A rational approach to the rent vs. buy decision in an irrational world
Published in · 8 min read · Oct 28, 2020
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The decision of whether to buy or rent a home has become one of the most debated topics in personal finance. While some believe that owning an asset is always better than paying rent, others look at the cost of ownership as too high to make it worthwhile.
Luckily, Canadian portfolio manager and YouTuber Ben Felix developed a rational approach to answering the rent vs. buy decision that he calls the 5% rule.
Here is how the 5% rule works. Multiply the value of the home by 5%, then divide that number by 12 to get your breakeven point. If the monthly rent on a comparable home is below the breakeven point, it makes financial sense to rent. If the monthly rent is higher than the breakeven point, it makes financial sense to buy.
In this article, I’ll review the 5% rule and expand on the discussion by focusing on some of the crucial questions that the 5% rule does not address and other critical questions you should ask before deciding whether to rent or buy.
The 5% rule
The idea behind the 5% rule is to compare what Ben Felix calls the “unrecoverable costs” of renting and buying a home.
The monthly cost of renting a home is simple; it is equal to how much you pay in rent.
The monthly costs of owning a home are more complicated. Homeownership costs generally fall into three categories.
- Property tax
- Maintenance costs
- Cost of capital
As part of the 5% rule, Felix assumed the annual cost of taxes and maintenance to be 1% of the value of the home. For a $500,000 home, that would work out to be $5,000 for both taxes and maintenance for a total annual cost of $10,000.
You might be wondering what “the cost of capital” of buying a house means?
This is where things get a bit technical, but essentially it refers to the cost of a mortgage + the opportunity cost of using your downpayment to buy a house rather than invest in the stock market.
It’s best to illustrate with an example.
- Let’s say you buy a $500,000 house with a $100,000 down payment.
- You get a $400,000 mortgage at the rate of 3%.
- Felix then compared the historical return in the stock market compared to real estate and found that, on average, the stock market has outperformed real estate by 3% per year.
- That means your $100,000 downpayment has a 3% per year opportunity cost because you put it in real estate rather than the stock market.
- So the total cost of capital (debt+equity) is 3%.
That’s where we get to 5%
- 1% for property tax.
- 1% for maintenance costs.
- 3% for the cost of capital.
If you want to get into the details on the numbers behind the 5% rule, check out this article.
Here is how the 5% rule works in action
- Multiply the value of your home by 5%.
- Divide by 12.
- The result is the breakeven point, where renting is financially equivalent to buying.
Returning to our example where you are considering whether to buy a $500,000 house. Here is how to use the 5% rule to find the breakeven point on the rent vs. buy issue.
- Multiply the value of the home by 5% = $25,000
- Dividing that number by 12 = $2,083.
- $2,083 is the monthly breakeven point for owning that home
If you could rent an equivalent home for less than $2,083, you are better off renting.
If it would cost you more than $2,083 to rent a comparable home, you are better off buying.
The 5% rule is a rational framework to help think about the rent vs. buy decision. Having said that, it is far from perfect and does not address a lot of critical questions surrounding the decision of whether to buy a home.
Let’s address some of those issues not addressed by the 5% rule.
You were so preoccupied with whether or not you should; you didn’t stop to think if you could
The 5% rule answers whether it is rational to rent or buy a comparable home.
What it does not do and does not intend to do is answer an even more important question; are you in a financial position to buy a home?
One of the most common questions I get from readers when I write about real estate is how much of your income should you spend on housing costs?
There is no magic number, but the most common advice from financial experts is to spend no more than 30% of your gross income on housing costs.
How to determine if you can afford to buy a house in 5 steps
If you are wondering if you can afford to own a particular house, you can follow these five simple steps.
- Step 1: Google “mortgage calculator” and determine the estimated monthly mortgage for a house you are looking for. Multiply the monthly mortgage payment by 12.
- Step 2: Add 1% of the purchase price for property taxes.
- Step 3: Add 1% of the purchase price for maintenance costs.
- Step 4: Add an estimate for the annual utility costs.
- Step 5: Add the total from steps 1–4 and divide that number by your gross (pre-tax) annual income.
The result from step 5 will tell you how much of your gross income you can expect to spend on housing costs each year if you buy the property. If it is above 30%, then you likely cannot afford to live in that house.
