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The Premise
The cost of renting versus buying a home comes up all the time. What is the better financial decision, though? With renting, the total cost is just the amount that you give your landlord, which you never see again. For example, if your rent was $2,000 a month, multiply that by 12 months and you have $24,000 a year that you just never see again. The total cost of owning a home, however, includes a mortgage payment, which is comprised of interest and principal, as well as miscellaneous costs like maintenance per year. So to make an apples-to-apples comparison, we need to figure out how much money you will never get back in both scenarios.
This original take and unique angle was first presented by Ben Felix, a Canadian portfolio manager, here on YouTube. His video is titled "Renting versus Buying: The 5% Rule," and it's the inspiration for this video. I will link his video down below, so full credit to him. But it has been four years since he released his video, and these days mortgage rates are much higher. They sit between 6.5 and 7.5%, and so I felt like this topic needed a refresh for the times that we live in.
The main thing that we're trying to solve for is the cost of home ownership, and we need to get it to a monthly basis so that we can compare it to our rent costs and figure out which one is the better option for us. Theoretically, if our monthly cost of home ownership is cheaper than renting a comparable home, then we should probably be buying instead of renting, and the vice versa should apply.
Ben states that there are three components to home ownership, and figuring out this whole monthly cost calculation includes property taxes, maintenance costs, and the mortgage payment. The mortgage payment will be broken down into two different components, which we are going to discuss thoroughly today. However, all of these costs are associated with home ownership that a renter will not face.
Cost of Home Ownership
First, we need to talk about property taxes.
Property Taxes
Property taxes occur on any property that you own. Basically, by owning that property, you must owe the government or the state that you live in a certain percentage of the property's value in taxes every single year. In the United States, the average property tax rate is 1.11% across all residential real estate, so we're going to use that number in today's example. We're also going to use the example of a $500,000 home. If you live in Canada, Australia, or somewhere in Europe, I'm going to have a special tool that I'm going to link for you guys today where you can input your own numbers. However, for the purpose of today's video, let's just go with our example.
On a house like this, you're going to pay $5,500 in property taxes every single year. That's 1.11%, and those are the costs that you'll never see again.
Maintenance Costs
The next cost is the maintenance cost of your home. Experts suggest that you set aside 1 to 2% of your property's value per year just for maintenance costs. That could be a little bit more if your home is really old and you feel like it always needs fixing up. For simplicity's sake, we're going to use 1% in today's calculations. So our maintenance cost for a $500,000 home over the course of a year is going to be 1% of that, so $5,000 per year.
All right, so up until this point, we figured out the property taxes and the maintenance costs that we'll never get back for owning a home, and that amounts to about 2 to 2.11% per year of the property's value.
Mortgage Payment
Next up, we actually need to figure out the cost of the mortgage payment. Ben actually calls this the cost of capital, and that just means what our money is actually costing us by putting it into this home. Assuming a 20% down payment, that means you're going to finance, or take out a loan on, the remaining 80% of the home's value. Using simple numbers again, if our home value is $500,000, that means we are going to put a 20% down payment of $100,000 on the home and then finance the remainder, the $400,000, probably over the course of 30 years. That's the most common type of mortgage.
So there are two moving parts here. There's first the cost of the down payment, as well as what the loan is costing us. That's the cost of debt. A common thing that you'll hear people say is that there's an opportunity cost to your money. Basically, when you put the $100,000 on a down payment, that means you're not putting that $100,000 into the stock market to help you make more money. That's actually a pretty valid concern, and first we need to figure out what the opportunity cost of your down payment is. This is the first part of the cost of capital equation.
According to the data, the S&P 500 has returned, for the past 30 years, a 7.19% average per year adjusted for inflation. Residential real estate, or the median home prices in the United States, over the past 30 years has actually appreciated 1.97% after accounting for inflation. I purposefully used median home prices in this situation because if I had included commercial or rental properties, that would have skewed the real estate returns way higher. Since most people are renting a home and then comparing it to residential real estate, we should probably use the residential real estate median home pricing for simplicity's sake.
If stocks are returning about 7% per year on average and real estate is returning about 2% per year on average, that means the difference between these two is around 5%. So stocks are outperforming real estate by 5% per year. If you put $100,000 on a down payment, that's the $100,000 that could be earning 5% more per year had you invested it into the stock market. That's the money that you could be earning if it weren't invested into this home. We'll plug in some real numbers here soon, but first I just wanted to illustrate this concept. This is the first part of the cost of capital, or the cost of the mortgage payment.
