A great framework for developing positions and hypotheses is what Stanford professor Paul Saffo describes as strong opinions, weakly held. Using this approach, my ideas on home ownership have evolved over the years.
Like most Americans, I started out believing home ownership is a great investment. A few months after finishing graduate school, I started my career and got married. My wife and I then put down 5% and bought our first house that came with a 30 year mortgage.
I started viewing our home as a liability that tied up capital and drove our spending, rather than it being an asset that would help us achieve our financial goals. But that view is incomplete as well.
Home ownership is not a great investment for everyone. But it can be a great lifestyle decision with financial upside. Ultimately, we decided home ownership was the right decision for us.
What are the financial planning implications of choosing home ownership? What advantages does home ownership provide?
Hedge Inflation and Provide Certainty By Locking In Your Housing Expenses
The first benefit of home ownership is true whether you own your home outright or whether you are carrying a fixed rate fully amortizing mortgage. You control exactly what you will spend on mortgage and interest payments for the term of the mortgage. If you choose to pay the mortgage off, you eliminated these expenses completely.
Fixing or eliminating your housing expense can provide a psychological benefit. With so many uncertainties baked into any retirement scenario, having certainty over this large expense can be comforting.
Having housing costs fixed also offers a tremendous inflation hedge. Those who rent need to prepare for the potential of rent increasing at or greater than the rate of inflation.
You must not ignore the fact that homeownership comes with unexpected expenses as well as property tax increases over time. However, renters are exposed to these risks as well. They are passed on to them indirectly in the form of rent increases.
Tax Advantages of Home Ownership
You can lower the amount of income taxes you pay over your lifetime. This is accomplished by deferring as much income as possible in your higher earning working years. You can then recognize this deferred income at lower marginal tax rates when you have little or no other income.
Owning your home outright in early retirement enables you to live well without needing much income. A rent or mortgage payment is the largest expense in most households. Eliminating it gives you greater control over how much income you need.
Needing less annual income enables you to spread your deferred earnings over more years. Thus you pay less income tax when it falls into lower marginal tax rates.
Living well for less introduces an often overlooked secondary tax benefit. You can optimize Affordable Care Act (ACA) tax credits. These credits are based on household income (MAGI to be technically correct).
The cost of an identical health insurance plan on the open marketplace can vary by tens of thousands of dollars per year between those who can optimize subsidies by limiting their income and those paying the full cost because they can’t. Lowering hosing costs is a powerful lever to pull to lower the income you need to live.
Another strategy to lower your lifetime tax burden is to utilize a Roth IRA conversion ladder. This requires rolling over a targeted amount of money from tax-deferred investments to Roth IRA accounts each year. Needing less income to support your spending gives more space in favorable marginal tax brackets to do these conversions.
Eliminating mortgage and rent payments helps with all of these tax minimization strategies.
Moving to Create Income
One argument against home ownership is that it ties up capital that can’t be used to fund your lifestyle. If you’re willing to move to free up some of that capital to fund your retirement, that’s not necessarily true.
Owning a home with the plan to sell it later provides options that can enable you to retire sooner. Home ownership can also provide a contingency plan if you need to free up capital in retirement.
Some people think developing a high savings rate to enable financial independence and early retirement is impossible for many people who live in high cost of living areas. This can be a legitimate challenge during your working years.
But there is no rule that says you must stay in a high cost of living area when you no longer need to earn an income. Utilizing geoarbitrage, moving from a higher cost of living area to a lower cost area where your dollars stretch further, provides a way to free up capital tied up in a home while simultaneously improving lifestyle.
I recently discussed this scenario with friends who live and work in the high cost-of-living Washington D.C. metro area. They are contemplating early retirement and are considering different variables that could impact their decision. If they sell their current home and buy something comparable in our area they would pocket about $500,000.
Assuming a 3-5% safe withdrawal rate, that $500,000 would create an annual income stream of $15,000-$25,000. This would also significantly decrease their spending by lowering taxes and cutting the amount they currently spend on travel.
You may not want to move to a lower cost area. Family connections, friendships developed over working years, or other lifestyle considerations could make staying in your current location attractive. A similar strategy could be used with downsizing your home to free up capital.
There are various reasons it may make sense to own a larger home during your working years. With kids at home, having extra space can be a luxury. A home gym can provide convenience and enable a healthier lifestyle. Many people keep a home office.
As your stage in life changes, so do housing needs. Things that at one point were luxuries and conveniences can become burdens to maintain and add unnecessary costs.
Selling a home and downsizing to a lower cost home can provide a sudden infusion of cash. This decision can also come with ongoing economic benefits in the form of lower taxes, maintenance expenses, and utility bills.
Making one decision to use your house to create income through geoarbitrage or downsizing can completely change your retirement options.
Staying and Creating Income
Some people may be set on staying in their home for life. Home ownership provides several options to fund your retirement while providing diversification away from stocks and bonds.
Creating Rental Income
Times are changing. Services like HomeAway and Airbnb make it easier than ever to use your home as a source of income when you’re not using it for your own shelter. Homeowners now use primary residences to produce income in ways that would have been challenging, if not impossible, just 5-10 years ago.
