True Cost of Home Ownership (TCHO), a New Metric

TCHO is a holistic measure of home costs based on the market value of home and not on the mortgage payment. It includes permanent costs (interest, property tax, HOA, etc.) and the opportunity cost of equity.

When asked about the cost of owning a home, the first thing that comes to most people’s mind is their mortgage payment. TCHO is a holistic new metric that captures the true cost of home ownership based on its market value. It only includes permanent costs such as after-tax mortgage interest, property tax, HOA fees, etc. and not the principal portion of the mortgage which is recouped when the home is sold. It also includes the opportunity cost of equity, an implicit cost, that could have been invested elsewhere instead of being tied up in the home. Home equity is built from the initial down payment, accrued principal and market appreciation. The mortgage payment is irrelevant to TCHO.

TCHO for a primary residence:

To simplify, we will assume that the home equity would have returned the same rate as the mortgage rate, had it been invested somewhere else. This assumption lets us apply the after-tax interest rate to calculate both the interest cost on the outstanding loan balance as well the opportunity cost of equity. They both add up to the current market value of the home. We will also calculate the property tax assuming no tax benefits because of TCJA (please see “TCJA Changes to Real Estate” for more details). We use a slightly inflated property tax rate of 1.2% (based on California market) to account for additional charges such as home insurance, HOA or other mandatory fees. A 4.5% interest rate and 33% tax rate are assumed.

        After-Tax mortgage interest rate = Interest rate x (1 – Tax rate)
                                                                   = 4.5% x (1 – 33%)
                                                                   = 3%

        Monthly TCHO = Market value ‘P’ x After-Tax interest rate + Property Tax
                                   = (P x 3% + P x 1.2%) / 12
                                   = 0.35% of Market Value

We now use TCHO to calculate the rent equivalency of buying a home by equating rent to the monthly TCHO.

        Rent             = Monthly TCHO
                              = 0.0035 x Home Price
        Home Price = Rent x 300

Every $1 in monthly rent payment will buy about $300 of primary home. For example, the true cost of owning a $900K primary residence is the same as paying $3000 in rent.

TCHO for an investment property:

The tax benefit from interest deduction is neutralized by taxable rental income. Hence, the raw interest rate, and not the after-tax rate, is used for calculating the TCHO.

        Monthly TCHO = Market value ‘P’ x Interest rate + Property Tax
                                    = (P x 4.5% + P x 1.2%) / 12
                                    = 0.5% of Market Value

We next use the TCHO to calculate the rental income equivalency of buying an investment home by equating rental income to monthly TCHO.

        Rental Income                      = Monthly TCHO
                                                        = 0.005 x Investment Property Price
        Investment Property Price = Rental Income x 200

Every $1 in monthly rental income will offset about $200 of investment property. For example, a $500K investment home needs to generate at least $2,500 in rental income to breakeven.

The metric of TCHO can also be applied to calculate the forward-looking rental ROI. We remove permanent costs from the rental income and divide it by the current equity in the home. All the values need to be annualized. This measure will allow you to compare the cash flow from rental income to other investments.

        Rental ROI = (Rental income – Interest – Property Tax – HOA/Other fees) / Equity
        Equity = Market value – Loan balance

Let us now apply the rental property example we used earlier: $500K investment property with a $2,500 rental income, 4.5% interest rate, equity is the 20% down payment and assume $1K/year for other fees.

Rental ROI = ($2,500 Rental income x 12 Months – 80% LTV x $500K Purchase price x 4.5%
                        Interest rate – 1.2% x $500K Property tax – $1K Other fees) 
                        / 20% x $500K Equity
                    = ($30K – $18K – $6K – $1K)/$100K
                    = 5%

In summary, TCHO factors for a primary residence and investment property are 300 and 200 respectively. It means that every $1 in TCHO cost would buy about $300 of a primary residence or $200 of an investment property. Refer to our blog “Comparing Home Buys Using the TCHO Metric” for other uses of TCHO.

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