I realize that not everyone will be comfortable having roommates. However, from a purely financial point of view, it dramatically lowers the cost of homeownership.
As with every financial decision, there is an opportunity cost. If you choose to live alone in a 3-bedroom house the opportunity cost of privacy is the cost of homeownership. If you choose to rent out spare rooms you can have your tenants pay some or all fo the costs of homeownership and your opportunity cost is the forgone privacy.
Only you can decide which cost is worth paying.
Overall, I love this way of thinking about financial decisions and am a huge fan of Ben Felix. Check out his video explaining the 5% rule here.
What do you think about the 5% rule? Keeping in mind this is an oversimplification, would you use the 5% rule as part of your decision making around the buy vs rent dilemma? Let me know in the comments.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions