Is Buying a House Better than Renting? The 5% Rule of Real Estate. (2024)

Have you ever wondered about whether or not it is a good decision for you to buy a house instead of renting it? Or is it the other way around? For some people, renting somehow sounds a less good choice compared to buying a house, but is it really true?

The 5% rule was invented by Ben Felix, a portfolio manager at PWL Capital based in Canada. This rule is aimed to help assess the rent vs buy decision in real estate industry. Buying or renting is such a hard decisions among potential home buyers. The up and down sides of both renting and buying will be discussed further in this article together with how The 5% Rule will help you make the best decision possible in real estate industry.However, before we try to dig in more about how the 5% rule works and how you can apply it in your housing demand decision making, it is best for you to understand the exact differences between renting and buying a house to give you a clear understanding regarding these two.

Renting a house has always been seen as a “throwing-away” money decision, which is a total myth.In fact, we all need a place to reside, which will cost us money in some way. While it is true that monthly rent payments do not contribute to equity growth, but not all of the costs of owning contribute to equity growth. When you rent, you have the freedom to move whenever your contract expires. However, if your landlord decides to sell the property or convert your apartment complex into condos, you may be forced to relocate quickly, or in a dramatic way, they could simply raise the rent to an amount that you are not willing or cannot afford.

Meanwhile, owning a house does offer you intangible benefits such as a sense of stability, belonging to a community, and “pride” of ownership, which leads to validation. It is not, however, suitable for restless or itinerant individuals. The first illiquid asset was real estate. If the home market is down, you might not be able to sell when you desire. Even if it's up, selling incurs considerable transaction expenses. When you own a home, it is much more expensive to change your mind about where you want to live since the total cost of ownership is typically higher than the total cost of renting. Even if the monthly mortgage payment is comparable to (or less than) the monthly rent, this is true. Some of the costs that a home owner should pay attention to are property taxes, water and sewer service, repairs and maintenance, homeowners insurance, and even pool cleaning if there is any in the house you’re buying. This is why buying a house is such a huge and important decision to make.

Before you decide whether to buy or rent a house, the 5% rule could be a perfect guidance for you to avoid mistakes being made. Through the 5% rule, you could estimate the exact three expenditures that homeowners bear but renters do not.

1. A property tax of one percent of the home's value is commonly anticipated. This is the first portion of the 5% rule.
2. Maintenance costs are also estimated to be 1% of the home's worth. The 5 percent rule is broken down into two parts.
3. The cost of capital is estimated to be 3% of the home's worth, which is basically to purchase a home, you must make a cash down payment, and is usually 20% of the house's value, so you'll need a mortgage to cover the remaining 80%, and your equity is the amount you put down as a down payment, and your debt is your mortgage. The total worth of your home is equal to the sum of your debt and equity. The total cost of capital is equal to the total cost of debt plus the total cost of equity. The interest you pay on your mortgage is used to calculate the cost of debt, which is 3%.

Now, whether it's a mortgage or a down payment, we have a cost of capital estimate of 3%. We have our 5 percent Rule when we add this to the 2 percent projections for maintenance and property taxes. In other words, homeowners should anticipate to spend around 5% of their home's value in unrecoverable charges.

Now, at least as a simple example from PWL, we can compare the unrecoverable expenses of renting versus owning. Take the worth of the home you're thinking about, multiply it by 5%, and divide it by 12 months. Renting may be a good financial decision if you can get a place for less than that. For a $500,000 home, you may predict $25,000 in yearly, non-recoverable costs, or $2,083 each month.

The 5 percent Rule is, without a doubt, an oversimplification indeed. Things alter when we factor in factors like tax rates and portfolio asset mix. The 6.57 percent predicted return on equities, for example, is a pre-tax return. That's good in an RRSP or TFSA, but in a taxable account, the after-tax predicted return for someone taxed at the highest marginal rate in 2019 Ontario may be closer to 4.6 percent. The cost of equity capital is reduced as a result. Similarly, the cost of equity capital decreases if the investment portfolio is less aggressive than 100 percent equity. When we consider this in terms of financial considerations, it simply means lowering the 5% rule and lowering the total unrecoverable expenses of property ownership.

Lastly, as your investment buddy, we are ready to assist you finding your dream house either it is for renting or buying!

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