Now, if you aren't in the United States, you can simply Google what global real estate returns are, or perhaps your own country's real estate returns, and compare them to the S&P 500 or any stock market index that you have. What I found, though, is that stocks tend to outperform real estate, depending on your country, by around 3 to 5%.
The second part of the cost of capital equation is the cost that the interest payments are costing you, also known as the cost of debt. Just for simple calculations today, we're going to assume that it is $28,000 per year. We'll just use the straightforward method of loan balance times the interest rate per year. This is going to give us a really conservative buffer on figuring out what types of homes we can afford and what the costs are that we don't get back.
All right, if you guys are still following here, then the cost of capital is the opportunity cost of the down payment, which we figured out was 5% of $100,000, that's $5,000, plus the $28,000 in interest payments per year. That's a total of $33,000 in costs every year that we don't get back. Represented as a percentage, we would take $33,000 divided by the home's value, and that equals 6.6%.
All right, so now that we have all of those numbers, let's add up everything that we've talked about already: the property taxes, the maintenance costs, and the cost of capital, and we will come up with a really simple rule. Hopefully the formula will be on the screen right here. It is therefore the property tax of 1.11%, plus the 1% maintenance cost, plus 6.6% cost of capital, and our total is 8.71%.
The 8.71% Rule
We can use this 8.71% as a quick and dirty, easy guideline to figure out what the cost of home ownership looks like on a monthly basis. The rule here is to take the home price, multiply it by 8.71%, and then divide it by 12. That's the total cost of your home ownership on a monthly basis.
So if you have a $400,000 home in your area, we would take that $400,000 number, multiply it by 8.71%, and that gives you the annual cost of home ownership there, which is $34,840. Now divide that by 12 and you get about $2,903. That's how much it would be costing you on a monthly basis in terms of home ownership. So if it's cheaper to rent a $400,000 comparable home in your area for less than $2,903 per month, that heavily tips the scale in favor of renting.
I also made this handy calculator in Google Sheets that you can download for free. If you want to go in and play around with all the numbers, you're able to. The link will be down below. You can edit the home price that you're looking at, change the variables like property taxes, maintenance costs, your down payment, and so on, and at the very end of the calculator it'll tell you what your break-even monthly payment is. That way, if mortgage rates change or you live in a different country, you can use this calculator to get a good gauge on what the renting versus buying situation looks like for you.
Now, this rule is incredibly simple, and a lot of people will love it, but a lot of people will also throw some hate on it. It does help you assess what your break-even point is on a monthly basis, but it does have a lot of flaws, and there are some important considerations we should talk about that don't involve the math of buying a home as well.
Flaws of Rule (DO NOT SKIP)
The first flaw that I see is that humans are often irrational and often impulsive. There are times that I know it's not a great idea to buy a $7 latte, but I go ahead and splurge on it anyway. Just because there's an opportunity cost consideration of your capital, it doesn't mean that if you don't make that down payment, the renter is going to take that $100,000 they might have and invest it perfectly into the market and capitalize on their opportunity cost. Basically, investing takes a lot of discipline, and you also have to play pretty perfectly. Who's to say that the renter is not going to take that down payment and just put it all on black, or maybe on red? I don't even know what I'm talking about at this point, but you get the idea: humans are irrational and not always perfect.
I also view a mortgage payment as almost a forced savings method, because you are accruing equity while you pay your mortgage payment. That's going to be a really good thing for a lot of Americans who are not very good at saving in general.
On that topic of building equity, today we talked about the cost of interest as simply being the mortgage rate times your loan amount. In actuality, mortgages don't work like that. Mortgages are on what's called an amortization schedule, which means at the beginning of the mortgage you're actually paying less in equity and more of the interest upfront. But as the 30 years progress, what actually happens is that you start to pay less in interest and more in equity. So at this point, I've realized that your cost of equity and your cost of debt are always changing because of the variation of the amortization schedule. If you pair that with the fact that there are also 15-year mortgages out there, and there are different types of variable-rate mortgages, then we have a lot of variables that we are not accounting for in today's simple rule. Plus, at the end of 30 years, the cost of interest is virtually gone. It's almost all equity at that point, and that will change the rule that we're talking about today considerably.
