Introduction

The age-old question: rent or buy?

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 is $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 mortgage payments comprised of interest cost, principal cost, and miscellaneous costs like maintenance per year:

So, to make an apples-to-apples comparison, we need to figure out how much money we'll never get back again in both scenarios.

A unique perspective on the cost of housing

This original take and unique angle were first presented by Ben Felix, a Canadian portfolio manager, here on YouTube.

His video is titled 'Renting vs. Buying: The 5% Rule', and it's the inspiration for this article. However, it has been 5 years since he released his video, and these days mortgage rates are much higher, now sitting between 6.5 to 7.5 percent. So, I felt like this topic needed a refresh for the times we live in.

Why the 5% rule needs a refresh

The main thing we're trying to solve is the cost of homeownership, and we need to get it to a monthly basis. That way, 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 homeownership is cheaper than renting a comparable home, then we should probably be buying instead of renting, and vice versa.

Understanding the true cost of homeownership

The monthly cost is key

Ben states that there are three components to homeownership when figuring out this whole monthly cost calculation:

1. Property taxes
2. Maintenance costs
3. The Mortgage Payment: Opportunity Cost & Cost of Debt

The mortgage payment will be broken down into two different components, which we are going to discuss thoroughly today. However, all these costs are associated with homeownership that a renter will not face.

1. Property taxes: A yearly obligation

What are property taxes?

First, we need to talk about property taxes. Property taxes occur on any property that you own and basically mean that by owning that property, you must owe the government, or the state you live in, a certain percentage of the property's value in taxes every year.

Average property tax rates in the United States

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, where you can input your own numbers. However, for the purpose of today's discussion, let's just go with our example.

So, on a house like this, you're going to pay $5,500 in property taxes every year; that's 1.11%, and those are the costs you'll never see again.

2. Maintenance costs: The ongoing expense of homeownership

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 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.

3. The Mortgage Payment: Principal, interest, and more

Alright, so up until this point, we've 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.

Next up, we need to figure out the cost of the mortgage payment. Ben calls this the 'cost of capital', and so that just means what our money is 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 of $400,000 probably over the course of 30 years. That's the most common type of mortgage.

Putting it all together: Comparing renting vs. buying

There are two moving parts here: first, the cost of the down payment, as well as what the loan is costing us - the cost of debt. A common thing that you'll hear people say is that there's an opportunity cost to your money. When you put $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 a valid concern, and first, we need to figure out what the opportunity cost of your down payment is, and 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 an average of 7.19% per year, adjusted for inflation.

Residential real estate, or the median home prices in the United States over the past 30 years, have appreciated 1.97% after accounting for inflation. I purposely 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. And 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% which means stocks are outperforming real estate by 5% per year.

So, if you put $100,000 on a down payment, that's $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. So, we'll plug in some real numbers here soon, but first, I just want to illustrate this concept. This is the first part of the cost of capital or the cost of the mortgage payment.

If you aren't in the United States, you can just 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, or, AKA, this is 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 straight-up method of loan balance times the interest rate per year, and so this is going to give us a conservative buffer on figuring out what type of homes we can afford and just what the costs are that we don't get back.

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%.

Now that we have all 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 simple rule. 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%. We can use this 8.71% then as a quick and dirty, easy guideline to figure out what the Cost of Homeownership looks like monthly. 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 homeownership monthly.

If you have a $400,000 home in your area, we will take that four hundred-thousand-dollar number, multiply it by 8.71%, and that gives you the annual cost of homeownership, which is $34,840. Divide that by 12, and you get $2,903. That's how much it would be costing you monthly in terms of homeownership. 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 vs buying.

Conclusion

The decision of renting vs. buying is a personal one

Now, this rule is incredibly simple, and many people will love it, but others might have reservations about it. It helps you assess what your break-even point is monthly, but it does have several flaws. There are some important considerations we should talk about that don't involve the math of buying a home.

There is no right or wrong answer

The first flaw I see is that humans are often irrational and sometimes impulsive. For instance, there are times when I know it's not a great idea to buy a seven-dollar latte, but I 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 will take that hundred thousand dollars and invest it perfectly into the market.

