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Rent vs. Buy

Renting vs. Buying a Home: The 5% Rule - Sourceful

morgage, finance, rent

Renting vs. Buying a Home: The 5% Rule Month Mortgage Calculation Details

Owner Renter 0 $ 400,000.00

1 $ 399,311.40

Purchase Price $ 500,000 Initial Investment (Calculated - not user input) $ 110,000 2 $ 398,621.08

Down Payment 20% Inflation 1.60% 3 $ 397,929.05

CMHC Premium (Applies to downpayments < 20%) $ - Renter's Insurance (Monthly) $ 20 4 $ 397,235.30

Closing Costs $ 10,000 Rent (Monthly) $ 2,083.33 5 $ 396,539.83

Amortization (Between 5 and 30 years) 30 After-Tax Investment Return: During Mortgage 6.00% 6 $ 395,842.63

Interest Rate 3.00% After-Tax Investment Return: After Mortgage 4.00% 7 $ 395,143.70

Periodic Interest Rate 0.25% 8 $ 394,443.03

Property Tax Rate 1.00% 9 $ 393,740.62

Maintenance Cost 1.00% 10 $ 393,036.46

Home Insurance (Monthly) $ 150 11 $ 392,330.56

Real Estate Growth Rate 2.60% 12 $ 391,622.90

Monthly Payment (Calculated - not user input) $ 1,682 13 $ 390,913.48

14 $ 390,202.30

15 $ 389,489.35

With the default values set when you download this spreadsheet, the calculations illustrate the math behind the 5% rule for the rent vs. buy decision. The 5% rule says that if you can rent for 5% or less of the value of a home, then renting is as good of a financial decision as owning. Of course, changing the inputs can affect the calculation. The sheet is set up so that most of the initial values are relative values. If you change the Purchase Price (cell C4), the sheet will adapt such that the 5% rule illustration holds true. However, if you edit cells other than Purchase Price you may notice that the 5% rule breaks down. Experiementing with variables like the amortization, interest rate, real estate growth rate, property tax and maintenance costs, inflation, and investment return is an interesting exercise. I have built in the ability to change the expected return during and after the mortgage pay back period. My thinking is that if someone is retiring around the time they pay off their mortgage, they may scale back their equity exposure. 16 $ 388,774.64

17 $ 388,058.14

18 $ 387,339.87

19 $ 386,619.81

20 $ 385,897.96

21 $ 385,174.32

22 $ 384,448.89

23 $ 383,721.64

24 $ 382,992.60

25 $ 382,261.74

26 $ 381,529.06

27 $ 380,794.57

28 $ 380,058.25

29 $ 379,320.10

30 $ 378,580.12

31 $ 377,838.29

32 $ 377,094.63

Interestingly, we see that the renter and owner have a similar net worth throughout the mortgage pay back period. The owner is putting a larger amount of cash into home equity, while the renter saves a relatively small amount into their portfolio - keep in mind that we are assuming that the renter is saving the annual cash flow cost difference between renting and owning. The dollars put toward home equity are growing at less than half of the rate of the dollars put into the portfolio. As soon as the mortgage is paid off, the renter begins to have a substantial advantage in terms of the growth in their net worth. This is driven by the fact that a large portion of the growth in net worth for the owner had been driven by the leverage and forced savings built into their mortgage payment. As soon as the mortgage has been paid off, the equity increases for the owner drop down to the annual increase in the value of their home, while the renter's net worth, with a portfolio worth as much as the owner's home, is growing twice as fast. 33 $ 376,349.12

34 $ 375,601.75

35 $ 374,852.53

36 $ 374,101.45

37 $ 373,348.50

38 $ 372,593.68

39 $ 371,836.98

40 $ 371,078.41

41 $ 370,317.95

42 $ 369,555.60

43 $ 368,791.35

44 $ 368,025.21

45 $ 367,257.17

46 $ 366,487.21

47 $ 365,715.34

48 $ 364,941.56

49 $ 364,165.85

50 $ 363,388.22

51 $ 362,608.65

52 $ 361,827.15

The cash flow requirements of the owner are highest in the year that they purchase the home, and then increasing slightly each year with the value of the home. We assume that in each year, including year 0 when the home is purchased, the renter invests the difference between their own cash needs and the owner's cash needs. We are comparing the owner to what the owner could have done with that cash had they continued renting. Most interesting is when the mortgage is paid off and the renter has resulting higher cash flow costs than the owner. This is where many people get stuck on the idea that buying is superior. However, the renter has an asset that is growing much faster than the owner's home. They are able to absorb the higher cash flow costs with the portfolio growth while also seeing their net worth increase faster than the owner's. This is an illustration of the opportunity cost of equity that home owners incur. 53 $ 361,043.70

54 $ 360,258.31

55 $ 359,470.97

56 $ 358,681.67

57 $ 357,890.41

58 $ 357,097.18

59 $ 356,301.99

60 $ 355,504.82

61 $ 354,705.66

62 $ 353,904.52

63 $ 353,101.40

64 $ 352,296.27

65 $ 351,489.15

66 $ 350,680.02

67 $ 349,868.88

68 $ 349,055.72

69 $ 348,240.55

70 $ 347,423.34

71 $ 346,604.11

72 $ 345,782.85

Finally, we can see the amount that the renter would need to be saving into their portfolio during the mortgage pay back period, and spending from their portfolio after the mortgage pay back period, in order to keep pace or exceed the net worth of the owner. This assumption, particularly in the saving phase, is crucial. If the renter is not saving the cash flow cost difference between renting and owning, then the owner will come out far ahead. 73 $ 344,959.54

74 $ 344,134.19

75 $ 343,306.78

76 $ 342,477.32

77 $ 341,645.80

78 $ 340,812.22

79 $ 339,976.56

80 $ 339,138.83

81 $ 338,299.01

82 $ 337,457.11

83 $ 336,613.12

84 $ 335,767.03

85 $ 334,918.84

86 $ 334,068.54

87 $ 333,216.13

88 $ 332,361.60

89 $ 331,504.95

90 $ 330,646.16

91 $ 329,785.25

92 $ 328,922.20

93 $ 328,057.00

94 $ 327,189.65

95 $ 326,320.15

96 $ 325,448.49

97 $ 324,574.66

98 $ 323,698.66

99 $ 322,820.48

100 $ 321,940.13

101 $ 321,057.58

102 $ 320,172.84

103 $ 319,285.91

104 $ 318,396.77

105 $ 317,505.42

106 $ 316,611.86

107 $ 315,716.07

108 $ 314,818.06

109 $ 313,917.82

110 $ 313,015.35

111 $ 312,110.63

112 $ 311,203.66

113 $ 310,294.44

Info
Tags morgage, finance, rent
Type Google Sheet
Published 21/05/2020, 22:15:52