Welcome to Part 2 of 2 of the MOAM guide to financial rules of thumb.
If you missed part 1, here’s the link.
Last week we discussed rules of thumb focusing on retirement, investing, and debt management. Today, we focus on real estate and homeownership.
The 5% rule of thumb to decide between renting or owning a home.
The 1% rule for real estate investing.
The 1% rule to budget for maintenance costs as a homeowner.
The 5% rule (buy vs. rent)
One of the eternal debates in personal finance is whether you should rent or buy a house.
There are entire books written arguing both sides of this debate.
However, if your only concern is maximizing wealth over your lifetime, the 5% rule is a handy rational framework.
The 5% rule was created by Ben Felix, a portfolio manager based in Ottawa, Canada, and the host of the Common Sense Investing YouTube Channel. The 5% rule is a calculation of the “break-even point” on the buy vs. rent decision.
Here’s how the 5% rule works.
Multiply the value of a house by 5%
Divide by 12.
This is your break-even point.
If you can rent a comparable home for a lower monthly rent, it makes sense to rent.
If the monthly rent for a comparable home is higher, it makes sense to buy.
An example of the 5% rule
Let’s say you are considering whether to buy a $500,000 house.
5% of $500,000 is $25,000.
$25,000 ÷ 12= $2,083.
If you can rent a comparable home for less than $2,083, then renting makes good financial sense.
If the rent for a comparable home is more than $2,083, then buying makes more sense.
The math and assumptions behind the 5% rule
This get’s a bit complicated, but here is how Ben Felix comes up with the math for the 5% rule. As I said before, it is all about comparing the cost of renting vs. the cost of owning.
The cost of renting is simple; it’s the rent and renters insurance you must pay.
The cost of homeownership is a bit more complicated because there are a lot of invisible costs associated with homeownership.
Ben breaks down the annual cost of homeownership into three categories, which total 5%.
Property tax: 1%
Home maintenance 1%
The cost of debt /cost of equity: 3%.
The 3% to the cost of debt and equity is where things get a bit more complicated.
The cost of debt is assumed to be around 3%, which is what Ben assumed would be the average interest on a mortgage at the time he made the video.
The 3% cost of equity is the difference between the expected return on your home vs. the expected return of investing in the stock market. It is the opportunity cost of owning a home rather than investing in the market.
If you want to get into the weeds of the details of the 5% rule, why not simply watch Ben Felix’s video below.
Limitations of the 5% rule
I’m a fan of Ben’s YouTube channel. He approaches all financial decisions from a hyper-rational point of view. The 5% rule makes sense to me, but I was trained to think like an economist.
The 5% rule is based on the assumption that if you choose to rent that you would invest every penny, you saved by not having to take care of the maintenance costs of owning a home.
The best part of owning a home is that it creates forced savings through paying down the mortgage. When we are left to our own devices, most of us do not save enough.
For that reason, I don’t think the 5% rule would work for most people.
That being said, if the rational approach of the 5% rule is appealing to you, I would suggest you start reading my book, the rational investor, available here.
The 1% rule (Real estate investing)
If you are going to invest in real estate, you will need to know ahead of time if the property you are considering buying is likely to be cashflow positive. Meaning, that you want to know if the income the property generates through rent will be more than all of the operational costs associated with the property.
One rule of thumb that many real estate investors use to determine if a property is likely to be cashflow positive is the 1% rule. According to the 1% rule, the rent generated from the property should be at least 1% of the purchase price.
If you were buying a $300,000 property, the monthly rent would need to be $3,000 to meet the 1% rule.
I like the 1% rule because it is a handy, straightforward calculation that anyone can quickly perform. However, let me be absolutely clear, you should not make a real estate investment based on a rule of thumb like the 1% rule.
Also, given the insane run-up in real estate prices in recent years, you would be hard-pressed to find many properties that meet the 1% rule. The average price of a detached home in my city is $1 million, and I can guarantee these houses are not renting for $10,000 per month.
This has promoted some real estate investors to adopt the 0.5% rule. Which, to me is a sign that there might be too much speculation baked into real estate prices and is one of the reasons I have backed off investing in physical real estate in recent years.
The 1% rule (homeownership maintenance costs)
Some costs associated with homeownership are straightforward, such as your mortgage and property tax payments.
The one area of homeownership that blows up a lot of people’s budgets is home maintenance costs. Will your roof blow off this year? When will the furnace finally die?
These are questions that are difficult to know without a crystal ball, so it makes budgeting for these rare but expensive events a big challenge.
The 1% rule is a quick rule of thumb that says you should budget 1% of the value of your home for maintenance costs per year.
If you have a $500,000 house, you would budget $5,000 per year for home maintenance.
It’s far from perfect but is a good starting point and a reminder that you should be setting aside money for these unexpected costs.
The 30% Rule (housing costs)
This is a classic rule of thumb that says you should not spend more than 30% of your pre-tax income on housing costs.
If you make $10,000 per month, you would not spend more than $3,000 per month on housing according to the 30% rule.
That includes all housing-related costs.
For renters that’s typically rent + insurance + utilities
For homeowners that’s mortgage + insurance + utilities + property tax + maintence costs.
Rules of thumb are a great starting point but a poor ending point
Financial rules of thumb can be a useful tool if they are used as intended as the first step of a more detailed research process.
Remember the essential truth about any rule of thumb: It should be your starting point, never your ending point.
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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.
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