Should You Rent Or Buy A Home? The 5% Rule Helps You Make The Life-Changing Decision
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You may be considering purchasing a new home because rental prices have surged 21.3% for a one-bedroom year-over-year and 16.7% for a two-bedroom nationally. However, will it be cost-effective to make the move from renting to becoming a homeowner? The 5% Rule may help you make one of the most important decisions of your life.
What Is The 5% Rule?
The 5% Rule was developed by a Canadian portfolio manager named Ben Felix – who notes, “To properly assess the rent-versus-buy decision, we need to compare the total unrecoverable costs of renting, to the total unrecoverable costs of owning.”
Unrecoverable costs include maintenance, property taxes, and the cost of capital (mortgage interest + opportunity costs + insurance). Homeowners are burdened with these unrecoverable costs that money is spent on that will never be seen again. These costs don’t improve property value, but merely maintain the home’s value. Typically, these unrecoverable costs are 5 percent of the home’s value – thus the 5% Rule. Property tax is generally 1% of your property’s value, maintenance costs 1%, and the cost of capital is commonly 3% of the value of the home.
Much like unrecoverable costs of homeownership, rent is also money spent that will never be seen again. Rent does not provide any investment value.
The Five Percent Rule helps you decide on whether to buy a home or rent by comparing the unrecoverable costs of owning a home versus renting a property.
How Does The 5% Rule Work?
For example, let’s say you are considering buying a $500,000 home.
Multiple the home’s value by 5% = $25,000
Divide that number by 12 for each month in the year = $2,083
If your rent for a comparable property is more expensive than $2,083 then you should buy a home. However, if your rent is cheaper, then you should continue to rent, according to the 5 Percent Rule.
Things To Consider When Utilizing The 5% Rule
Felix admits that the 5% Rule is merely a guidance, and can be an “oversimplification” when it comes to the complex and life-changing decision to purchase a home.
“When we start considering variables like tax rates and portfolio asset mix, things change,” Felix explains. “For example, the 6.57% expected return for stocks is a pre-tax return. That’s fine in an RRSP or TFSA, but in a taxable account the after-tax expected return might be closer to 4.6% for someone taxed at the highest marginal 2019 Ontario rate. This reduces the cost of equity capital.”
“Similarly, if the investment portfolio is less aggressive than 100% equity, the cost of equity capital decreases,” he continues. “If we think about this in terms of making financial decisions, it would just mean adjusting the 5% rule downward, reducing the total unrecoverable costs of homeownership.”
In conclusion, Felix notes that if you are a conservative investor then you should use a 4% rule for your real estate purchase.
[Photo via Pexels]
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