It’s a common misconception that it is imperative to own your own home before buying investment properties. And it’s correct that at one time, living the “American Dream” meant homeownership and a nice car or two in the driveway. However, altering ideas, modern lifestyle preferences, and even a renewed unwillingness to commute to work have generated big shifts in rental real estate investing.
Depending on the area and your desired standard of living, this could make more sense to rent your home while you build an investment portfolio. To determine whether you should rent or buy your primary residence, you can (and must) employ what’s known as the 5% rule.
The 5% Rule
The 5% rule is an uncomplicated method to measure whether it costs more to buy or rent a home. On the renting side, estimating your cost is effortless: it’s the amount you pay in rent every month. On the homeownership side, though, situations are a little more complicated. The costs of owning a residential property involves more than merely your mortgage payment. This is where the 5% figure enters the scene. It is a strategy to compare the cost of renting to owning a home more properly.
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 encounter, whereas renters do not. Let’s break down each one:
- Property tax. Applying this simplified technique, the cost of property tax would be roughly equal to 1% of the home’s value.
- Maintenance costs. Constant maintenance and repairs are also something homeowners pay for more regularly than renters do. For example, property tax, this class is also assumed to be around 1% of the house’s value.
- Cost of capital. The cost of capital makes up the remaining 3% of the 5% rule. In basic terms, the cost of capital is what you could be receiving with the money tied up in your home (usually in the form of a down payment) if it was invested in some other form, including an investment property or the stock market. It’s a cost due to the interest you pay on your mortgage, often around 3%.
Applying the 5% rule would appear like this:
- Multiply the value of the property you own/want to acquire by 5%.
- Divide by 12 (to get a monthly amount).
- If the resulting amount is higher than you would spend to rent an equivalent property, renting your home and investing your money in rental properties may work best.
Why You Should Use It
Even though the 5% rule is an oversimplified way to compare the costs of renting with homeownership, it may be an imperative tool for rental real estate investors. Not only can you utilize it to make personal decisions regarding your personal residence, if you own rental properties in areas where the cost of living is high, you could also teach it to your tenants to help them appreciate the benefits of staying in your rental home longer. In markets where property values are very high, this strategy might prove to be a useful resource as you make all future real estate investments.
Are you eager to make your next move as a rental real estate investor? Our Twin Falls property managers can assist! Contact us online for more information on finding and evaluating investment properties.
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