It’s a common misconception that you should own your own home before buying investment properties. And the facts really confirm that before, living the “American Dream” meant homeownership and a nice car or two in the driveway. Yet, changing ideas, modern lifestyle preferences, and even a renewed unwillingness to commute to work have gotten huge shifts in rental real estate investing.
Depending on where you live and your desired standard of living, it may make more sense to rent your home while you build an investment portfolio. To figure out whether you should rent or buy your primary residence, you can (and should) use what’s known as the 5% rule.
The 5% Rule
The 5% rule is a straightforward strategy to determine whether it costs more to buy or rent a home. On the renting side, figuring out your cost is uncomplicated: it’s the amount you pay in rent every month. On the homeownership side, though, things are a little more complex. The costs of owning a residential property include more than simply your mortgage payment. This is where the 5% figure plays its part. It is a method to compare the cost of renting to owning a home.
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 pay and renters do not. Let’s break down each one:
- Property tax. By utilizing this basic method, the cost of property tax would be roughly equal to 1% of the home’s value.
- Maintenance costs. Consistent maintenance and repairs are also something homeowners spend more frequently than renters do. Like property tax, this class is also believed 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 simplified terms, the cost of capital is what you could be earning on the money tied up in your home (usually in the form of a down payment) if it was invested in some other form, such as 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 look like this:
- Multiply the value of the property you own/want to obtain by 5%.
- Divide by 12 (to get a monthly amount).
- If the resulting amount is more significant than you would spend to rent an equivalent property, renting your home and investing your money in rental properties might seem okay.
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. You can use it not only to conduct personal judgments 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 with recognizing the benefits of staying in your rental home longer. In markets where property values are relatively high, this tool might definitely be a great resource as you make all future real estate investments.
We are pledged to the letter and spirit of U.S. policy for the achievement of equal housing opportunity throughout the Nation. See Equal Housing Opportunity Statement for more information.