That is another benefit or upside to buying over renting: at the end of 30 years, you actually have a tangible asset that could have appreciated in value over time. The renter, on the other hand, has been paying this monthly payment every single month, and it's been going into their landlord's pocket and bank account, and they never see the fruits of that money.
The third flaw that I see often with this rule is that it always assumes that the conditions are the exact same. Inflation could go crazy one year, which it actually has been, or perhaps your mortgage rate could double, or perhaps the opportunity cost of your equity is a lot different. That's definitely something to consider, and it's also why I built the calculator so that it could always be revised.
Lastly, we didn't even discuss the tax benefits of deducting mortgage interest. If you are in the United States, you can deduct mortgage interest against your income. The standard deduction in the United States is $13,000 to $14,000 per year on an individual basis. So if you don't have more than that in mortgage interest to write off, then it's not really worth it. However, if you do have more than $14,000, let's say in mortgage interest that you can deduct, then it actually lowers your overall cost of home ownership on a monthly basis. You'd actually have to run these numbers on your own because there are so many variables that come with mortgage interest as well as the deduction, including your tax bracket, your mortgage amount, and your interest rate.
Pros of Owning
There are also some pros to owning a home that do not involve math calculations at all. The first is that you have predictable, fixed payments, especially with a fixed mortgage, since your payment never actually changes too much. What you can do is budget for your mortgage payment accurately, whereas if you are renting, your landlord could jack up the price at any given moment.
Another pro is that you have way more control when you own your own home. Basically, if you make modifications or updates to your property, you don't have to run it by a landlord. You also have added security, because the landlord isn't going to just evict you or kick you out because they sold their property to another owner.
The other nice thing about owning a mortgage is that inflation actually helps you out. I know this sounds a little bit counterintuitive, but basically what it means is that you owe fewer dollars in terms of value over time. I'll give you a pretty extreme example here that doesn't really exist, but let's pretend for a moment that there was a 50-year fixed mortgage and that you bought your house 50 years ago. Before you come for me, I know that there's not a 50-year mortgage out there, and the 40-year mortgage is just a myth as well, but just entertain me for the sake of this example. So 50 years ago, you get a 50-year fixed-rate mortgage, and your mortgage payment is $300 per month. Well, back then, $300 a month is like $2,000 a month today. However, because of this fixed mortgage payment that you have, you're still paying $300 a month for the entire life of the loan. These days, I don't know about you guys, but $300 doesn't seem like all that much. That actually happens with a normal 30-year mortgage too, just on a smaller, lesser scale.
The last and biggest pro of owning a home is that you could see a ton of capital appreciation when it comes to your home value. Take a look at this example from one of the homes in my area that sold earlier this year. It sold for $599,000 back in 1995 and recently sold in January for $3.23 million. That clearly outperformed the median home price appreciation in the United States by a factor of at least three.
Home ownership isn't just about the costs and the investments, though. Obviously, sometimes it's just downright fulfilling to own your own home. There's also peace of mind in knowing that you have a home to retire in and live the rest of your life in, especially while you have the capacity to do so right now versus later on in life.
Pros of Renting
I do want to point out that there are some pros to renting, which I want to talk about. The first is flexibility. You're not going to be tied down to a home for 30 years. If for some reason you live in a city right now and you want to leave next year, or even next month, if you just want to break your lease early, you can do that. The next one is that you don't owe taxes or maintenance or any type of cost like that when you're renting. You simply rent the place, perhaps you have some renter's insurance, and that's it. Life is just a lot simpler in that regard. Lastly, you can also get access to some really great amenities by renting in some big buildings, especially in big cities. They'll have doormen, which is nice for security. They'll have gyms, they'll have pools, they'll have different places for barbecuing and holding events, and you're just not going to get that when you own a home.
The Main Takeaway
The biggest takeaway that I have for you guys today is that you need to run your own numbers when it comes to renting versus buying a home, especially if you're trying to figure it out for your own location. However, with the calculator and the 8.71% rule, I think you should be pretty financially equipped to figure out the situation on your own. With mortgage rates being so high in the United States as of right now, it really looks like renting is going to be much more appealing than owning a home, especially in the short interim period. However, if you're planning on staying in a place for more than 5 to 8 years and you're actually buying a home, I think that has the greatest potential for the most amount of upside in terms of an investment.
All right, I hope that you found this video helpful. If you did, make sure to subscribe to this channel, and also check out my next video, which I'm going to leave right here. Let me know what you guys thought in the comments about the renting versus buying situation, and I'll see you guys in the next video. Peace.