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9 min read · Jun 6, 2023
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The debate between renting and buying a home often revolves around the financial aspects. Which option is the better financial decision? When you rent, the total cost is simply the amount you pay your landlord without any return.
For example, if your monthly rent is $2,000, you end up spending $24,000 per year, and you won’t see that money again. On the other hand, owning a home involves a mortgage payment that includes interest, principal, and additional expenses like maintenance.
To make a fair comparison, we need to determine the amount of money we won’t get back in both scenarios. This concept was first introduced by Ben Felix, a Canadian portfolio manager, in his video “Renting vs. Buying: The 5% Rule.” However, since that video was released four years ago and mortgage rates have increased, it’s time to update the analysis for the current times.
The main objective is to calculate the cost of homeownership on a monthly basis and compare it to renting costs. If the monthly cost of owning a home is lower than renting a similar property, buying might be the better option. Conversely, if renting is cheaper, it may be more beneficial.
According to Ben, there are three components to consider in determining the monthly cost of homeownership: property taxes, maintenance costs, and the mortgage payment. Let’s delve into each of these components.
Property Taxes
Property taxes are an annual obligation for property owners. They represent a percentage of the property’s value that you owe to the government or state each year. In the United States, the average property tax rate for residential real estate is 1.11%. For this example, let’s assume we have a $500,000 home, which results in annual property tax payments of $5,500.
Homeowners insurance is an important consideration when comparing the costs of renting versus buying a home. This type of insurance provides financial protection in case of damage to your home, its contents, or liability for accidents on your property.
The cost of homeowners insurance varies based on factors like the home’s value, location, and coverage options. It’s important to review different policies to ensure adequate coverage.
Homeowners insurance rates by state for 2023
Homeowners insurance covers risks such as fire, theft, vandalism, and certain natural disasters. It also offers liability coverage for accidents involving guests on your property.
Including the cost of homeowners insurance in your budget is crucial when calculating the monthly cost of homeownership. While it adds an extra expense, it provides valuable protection and peace of mind.
Before buying a home, research insurance options, understand coverage, and consult with professionals to find the right policy. By considering homeowners insurance, you can make a more informed decision about renting or buying a home.
Maintenance Costs
Maintenance costs are another expense associated with homeownership. Experts recommend setting aside 1–2% of the property’s value per year for maintenance. For simplicity, let’s assume 1%, resulting in $5,000 per year for a $500,000 home.
Check out all the property maintenance costs by state:
Home Maintenance by State 2023
Check out this detailed budget guide for home maintenance:
Budget Guide for Home Maintenance
The Cost of Capital
Now, let’s calculate the cost of the mortgage payment or the cost of capital. Assuming a 20% down payment on a $500,000 home, we finance the remaining 80% through a mortgage over 30 years. The cost of capital has two components: the opportunity cost of the down payment and the cost of debt.
Opportunity Cost of the Down Payment
The opportunity cost of the down payment refers to the potential return that money could have earned if invested elsewhere, such as the stock market. Over the past 30 years, the S&P 500 has averaged a 7.19% annual return, adjusted for inflation, while residential real estate has appreciated by 1.97% on average. This implies a 5% difference. If you put $100,000 as a down payment, that’s $5,000 you’re missing out on potential stock market gains.
Cost of Debt
The second part of the cost of capital is the cost of debt, which represents the interest payments on the mortgage. For simplicity, let’s assume an annual cost of $28,000, calculated by multiplying the loan balance by the interest rate.
Adding up all these costs — property taxes, maintenance costs, and the cost of capital — we arrive at a rule of thumb. Take the home price, multiply it by 8.71%, and divide by 12 to obtain the monthly cost of homeownership. For example, a $400,000 home would result in a monthly cost of $2,903.
If renting a comparable home costs less than $2,903 per month, it may be more beneficial to rent. However, if the monthly cost of renting is higher than the calculated monthly cost of homeownership, it might make more financial sense to buy.
It’s important to note that this analysis doesn’t take into account other factors that might influence the decision to rent or buy, such as lifestyle preferences, flexibility, and long-term goals. Financial considerations are just one aspect to consider.
Additionally, this analysis assumes that the property value appreciates at a rate of 1.97% on average, which may vary depending on the location and market conditions. It’s crucial to research and consider the historical trends and future prospects of the real estate market in your area.
Ultimately, the decision to rent or buy a home should be based on your personal circ*mstances, financial goals, and lifestyle preferences. It’s recommended to consult with a financial advisor or real estate professional who can provide personalized advice based on your specific situation.
Remember, homeownership entails additional responsibilities and costs beyond the monthly mortgage payment, such as property insurance, homeowners association fees (if applicable), and potential repair expenses. Renting, on the other hand, offers flexibility and fewer obligations but may not provide the same long-term financial benefits.
The 8.71% rule has a few notable flaws that should be considered before making a decision between renting and buying a home.
- Human Irrationality: One flaw lies in the assumption that individuals will make rational decisions with their capital. Humans are often impulsive and not always disciplined when it comes to investing. Even if there is an opportunity cost associated with the down payment, it doesn’t guarantee that renters will invest the money wisely. People may make irrational financial choices, which can affect the potential returns.