Do your research and make the choice that's right for you

Investing takes a lot of discipline, and you must play your cards right. Who's to say that the renter won't take that down payment and gamble it away? Humans are irrational and not always perfect.

Another aspect to consider is that I view a mortgage payment as almost a forced savings method. You are accruing equity while you pay your mortgage, which can be beneficial for many Americans who struggle with saving. On the topic of building equity, today we discussed the cost of interest as simply being the mortgage rate times your loan amount. However, mortgages don't work like that. Mortgages are on what's called an "Amortization Schedule", meaning at the beginning of the mortgage, you're paying less in equity and more in interest, but as the 30-year term progresses, you start to pay more in equity and less in interest. Therefore, your cost of equity and your cost of debt are always changing due to the variation in the amortization schedule.

If you also consider the existence of different types of mortgages, like 15-year mortgages or variable rate mortgages, we have a lot of variables that we're 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. This changes the rule that we're discussing today considerably and is another upside to buying over renting.

The third flaw I see often with this rule is that it always assumes that conditions remain the same. However, inflation could spike one year, or your mortgage rate could double, or perhaps the opportunity cost of your equity is different. That's why I built the mortgage calculator, so it can always be revised.

Lastly, we didn't even discuss the tax benefits of deducting mortgage interest. In the United States, you can deduct mortgage interest against your income. Now, the standard deduction in the U.S. is between $13,000 to $14,000 per year on an individual basis. If you don't have more than that in terms of mortgage interest to write off, then it's not worth it. However, if you do have more than $14,000 in mortgage interest to deduct, it lowers your overall cost of home ownership monthly. You'd have to run these numbers on your own because there are so many variables, including your tax bracket, mortgage amount, and interest rate.

There are also some non-mathematical pros to owning a home

1. The first is that you have predictable, fixed payments, especially with a fixed mortgage. Since your payment doesn’t change much, you can budget for your mortgage payment accurately, whereas if you are renting, your landlord could increase the price at any time.
2. Another pro is that you have much more control when you own your home. If you make modifications or updates to your property, you don’t have to seek approval from a landlord. You also have added security because a landlord can’t evict you or sell the property to another owner.
3. Another nice aspect of owning a mortgage is that inflation works in your favor. This might sound counter-intuitive, but it means that over time, you owe less in terms of the dollar's value. For example, let’s pretend there was a 50-year fixed mortgage, and you bought your house 50 years ago. Back then, a $300 monthly payment might have been equivalent to $2,000 today. However, because of the fixed mortgage payment, you're still only paying $300 a month, which seems much less today. This principle also applies to a normal 30-year mortgage, just on a smaller scale.
4. The last and biggest pro of owning a home is the potential for significant capital appreciation in your home's value. Take, for example, a home in my area that sold for $599,000 back in 1995 and recently sold for $3.23 million. That clearly outperformed the median home price appreciation in the United States by a significant margin. However, homeownership isn't just about costs and investments. Sometimes, it's just fulfilling to own your own home. There's also peace of mind in knowing that you have a home to retire in and live out the rest of your life, especially while you have the capacity to do so.

There are also pros to renting

1. The first is flexibility: you're not tied down to a home for 30 years, so if you want to move, you can do so more easily.
2. Next, when you're renting, you don't owe taxes, maintenance costs, or any related expenses. Life is simpler in that regard.
3. Lastly, by renting, you can access great amenities in some buildings, such as doormen for security, gyms, pools, and spaces for events, which you might not get when you own a home.

The biggest takeaway is that you need to run your own numbers when it comes to renting versus buying a home, especially for your specific location. However, with the mortgage calculator and the 8.71% rule I provided today, you should be well-equipped to figure out the situation on your own. With mortgage rates being high in the United States right now, renting seems more appealing than owning a home, particularly in the short term. However, if you're planning on staying in a place for more than 5 to 8 years and are considering buying a home, that might have the greatest potential for investment upside.