3 Simple Reasons Why Ditching the 5% “Rule” Will Save You Money
By: Opher Ganel
Tags: Home, Financial Strategy, Real Estate, Money, Finance

The “5% rule” was developed by YouTuber Ben Felix and written about at some length by Ben Le Fort. Felix tried to create a simple rule of thumb to help people rationally figure out the merits of renting a house vs. buying.

In brief, the math proposed by Felix tries to capture the financial cost of buying a home as follows:

The cost of property tax — according to Felix this is 1% of a home’s cost

The cost of maintenance — Felix estimates this too at 1%

The capital cost of buying a home’s — Felix estimates this as 3% on every dollar you pay toward the cost of the home (down payment and the principal portion of every mortgage payment, based on stocks having a 3% higher the long-term annual return than real estate), and 3% mortgage interest cost

There you have it, the basis for the “5% rule” in all its simplistic (and wrong) “glory.”

My Favorite Quote from Albert Einstein Hints at the Problems of the 5% Rule

Albert Einstein is quoted as having said, “Every problem should be simplified as far as possible, but no further…” (my emphasis).

“Every problem should be simplified as far as possible, but no further…” — Albert Einstein

This is the main problem with this so-called “rule.”

It simplifies a complicated situation much further than is possible without going from simplified to simple-minded and flat-out wrong.

In fact, as I show below, following this “rule” can cost you a lot of money and, conversely, ditching it will save you a bundle.

Let’s dissect each part of the above list to figure out where it all goes horribly wrong.

Property Tax Isn’t 1% of Your Home’s Cost

According to WalletHub, property tax rates in the US vary widely between states. In Hawaii, it averages 0.27% of a home’s appraised value. In New Jersey it’s a mind-boggling 2.47%! The nationwide average is about 1.16% of appraised value.

This means that if you live in NJ, following Felix’s 1% estimate might cost you more than an extra 1% if you were to buy instead of rent, whereas in Hawaii, it would cost you nearly 1% less to buy instead of rent (assuming the rest of the 5% rule held true, which we’ll soon see it does not).

In my home state of Maryland, as in many states, the rate varies from county to county. According to SmartAsset, it’s lowest in Garret County, at 0.84% and more than double, 1.70%, in Baltimore City.

One thing you might have noticed is that I repeatedly quote property tax rates as a percentage of assessed value. This matters, because the assessed value is often lower than the market value of your home by 20% or more.

Further, all this ignores any reduction due to low-income provisions that might cap your specific property tax rate.

Maintenance Cost Isn’t 1% of Your Home’s Cost

This cost varies widely, depending on the cost of your home and its condition.

For homes in good repair, especially where local real estate prices are high, it can be less than 0.5%. That’s what my costs have been over the past few years, including homeowner’s insurance.

On the flip side, if you’re buying a fixer, you’ll probably have to shell out a lot more than 1% because (a) you’ll have to pay for more repair work, and (b) the cost of a fixer is lower than the cost of the same home if it were in pristine condition.

For example, if your maintenance and repair costs are double mine but your home costs half as much, you’ll be paying 4 times as high a fraction of your home’s value, 2% rather than my 0.5%.

The Capital Cost Isn’t 3% of Your Home’s Cost and May Even Go Negative

Here, we need to consider two separate aspects, like Felix does.

The opportunity cost of your non-interest payments (down payment and principal portion of mortgage payments)

The mortgage interest cost

We’ll start with the non-interest portion. Felix simply assigns the 3% annual difference between returns on money invested in the stock market vs. the more gradual appreciation of home values.

This is wrong because:

Many people fail to invest the difference, and spend much of it instead. Even those who do invest likely don’t invest all of it in stocks, but rather have some significant portion in e.g. bonds. Those return about 6% less per year than stocks, or 3% per year less than real estate. If you keep 40% of your portfolio in bonds, your long-term returns will be about 0.6% higher than real estate, not 3% higher. Felix failed to account for inflation. Specifically, inflation reduces the value of the dollars you owe and those you pay. If we assume the same $400,000 mortgage at 3% interest mentioned by Le Fort, and that you’ll stay the average 10 years in the home before selling it, your payoff amount will be nearly $90,000 lower in inflation-adjusted dollars than in nominal dollars. This works out to almost exactly 3% reduction in your annual opportunity cost. This assumes inflation returns to its 3.5% long-term annual average. If it goes higher, this helps you even more.

Next, let’s consider your mortgage interest.

Inflation, again, helps you as a debtor with loans not indexed to the consumer price index (CPI). If inflation returns to its long-term 3.5% annual average, it will slightly reduce the cost of your interest payments in inflation-adjusted dollars each year. Over a decade, this would save you 1.5% out of the 3% nominal cost of interest. Americans enjoy a mortgage interest tax deduction on balances of up to $750,000. Depending on your income, if you pay federal, state, and local income tax, this may save you more than a third of your interest, reducing it from 3% in Le Fort’s example to 2%. Accounting for inflation too, this drops to about 0.5%.

In short, if you invest the dollars you don’t use to pay down your mortgage with a typical 60/40 split between stocks and bonds, buying a home will “cost” you only 0.6% rather than 3% a year.

Inflation and tax deductions will reduce your costs by another 2.2% (if you’re Canadian and don’t get that deduction, this is 1.7% a year instead).

Thus, all told, this factor actually gains you between 1.1% (for Canadians) and 1.6% (for Americans who deduct the mortgage interest and have a combined income tax rate of about 33%), rather than costing you 3%.

The Bottom Line — a So-Called “Rule” Thoroughly Debunked

If you’re in a situation like mine, your property tax costs about 0.8% of your home’s market value, your maintenance and insurance total about 0.5%, and your inflation-adjusted “capital cost” (assuming inflation returns to its long-term 3.5%/year average) is actually a gain of about 1.6%.

This means that on average, your “costs” for buying our home would be a gain of ~0.3% of the home’s market value rather than Felix’s cost of 5%.

On average, your “costs” for buying our home could be a gain of ~0.3% of the home’s market value rather than Felix’s cost of 5%.

This is why I say that following this so-called 5% “rule” can cost you a lot of money, and ditching it can save you that money.

If you’re considering whether to buy a home for say $500,000 or rent a similar one for $2000 a month, the 5% “rule” would tell you renting will be the better bet by about $1000/year. However, based on the above math, by buying you’d actually save ~$25,500/year!

Some Caveats

The above is based on several assumptions, and to the extent those don’t apply to you, your results will be different.

For example, if you live in NJ, your property tax rate will be about 2% (assuming assessed value underestimates your home’s value by 20%).

If you buy a fixer, your maintenance costs could easily be another 2%.

If you can’t deduct your mortgage interest (e.g., because your itemized deduction will be lower than the standard deduction), you’re an aggressive investor who invests 100% in stocks, and inflation drops to near 0%, your capital cost will indeed be around Felix’s 3%.

In this scenario, your total cost to compare the rent would in fact be 7% instead of 5%, in which case even a $2800 rent would save you about $1400 a year compared to buying a similar property.

About the Author

Opher Ganel has set up several successful small businesses, including a consulting practice supporting NASA and government contractors. His most recent venture is a financial strategy service for independent professionals (where you can sign up for his biweekly newsletter and get some nifty free PDFs). You can also connect with him by following his Medium publication, Financial Strategy.

Disclaimer

This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.