- Changing Cost of Capital: The calculation of the cost of capital assumes a fixed interest rate over the entire mortgage term. However, mortgages follow an amortization schedule, meaning the proportion of interest and equity payments change over time. Initially, more interest is paid, while later in the mortgage, more equity is accrued. Additionally, the rule does not account for variations in mortgage types, such as variable-rate or shorter-term mortgages, which can affect the cost of capital.
- Changing Conditions: The rule assumes that conditions will remain the same over the long term. However, factors such as inflation and fluctuating mortgage rates can significantly impact the cost of homeownership. These changing conditions need to be considered when evaluating the long-term financial implications of buying a home.
- Tax Benefits: The article overlooks the potential tax benefits associated with deducting mortgage interest. In the United States, individuals can deduct mortgage interest from their taxable income. This deduction can lower the overall cost of homeownership on a monthly basis. However, the actual impact of this benefit depends on various factors, including tax brackets, mortgage amount, and interest rate. Calculating the true cost of homeownership should take these variables into account.
- Predictable Fixed Payments: Enjoy the benefit of predictable fixed mortgage payments, allowing for accurate budgeting, unlike renting where landlords can increase rent prices unexpectedly.
- Control Over Home: As a homeowner, you have greater control over your property and can make modifications or updates without seeking approval from a landlord.
- Added Security: Owning a home provides added security, as you won’t be at risk of eviction or displacement due to a change in property ownership.
- Inflation Advantage: Homeownership can work in your favor when it comes to inflation. Over time, the value of the dollars you owe on your mortgage decreases, resulting in a relatively lower payment compared to the rising cost of living.
- Capital Appreciation: One of the significant advantages of homeownership is the potential for capital appreciation. Your home’s value can increase over time, providing a substantial return on investment.
- Flexibility: Renting offers greater flexibility, allowing you to easily move or change locations without the commitment of a long-term mortgage.
- No Taxes, Maintenance, or Down Payment: When renting, you are not responsible for property taxes, maintenance costs, or down payments, making life simpler and more cost-effective.
- Access to Amenities: Rental properties, particularly in urban areas, often provide access to amenities such as doormen, gyms, pools, and communal spaces for socializing, which may not be available to homeowners.
YOU MUST READ THESE 2 BOOKS BEFORE YOU DECIDE:
1. Buy, Rehab, Rent, Refinance, Repeat
2. Rental Property Investing: How to Create Wealth
Consider weighing the financial aspects, your future plans, and your overall lifestyle goals before making a decision. Seek professional guidance to evaluate all factors and make an informed choice that aligns with your individual needs and circ*mstances.
What is the 8.71% rule?
The 8.71% rule is a guideline used to compare the monthly cost of owning a home with renting costs. It involves taking the home price, multiplying it by 8.71%, and dividing by 12 to obtain the monthly cost of homeownership. If the monthly cost of renting a comparable home is lower than the calculated monthly cost of homeownership, renting may be more beneficial.
How accurate is the assumption of property value appreciation at 1.97%?
The assumption of 1.97% property value appreciation is an average and may vary depending on the location and market conditions. It is essential to research and consider historical trends and future prospects of the real estate market in your specific area to obtain a more accurate understanding of property value appreciation.
What are the limitations of the 8.71% rule?
The 8.71% rule has a few limitations to consider. It assumes rational decision-making by individuals, which may not always be the case. It also assumes a fixed interest rate over the entire mortgage term, disregarding variations in mortgage types and changing conditions. Furthermore, the rule overlooks potential tax benefits associated with deducting mortgage interest, which can impact the overall cost of homeownership.
What are some pros of homeownership?
Homeownership offers benefits such as predictable fixed mortgage payments, control over your property for modifications or updates, added security against eviction or displacement, potential advantages in inflation as the value of mortgage payments decreases over time, and the possibility of capital appreciation, which can provide a return on investment.
What are the advantages of renting?
Renting provides advantages such as flexibility to easily move or change locations without the commitment of a long-term mortgage, avoiding responsibilities for property taxes, maintenance costs, and down payments, and access to amenities that rental properties may offer, such as gyms, pools, and communal spaces.
How do property taxes and maintenance costs vary from state to state?
Property taxes and maintenance costs can vary significantly from state to state. Some states may have higher property tax rates than others, while maintenance costs can be influenced by factors such as labor costs and regional price differences. It’s essential to consider the specific state you are interested in and research the local rates and costs to get a more accurate picture of what to expect.
Should I consult with a professional before making a decision?
Yes, it is recommended to consult with a financial advisor or real estate professional who can provide personalized advice based on your specific situation. They can help you assess your financial goals, analyze market conditions, and consider various factors beyond the financial aspects to make an informed decision.
Disclaimer: The information provided in this article is for general informational purposes only and should not be considered as financial, legal, or professional advice. The article presents concepts and calculations based on certain assumptions, which may not apply to individual circ*mstances or specific locations. Readers are encouraged to consult with financial advisors, real estate professionals, or other qualified experts to obtain personalized advice and make informed decisions regarding renting versus buying a home.
