Many people mistakenly believe that you need to own your own home before purchasing investment properties. Traditionally, the “American Dream” was associated with homeownership and having a couple of nice cars in the driveway. However, changing mindsets, modern lifestyle preferences, and a growing reluctance to commute to work have led to significant shifts in the rental real estate market.
Depending on where you live and the lifestyle you want, it might be more beneficial to rent your home while you build an investment portfolio. To decide whether you should rent or buy your primary residence, you can use the helpful 5% rule.
The 5% Rule
The 5% rule is a simple methodology for determining whether it costs more to buy or rent a home. When it comes to renting, assessing your costs is straightforward—it’s simply the rent you pay each month. However, homeownership involves more complexities. The expenses of owning a residential property go beyond just your mortgage payment.
This is where the 5% figure is useful; it provides a more accurate comparison between the costs of renting and owning a home.
How It Works
The three main components of the 5% rule are property tax, maintenance costs, and the cost of capital. Homeowners spend these costs, while renters do not.
- Maintenance: Homeowners also pay more often for routine maintenance and repairs than renters. This category, along with property tax, is expected to be roughly 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 make with the money tied up in your home (usually in the form of a down payment) if it was invested in another form, 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 looks like:
- Multiply the value of the property you own/want to get by 5%.
- Divide by 12 (to get a monthly amount).
- If the resulting amount is more than you would spend to rent an equivalent property, renting your home and investing your money in rental properties might seem reasonable.
Why You Should Use It
Although the 5% rule is an oversimplified way to compare the costs of renting with homeownership, it can be a great tool for rental real estate investors. Besides the fact that you can 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 assist them in understanding the benefits of staying in your rental home longer. In markets where property values are very high, this tool might wind up being a crucial resource as you make all future real estate investments.
Are you determined to make your next move as a rental real estate investor? Our San Antonio property managers can help! Contact us online for more information on finding and evaluating investment properties.