It’s a common misconception that it is vital to own your own home before buying investment properties. And it’s true that before, living the “American Dream” meant homeownership and a nice car or two in the driveway. But switching ideas, modern lifestyle preferences, and even a renewed unwillingness to commute to work have brought considerable shifts in rental real estate investing.
Depending on where you live and your preferred standard of living, it may make more sense to rent your home while you build an investment portfolio. To discover whether you should rent or buy your primary residence, you can (and must) apply what’s known as the 5% rule.
The 5% Rule
The 5% rule is a straightforward procedure to analyze if it costs more to buy or rent a home. On the renting side, defining your cost is uncomplicated: it’s the amount you pay in rent every month. On the homeownership side, though, factors are a bit more tricky. The costs of owning a residential property encompass more than just your mortgage payment. This is when the 5% figure comes into operation. It is a method 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 undertake, and renters do not. Let’s break down one after another:
- Property tax. Using this uncomplicated technique, the cost of property tax would be roughly equal to 1% of the home’s value.
- Maintenance costs. Consistent maintenance and repairs are substantially more expensive for homeowners than for renters. This category, just like property tax, is assumed to represent roughly 1% of the house’s value.
- Cost of capital. The cost of capital makes up the remaining 3% of the 5% rule. To simplify this, the cost of capital is what you could be getting with the money tied up in your home (usually in the form of a down payment) if it was invested in some other manner, such as an investment property or the stock market. It’s a cost because of the interest you pay on your mortgage, often around 3%.
Applying the 5% rule would seem like this:
- Multiply the value of the property you own/want to possess by 5%.
- Divide by 12 (to get a monthly amount).
- If the resulting amount is bigger than it would cost to rent an equivalent property, renting your home and investing your money in rental properties may work better.
Why You Should Use It
Although the 5% rule is an oversimplified way to compare the costs of renting with homeownership, it can be an important tool for rental real estate investors. You may use it not just to make personal actions 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 comprehend the benefits of staying in your rental home longer. In markets where property values are relatively high, this approach could prove to be an excellent resource as you make all future real estate investments.
Are you keen to make your next move as a rental real estate investor? Our Lampasas property managers can assist! Contact us online for more information on finding and evaluating investment properties.
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