People are human, and humans are not rational
My educational background is in economics, so naturally, I love the 5% rule because it explains how a perfectly rational person would make a decision.
Here is the problem with the 5% rule and most economic models; people are not rational.
That is where the “cost of equity” assumption falls on its face. If you had $100,000 saved for a down payment on a $500,000 house and you decided to rent instead of buy, the 5% rule assumes you would invest that $100,000 in the stock market.
It’s what the perfectly rational person would do.
Sadly, the perfectly rational person does not exist. In reality, most people would not invest any of that $100,000 in the stock market, let alone the whole thing.
Perhaps the greatest benefit of owning a home is that it forces people to save.
- On average people do a poor job of finding money to invest in the stock market.
- Overwhelmingly, people do a fantastic job of making their mortgage payments.
When considering whether to rent or buy, It’s important to be honest with yourself. The less likely you would be to invest extra money as a renter, the more the math favors owning over buying.
I wish more people were comfortable investing (it is one of the goals of this publication), but the data is clear that people won’t (or can’t) save enough money unless they are forced to do so.
That is why pension plans and mortgage payments are an easy way for people to boost their savings rate; when saving is made mandatory, people will save.
Closing costs of buying a home
When you buy a home, there are a lot of fees and taxes you will have to pay.
- Underwriting fees
- Land/deed transfer taxes
- Legal fees
- title insurance
- Real estate agent commissions (often “paid” by the seller, but it’s baked into the price of the home)
- Home inspection
All-in closing costs can range from 2%-7% of the purchase price of a property.
These closing costs are not explicitly accounted for in the 5% rule.
This would add to the opportunity cost of owning a home for the rational person who would invest the money otherwise used for closing costs. However, as we have already discussed, most people are not rational and would probably only invest a small percentage (if any) of the savings on closing costs if they chose to rent.
The mortgage interest deduction
One of the smartest questions when I first wrote about the 5% rule was how the mortgage interest deduction factored into the equation?
The answer is that it does not.
Like me, Ben Felix, who came up with the 5% rule, is Canadian. Sadly, we Canadians do not have a similar program to the Mortgage Interest Deduction in the U.S, where homeowners can potentially deduct interest on $750,000 to $1 million of mortgage debt.
If you live in the U.S and you can deduct some or all of the interest you pay on your mortgage from your taxes, that pushes the math to favor owning over renting.
The higher your marginal tax rate, the more attractive buying looks compared to renting for those in the U.S.
House hacking
The 5% rule assumes that if you buy a home, you and your family are the only people that will live in that home.
But what if that isn’t the case?
The term house hacking refers to situations where someone finds a way to generate rental income from their primary residence. This effectively lowers the cost of housing for the homeowner.
Common examples of house hacks include;
- Renting your house on Airbnb when you are out of town.
- Renting out a room in your house.
- Buying a multi-family property and living in one unit while renting out the others.
- Turning a basement into a (legal) apartment and renting it out.
Once you own your home, you own the asset. That gives you more freedom of what to do with that asset compared to someone who rents.
The more income you can generate from your primary home, the more the math favors buying over renting. Of course, you will need to factor in the risk and time associated with becoming a landlord, but the opportunity is there.
There is a reason homeownership is so popular
If we lived in a purely rational world where the incentives were equal between renting or buying a home, a lot more people would rent.
Unfourtantley, the world we live in is far from rational. When you consider the fact that most renters would not invest enough of the money they save, the forced savings provided by a mortgage payment, the tax incentives, and the opportunity for house hacks; the numbers begin to favor owning vs. renting.
That does not mean owning a home is always the right choice. First, you need to decide if you are in a financial position to be a homeowner.
Then you can use the 5% rule as a starting point on your rent vs. buy decision. But like with all financial rules of thumb, the 5% rule should be where your research begins, not where it ends.
Thinking of buying a home?
If you are thinking of buying a home, I invite you to enroll in my class on Skillshare called “How to save for a house in 5 simple steps.” Where you will learn how to build a savings plan that will turn the dream of homeownership into a reality.
In the interest of full disclosure, I do receive a referral fee from SkillShare if you sign up for the free trial. It does not cost you anything if you cancel before the trial ends and helps us keep this publication going.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.
