The 5% rule for rent vs buy

Rent has a ceiling you can set quickly with the 5 percent rule rent vs buy test. Take the home's price, multiply by 5%, then divide by 12. If the monthly rent for a similar place is under that figure, this shortcut favors renting. Across 756 US cities, we tested that calculation against our 7-year model and got a clear verdict. It gets 508 cities right, or 67%, and misses in 248. Each miss points in the same direction.

What does the 5% rule for rent vs buy mean?

It offers a quick comparison of the costs of renting and owning that you can't recover. Housing costs that never return to you are called unrecoverable costs. Rent dollars are all unrecoverable. Owning also has unrecoverable bills: property taxes, repairs, loan interest and stock gains you miss on your cash.

In a rent vs buy video from 2019, portfolio manager Ben Felix shared the shortcut. At 5%, a $500,000 home carries $25,000 in unrecoverable costs each year, or $2,083 a month. If you rent for less than $2,083, renting wins. Flip it around: $3,000 a month in rent lines up with a $720,000 home.

A typical $332,700 US home puts the 5% line at $1,386 a month, a bit below the $1,413 median rent. Ramit Sethi, a finance writer, tells CNBC a similar thing. Rent gets you a roof and a landlord who takes care of repairs.

Working out the 5 percent rule rent vs buy math

Find the monthly rent where costs break even by multiplying the home's price by 5% for yearly costs, then dividing by 12. In symbols: `value x 5% / 12`.

Felix set the 5% figure using 3 annual ownership costs:

• Property taxes, set at 1% of the value of the home.
• Maintenance on the home, at 1% of value.
• Cost of capital, set at 3% of the value of the home.

Cost of capital covers your borrowing costs plus the stock gains you give up with your down payment. In April 2019 mortgages sat near 3%, so Felix set the debt rate at 3%. Cash down numbers came from global real returns between 1900 and 2017, with housing up 1.3% a year and stocks up 5.2%. His forward estimates have stocks 3.57% ahead of real estate, which he rounded down to 3%. For conservative or taxable investors, he suggests closer to 4% rather than 5%, which he calls an oversimplification.

Putting the shortcut to the test across 813 US cities

A yearly hurdle of 5% corresponds to a price-to-rent ratio of 20. You divide a home's price by its annual rent to get this ratio. When a home costs 20 times a year's rent, that year's rent equals 5% of the price. With the shortcut, 20 or less means buy, and more than 20 means rent.

We compared the cutoff with our full 7-year model in 813 US cities. Drop the 57 toss-ups and you get 756 clear verdicts. The shortcut agrees with the model in 508 cities, which is 67%. It misses in 248.

We used Zillow Home Value and Observed Rent indexes and verdicts from our rent vs buy method with 20% down across 7 years as sources.

Each miss goes in the same direction. Every one of the 248 misses has the shortcut saying buy at 20 or under and the model saying rent. In the other direction, not 1 city misses.

Why does the rule say buy if renting wins?

Today's ownership costs are much higher than what the 2019 shortcut assumes because interest rates and transaction fees are higher. 4 gaps push an owner's yearly cost past 5% during a 7-year stay:

• Mortgage rates rose to more than twice their former level. Freddie Mac lists a 7.24% average for 30-year fixed mortgages, far above 3% and the January 2021 record of 2.65%.
• Closing costs get no attention from the rule. They are the fees you pay lenders, agents and local offices when you buy or sell. Buying costs 3.5% and selling costs 6% in our model.
• The rule leaves out home insurance. A typical US owner spends $1,308 a year on insurance, added to other costs of owning a home.
• What you pay in local taxes changes from place to place. The US average sits at 0.94%, close to 1%, though our model uses the rate for each city.

The 5% line for a typical $332,700 home equals $1,386 each month. With a 7.24% loan plus insurance and closing costs across 7 years, the true monthly cost reaches $2,950.

We used Zillow Home Value and Observed Rent indexes and verdicts from our rent vs buy method with 20% down across 7 years as sources.

Using this rent vs buy rule of thumb today

Use the 5% cutoff as a quick filter, not a final verdict. If monthly rent is under the 5% line, buying loses to renting and investing over 7 years. Each time the shortcut chooses rent, the complete city model agrees.

If rent sits above the 5% line, don't assume buying wins. The typical home's full yearly ownership cost is well above 5% of its price when mortgage rates are 7.24%. Use our city pages to check your town, or test your numbers with the rent vs buy calculator.