Depending on the area and your intended standard of living, it may make more sense to rent your home while you build an investment portfolio. To recognize whether you should rent or buy your primary residence, you can (and need to) apply what’s known as the 5% rule.
The 5% Rule
The 5% rule is a simple procedure to figure out whether it costs more to buy or rent a home. On the renting side, knowing your cost is simple: it’s the amount you pay in rent every month. On the homeownership side, however, things are a bit more confusing. The costs of owning a residential property include more than just your mortgage payment. This is where the 5% figure emerges. It is a method to compare the cost of renting to owning a home more directly.
How It Works
The three main components of the 5% rule include property tax, maintenance costs, and the cost of capital. These are costs that homeowners face, whereas renters do not. Let’s break down each one:
- Property tax. Using this basic procedure, the cost of property tax would be roughly equal to 1% of the home’s value.
- Maintenance costs. Daily maintenance and repairs are also something homeowners compensate for more regularly compared to renters. Like property tax, this category is similarly estimated to be about 1% of the house’s value.
- Cost of capital. The cost of capital makes up the remaining 3% of the 5% rule. In simple statements, the cost of capital is what you could be collecting on the funds tied up in your home (usually in the form of a down payment) if it was invested in some other manner, including an investment property or the stock market. It’s a cost because of the interest you pay on your mortgage, often around 3%.
Applying the 5% rule would appear like this:
- Multiply the value of the property you own/want to get by 5%.
- Divide by 12 (to get a monthly amount).
- If the resulting amount is bigger than it would cost to rent an equivalent property, renting your home and investing your money in rental properties may make perfect sense.
Why You Should Use It
Even though the 5% rule is an oversimplified way to compare the costs of renting with homeownership, it can be a helpful tool for rental real estate investors. Not only can you employ it to make personal choices about your personal residence, if you own rental properties in areas where the cost of living is high, you could also teach it to your tenants to assist them in knowing the benefits of staying in your rental home longer. In markets where property values are really high, this method could serve as a vital resource as you make all future real estate investments.
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