It’s a common misconception that it is important to own your own home before buying investment properties. What is more, it’s true that at one time, living the “American Dream” meant homeownership and a nice car or two in the driveway. However, switching ideas, modern lifestyle preferences, and even a renewed unwillingness to commute to work have made significant shifts in rental real estate investing.
Depending on the location and your anticipated standard of living, it may make more sense to rent your home while you build an investment portfolio. To find out if 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 an easy way to decide whether it costs more to buy or rent a home. On the renting side, defining your cost is simple: it’s the amount you pay in rent every month. On the homeownership side, though, things are much more complex. The costs of owning a residential property entail more than just your mortgage payment. This is where the 5% figure enters the picture. It is a way 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 do, whereas renters do not. Let’s break down each one:
- Property tax. Using this simplified method, the cost of property tax would be roughly equal to 1% of the home’s value.
- Maintenance costs. Regular maintenance and repairs are also what homeowners spend more commonly than renters do. Like property tax, this classification is also considered about 1% of the house’s value.
- Cost of capital. The cost of capital makes up the remaining 3% of the 5% rule. To make it simple, the cost of capital is what you might 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 buy by 5%.
- Divide by 12 (to get a monthly amount).
- If the resulting amount is more than you would pay to rent an equivalent property, renting your home and investing your money in rental properties may make more sense.
Why You Should Use It
Although the 5% rule is an oversimplified way to compare the costs of renting with homeownership, it can be a powerful tool for rental real estate investors. Not only can you utilize it to make personal decisions about your personal residence, but if you own rental properties in areas where the cost of living is high, you may also teach it to your tenants to assist them in distinguishing the benefits of staying in your rental home longer. In markets where property values are quite high, this tool might prove to be the best resource as you make all future real estate investments.
Are you ready to make your next move as a rental real estate investor? Our Pawtucket property managers can give assistance! Contact us online for more information on finding and evaluating investment properties.
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.