Many people dream of traveling in retirement. To some, a home is seen as an anchor that weighs down these dreams. You still have to pay expenses including property taxes, utilities, and possibly having to someone to maintain the property while you travel. Excellent online resources are available to teach you how to rent your home while you go traveling.
For others who don’t want to downsize, these same services give the option to use your primary residence to create income by renting out areas of your home that you’re not currently using. I’ve written how we designed our home ownership to retire sooner utilizing this approach.
For full disclosure, we have never made a penny renting our home out. But having the option to do so provides another contingency to our early retirement planning.
Turning Equity Into Income
I am debt averse. I never considered a home equity line of credit (HELOC) or home equity loan until a few years ago. We decided to buy our current residence and use it as a rental until we sold our former one.
A real estate investor friend suggested using a home equity loan against our former residence to buy our current one rather than getting a mortgage. I was amazed at the favorable terms we were able to obtain on a home equity loan. So we acted on his suggestion.
This opened my eyes to other ways it’s possible to use a home for your shelter and simultaneously use the equity to provide for your spending needs.
One option is to use a HELOC as an emergency fund. This can come with origination fees and annual expenses which should be considered. This strategy can also bring increased risk to your financial plan and enable unwise spending decisions if not used carefully.
It may be harder to get a loan or you may get less favorable terms as a retiree with little or no income. Still, for the right person this can be a viable and attractive option to use the equity in your home.
Another option that recently came onto my radar is a reverse mortgage. Respected retirement researcher Wade Pfau advises retirees to consider reverse mortgages as part of their retirement plans. He wrote an entire book on using reverse mortgages to secure your retirement.
Other interesting research from the journal of financial planning shows that using a reverse mortgage closer to the eligibility age of 62, rather than as a last resort, can increase retirement income and security in particular circumstances.
Using Your Home as Long Term Care Insurance
I’ve recently been thinking about the complex decision around buying long-term care (LTC) insurance.
A reader recently left a comment that has me thinking. She stated, “. . . I view our house as our long term care insurance. When we need assisted living, we will sell the house and have enough money for a very nice place.”
According to the website MedicareInteractive.org: “Home health care includes a wide range of health and social services delivered in your home to treat illness or injury. Services covered by Medicare’s home health benefit include intermittent skilled nursing care, therapy, and care provided by a home health aide. Depending on the circumstances, home health care will be covered by either Part A or Part B.”
However, according to Medicare.gov: “Medicare doesn’t cover long-term care (also called custodial care), if that’s the only care you need. . . You pay 100% for non-covered services, including most long-term care.”
A reasonable strategy is to stay in your home and receive home based services which are covered by Medicare as long as possible.
Owning your home can act as LTC insurance if the time comes that you can no longer live there without custodial care. You can then sell it to fund ongoing expenses. Simultaneously, you maintain the upside of keeping the home while not having paid LTC insurance premiums if you never need LTC.
Factoring Your Home Into Your Portfolio
Clearly, your home is an asset that provides different financial planning options as well as psychological comfort. But circling back to my first question: How does your primary residence fit into an investment portfolio?
Your primary residence is fundamentally different in several ways from assets such as stocks, bonds and investment real estate that are traditionally included in an investment portfolio. One difference is that your primary residence typically lacks the regular income component associated with other investments.
Another is that your home represents a largely illiquid sum of money tied up in one financial asset. You can’t easily rebalance a portfolio by selling off a portion of your home if it is appreciating faster than your other assets. Conversely, you shouldn’t buy a bigger house than you need because you arbitrarily determine that your house should be a certain percentage of your portfolio.
For those reasons, we don’t consider our home as part of our investment portfolio. We don’t factor home ownership into our asset allocation, rebalancing, and withdrawal strategies.
Factoring Your Home Into Your Financial and Retirement Plans
This leads into the second question we started with. How does home ownership factor into an overall financial and retirement plan?
There is no one size fits all answer to this question. There are many opportunities to use home ownership as part of an overall financial and retirement plan.
My goal with this blog post is to highlight some options. Think about which make sense for your situation. You can’t use all of these strategies. For example, you wouldn’t want to take equity out of your home if you are banking on being able to use the equity to fund your LTC needs.
My own thinking about home ownership, as with most things in life, is constantly changing. It evolves as I continue to accumulate knowledge and experience.
How do you factor home ownership into your investment and retirement plans? Have you thought of ideas I’ve missed? Have you utilized any of these strategies to your advantage, or found they didn’t work well for you? Share your thoughts and experiences in the comments below.
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[Chris Mamula used principles of traditional retirement planning, combined with creative lifestyle design, to retire from a career as a physical therapist at age 41. After poor experiences with the financial industry early in his professional life, he educated himself on investing and tax planning. Now he draws on his experience to write about wealth building, DIY investing, financial planning, early retirement, and lifestyle design at Can I Retire Yet? Chris has been featured on MarketWatch, Morningstar, U.S. News & World Report, and Business Insider. He is also the primary author of the book Choose FI: Your Blueprint to Financial Independence. You can reach him at email@example.com.]
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