Buying a home is often seen as a step forward in the game of life. But choosing the right time can be tricky. If you’re trying to figure out whether you should continue to rent or get your foot on the property ladder, it’s worth having a look at the 5% rule.
What Is the 5% Rule?
The 5% rule was coined by Canadian investment portfolio manager Ben Felix. It stems from the general consensus among potential homebuyers that if you can afford to make mortgage payments that are equal or less than what you’re paying in rent, then buying is a better alternative. However, the 5% rule puts the buying vs. renting dilemma in a different light by factoring in the unrecoverable costs that occur in both cases.
What are unrecoverable costs? If you’re renting, they’re self-explanatory: your monthly rent is an unrecoverable cost. The money spent does provide you with a place to live, but it won’t help you own an asset as homeownership does. Also, the cases in which it can be used to improve your credit score are still rare, and they largely depend on whether your landlord will report those payments to a credit bureau.
In the case of homeownership, unrecoverable costs do not consist of mortgage payments. This is where the 5% rule comes in, highlighting three types of costs and their estimates, as follows:
- Property tax, estimated at 1% of the home value;
- Yearly maintenance costs, also estimated at 1% of the property value;
- Cost of capital, or the mortgage interest rate, estimated at 3%.
When you add them up, these unrecoverable costs can add 5% of your home value to your yearly expenses.
Admittedly, maintenance can be considered a recoverable cost, as it can increase your home value through renovations and upgrades. However, renters looking to buy should factor in the cost of property tax and interest rates into their budget, as they can easily bulk up expenses by thousands of dollars each year.
How Can It Help You Decide?
The easiest way to look at the practical applications of the 5% rule is by using this simple formula: multiply the value of a property by 5%, then divide the number by 12. The result is a monthly break-even point, which could help you decide which is a better financial choice: buying or renting.
Let’s assume that you’re looking to buy a home in Canada, and the average price you’re looking at is around $680,000. Using the 5% rule, your break-even point is at $2,833 each month. This means that if you can find a rental that charges less than that, renting would make more sense. But if you’re paying more than $2,833 on rent, you might be better off buying a home instead.
One thing worth keeping in mind is that the yearly 1% set aside for maintenance is a bit ambitious. True, it is advisable to have that money set aside in case of emergency repairs. Yet, it’s unlikely that you will spend thousands of dollars on renovations and upgrades each year. So you can drop that 1% if you need to negotiate a bit of wiggle room in your budget.
Although the 5% rule can be seen as an oversimplification, it is helpful in giving you a wider perspective over the buying vs. renting conundrum. It is easy to base your decision just on finding a mortgage that’s cheaper than your current rent. The caveat is that this excludes not just hidden costs but also non-recoverable costs, which do not help you build equity.
Can You Use the 5% Rule on the U.S. Market?
It’s best to note that the 5% rule was formulated with the Canadian real estate market in mind. However, the figures are largely similar, especially when it comes to property taxes and mortgage interest rates. So, in theory, the rule can be applied to the U.S. market as well.
Like any mortgage calculator, the 5% rule cannot predict fluctuations in interest rates, taxes or property value. What it can do is give you a sense of perspective when it comes to the financial feasibility of homeownership. Depending on where you live, the 5% rule might even reveal that renting is cheaper than buying.
And speaking of the magical number 5, don’t forget about ‘the 5-year rule’. In most cases, it is advised that you should live in your home or use it as a primary residence for five years before selling it. The longer you live in your home, the more time you have to cushion your initial investment.
As helpful as the 5% rule is when it comes to helping you decide whether to rent or buy, your long-term plans should have just as big an impact on your decision.
This article is intended for informational purposes only and should not be deemed as legal, financial or investment advice or solicitation of any kind. Before purchasing real estate or insurance, always consult with a licensed attorney, financial advisor, insurance agent and real estate broker.