friends will have a pretty good guess.
Now ask them another question: How much implicit rent are they paying to live in their house? You’ll get nothing but puzzled looks. Maybe 1 percent of friends will even take a guess at this number.
Implicit rent is an opportunity cost, so the cost depends on what alternative investment opportunities are available.
Now ask it another way: How much could they rent out their home for? You’ll get more answers, but probably half will still have no idea, particularly if they live in a neighbourhood full of homeowners.
Ignorance is bliss.
Ask these questions of anyone who owns a home and lives in an expensive city, like Toronto or Vancouver, and then show them how to calculate the number. Once they do the math, they will be shocked by how much implicit rent they are paying.
Here are a couple different ways to calculate implicit rent. Depending on how you calculate it, you’ll get slightly different answers. Implicit rent is an opportunity cost, and because it’s an opportunity cost, the cost itself depends on what alternative investment opportunities are available. To figure out exactly what the cost is, a homeowner needs to actually change the way they are living — they need to sell their house, rent it out, remortgage it, or somehow otherwise invest the money they have tied up in their home in another investment.
First, how much implicit rent would a homeowner pay if they were to mortgage 100 percent of the value of their house?
To calculate this, take a guess at what the home is worth and multiply it by the mortgage rate you can get from your local bank. Any bank website will have posted mortgage rates. For instance, CIBC is currently offering a five-year, fixed-rate, closed mortgage at about 3 percent per year.
So, for an $850,000 house in Toronto (currently a below-average detached house price), the monthly interest is equal to the price times the mortgage rate, divided by twelve months in a year: $850,000 × 0.03 = $25,500 ÷ 12 = $2,125 per month. (Note that this calculation includes only the interest, or “rent,” portion of mortgage payments.)
This will easily be the lowest estimate of the cost of implicit rent because mortgage lenders in Canada offer very low rates of interest, since Canada subsidizes mortgage rates through its sponsorship of CMHC. This estimate will also be low because lenders don’t actually offer 100-percent mortgages — they almost always want you to put up some money for a down payment. If you borrow the entire amount needed to buy a home, the mortgage rate rises significantly … if you can find someone to lend you all of the cost.
Another way to figure out implicit rent is to look at other things you could do with your money rather than own a home. For instance, in Canada many investors have felt comfortable investing retirement money in defensive dividend-paying stocks, including banks, insurance companies, telecom and cable companies, REITs (real estate investment trusts), and pipelines. Let’s assume an investor invests in a portfolio of large, well-known dividend-paying stocks in Canada, generating an annual yield of 4.5 percent.
Under this scenario, a homeowner could estimate implicit rent by multiplying the house price by the yield on a basket of stocks and dividing by the twelve months of the year: $850,000 × 0.045 = $38,250 ÷ 12 = $3,187.50 per month.
If you aren’t comfortable with investing in individual stocks, you could consider using the yield on the S&P/TSX Dividend Aristocrats Index, which is an index (portfolio) of TSX-listed companies that have shown a regular pattern of increasing dividends over the past five years and have market capitalizations (the value of all the shares of the company) of at least $300 million. In short, the index is designed to provide investors with a conservative portfolio of defensive, income-producing stocks. Over the past ten years, this index has provided an annual total return of about 7 percent (yield plus appreciation of value), and the current yield on this index is about 4 percent: $850,000 × 0.04 = $34,000 ÷ 12 = $2,833.33 per month.
Now remember, what we’ve calculated in the three previous examples — mortgage interest on 100 percent of the value of a home, the value of a home invested at a 4.5-percent yield, and the value of a home invested at a 4-percent yield — has just been the implicit rent or opportunity cost of a home. The total cost of “rent” for a home also includes maintenance, utilities, insurance, and other items.
Another way to look at the cost of an owned home without a mortgage would be to find a home for rent nearby and use the asking rent as an estimate. Depending on where the home is and how nice it is, the amount a home rents for could be a lot more than the implicit rents we calculated, in part because the rent a landlord charges is supposed to cover not only the interest but also maintenance, property taxes, and insurance, among other things.
So for our $850,000-house example, we found implicit rent was somewhere between $2,125.00 per month and $3,187.50 per month, to which we would add: 1) maintenance costs (2 to 5 percent of the value of the home annually, or $1,416.66 to $3,541.66 per month); 2) property taxes (usually 0.5 to 1.5 percent per year, or $354.16 to $1,062.50 per month); and 3) insurance and other costs.
At a minimum, in today’s very low interest rate environment, an $850,000 home in Canada costs between about $4,000 and $8,000 per month to occupy. Regardless of the approach, those are big numbers. And those are the actual costs of occupying a home, whether you own the home or you don’t.
Attention Homeowners!
Before we wrap up this discussion, let’s do one more thing. If you happen to own a home with no mortgage, or just a small mortgage remaining, let’s calculate how much you are paying in rent, see what else you can do with that rent, and see whether you are over-consuming housing.
Take your house value and multiply it by 0.95, to reflect the transaction costs of selling your house. This is how much you could walk away with if you sold your house.
Take that number and multiply it by the Dividend Aristocrats yield (http://ca.spindices.com/indices/strategy/sp-tsx-canadian-dividend- aristocrats-index), and divide by twelve to get your implicit monthly rent. A good conservative and rough estimate, if you can’t find the current yield, would be 4 percent.
Add to that number all of the other “rents” you pay (monthly costs of property taxes at 0.5 to 1.5 percent per year, depending on what city you live in; estimate of maintenance cost at 2 to 5 percent per year; plus utilities, insurance, and any other regular expenses related to your house).
This is what you are spending to live in your house, on a monthly basis.
Now that you know that number, there are two things you can do with it. First, spend a bit of time comparing that number to the costs of other housing options you would consider. They could be nearby single-family houses, rental apartments, condominiums (for rent or sale), or even housing in another location.
If the amount of money you’re spending to live in your home on a monthly basis is significantly more than what your other housing options are, spend a bit more time thinking about what you would do with the extra money you would save by selling your house and moving to less expensive housing. If you were to save $1,000 per month, you could spend that money on four $3,000 vacations a year. Or you could take classes on something you’ve always wanted to learn about. Don’t be shy — think of the most fantastic thing you could spend money on, and you could probably figure out how to pay for it with the sale proceeds of your home!
It might sound reckless to suggest selling your house to spend money on other things you enjoy, but what we’re actually looking at is how much money you are spending on “consuming” the housing you are living in. Whether you spend that
