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 renting your next home because, while interest rates have skyrocketed, home prices have not seen significant changes over the last year. However, will it be cost-effective to make the move from becoming a homebuyer to renting? The 5% Rule may help you make one of the most important decisions of your life.
Pros Of Buying A House Over Renting
Building equity: When you buy a house, you are investing in an asset that can appreciate in value over time. As you make mortgage payments, you are building equity in the property, which can be used as a source of financial security in the future.
Tax benefits: Homeowners are eligible for certain tax deductions, such as deductions for mortgage interest and property taxes, which can lower the overall cost of homeownership.
Customization and personalization: When you own a home, you have the freedom to make any changes or renovations that you want, which can make it feel like a more personal space.
Forced savings: Making a mortgage payment each month forces you to save money, which can help you to build wealth over time.
Stability: Owning a home can provide a sense of stability and permanence, as you are not at the mercy of a landlord’s decision to raise rent or sell the property.
Building a Community: Buying a house in a neighborhood can help you to build a sense of community and connection to the area where you live.
Cons Of Buying A House Over Renting
Initial costs: Buying a house can be expensive, as it requires a large down payment and closing costs, as well as other expenses such as inspections and appraisals.
Risk of negative equity: If the value of a house falls below the mortgage outstanding, it can lead to negative equity, which means that the homeowner owes more than the house is worth.
Maintenance costs: Owning a house comes with the responsibility of maintaining and repairing the property, which can be costly and time-consuming.
Difficulty in relocating: Buying a house can make it more difficult to relocate, as selling a house can take time and be subject to market conditions.
Less flexibility: Buying a house can limit flexibility in terms of location, as it ties you to a specific area and makes it harder to move around as needs change.
Long-term commitment: Buying a house is a long-term commitment, and it may not be the right choice for those who want the flexibility to move around or change living arrangements.
Higher costs in some areas: In certain areas, owning a house can be more expensive than renting, especially if the housing market is not favorable.
Now that we understand the benefits and pitfalls of homeownership…
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.