How Much House Can You Really Afford?
Google “How much house can I afford?” and you’ll be awash in a sea of mortgage lenders. This is the mindset that younger people and the average consumer must take when it comes to buying a home: How much will a financial institution loan to me? And many, sadly, make their financial decisions based on how much they can borrow. They assume that you would want the maximum allowed.
But FIRE-oriented folk, potential early retirees, and the financially independent are likely to look at the problem from other, different perspectives. The first might be, how modest a house can I live in, and still be happy? Another perspective might be, how will this impact my budget and savings rate long-term? A final perspective, since many in that group can afford to pay cash, is not how much will my income qualify me to borrow, but rather how much of my net worth can I sink into a house without taking on undue risk or compromising my cash flow?
Is the answer to that question essentially the same as for the borrower, who is qualifying based on income? Or is it somehow different, when you are buying a home outright? When I was faced with the home buying decision late last year, I had to answer this question for myself….
Qualifying for a Mortgage
Let’s take a look at the constraints on housing deals using traditional mortgages. As we’ve said, the lens through which the vast majority of people look at home affordability is simply, how large a mortgage can they qualify for? Not surprisingly, the mortgage industry has a well-tested rule of thumb for making the determination. It’s known as the “28/36” rule.
According to FreddieMac, and many other mortgage resources, you should take on no more than 28% of your monthly gross (pre-tax) income in a mortgage payment — principal, interest, property taxes, home insurance. (Note that maintenance and utilities are not included in that number, whereas HOA dues might be.)
The relation of mortgage payment to gross income is known as the “front-end ratio”. It’s found by dividing your monthly housing expenses by your gross income and multiplying by 100. Some underwriters allow higher percentages, and some require lower. I’ve seen ratios as low as 25% and as high as 30%. But 28% is the most common rule.
For most people, “gross income” would just be wages. For a retiree, it would be the combination of pensions, Social Security benefits, and perhaps investment withdrawals, using a conservative safe withdrawal rate. Individual institutions are likely to have their own rules for getting a mortgage based on assets.
The 36% number is known as the “back-end ratio.” It’s the suggested upper limit once you add in monthly payments on all other debt to your housing expenses and divide by your gross income. This is an attempt by your creditors to keep your overall debt manageable.
The Sweet Spot?
In a brief search on the web, I couldn’t find the statistical justification for the 28/36 rule. It’s likely, after decades and millions in mortgages, that the industry has simply found that this number “works.” It nets them enough qualifying customers. Those customers stay solvent enough that companies can turn a profit.
Though I’m no fan of debt, my guess would be that the 28% rule is actually a little conservative. Mortgage companies can’t stay in business if sizable numbers of their borrowers default on their loans. So the rule likely ensures a safety margin so that the average, financially-pressured family can take on some extra expenses and still make their mortgage payments. By contrast, prospective early retirees have above-average financial resources and skills. And they likely have years of experience understanding and managing their expenses. They might be able to take on a bit more debt. But then, most prudent early retirees I know wouldn’t choose to do so. That’s how they got where they are, after all!
Leverage
Taking out a mortgage is a classic application of the principle of financial “leverage.” Most home buyers have a limited amount of cash — the down payment — which is not enough to buy the asset outright. So they borrow the difference and purchase the home using other people’s money. This lets them take possession of a larger asset than they could otherwise afford. Though it does leave them with debt, and a monthly cash flow obligation.
The financial benefits of home ownership are many. They include housing cost control, favorable tax treatment, potential rental income, and growing access to equity. Then there are the emotional benefits: control, predictability, familiarity. For many, taking on some debt in this case is worth it.
However, as recent history has demonstrated, the one-time truism that buying a house is always a good financial move is no longer the case. And, whenever you use leverage and borrow other people’s money, you have to play by their rules. Hence the inflexible and possibly conservative 28/36 rule for getting a mortgage.
Paying Cash
What if you don’t need to use leverage? What if you’re a financially independent early retiree paying cash for a home? In that case, you aren’t bound by any mortgage industry rules of thumb, just by prudence and common sense.
Buying a house with cash likely involves transferring money from paper assets (stock and bond funds) to a real estate asset. How will that affect your financial situation?
When I pondered this question a few months ago, I ultimately decided that, for me, the decision boiled down to the tradeoffs between a change in expenses and a change in investment returns. Starting from my current financial position, I had to analyze those two factors to know how a home purchase would impact us going forward, and how much house we could afford.
Expenses Versus Investment Returns
First the expense side. Simple enough. Buying a house would usually reduce your monthly expenses. By how much is open to some analysis. (See my rent versus buy article.) But it’s clear that when you buy a house outright, at a minimum, you are no longer on the hook for writing a monthly rent check. Yes, owning a house incurs many other expenses such as property tax, insurance, maintenance, HOA fees, etc. But you’d expect the monthly outlay to be less than rent. So, without that large monthly rent payment, you’d generally expect your monthly expenses to go down after purchasing a house.
Now the other side of the equation — investment returns. When buying a house with cash you are taking a chunk of principal and moving it to a different kind of investment. Probably from equity/debt instruments (stocks/bonds) to real property. How will the growth on that real property over time compare to the expected growth for the stock market?
General Real Estate Return Assumptions
This is where the analysis gets much fuzzier. Many experts will say, across a large geographic area and a long span of time, we shouldn’t expect real estate to do any better than the rate of inflation. A MarketWatch article argued that “Houses are ordinary consumable goods: wood, stone and metal bound together through labor. There’s no reason to believe they should enjoy a special rate of return distinct from those for, say, apples and shoes.”
But of course houses and shoes are different. Homes generally appreciate in value, whereas most other manufactured goods depreciate over time. That’s in part because homes have very long lifetimes and are built on permanent and finite land. The world is getting more crowded. The planet is not creating more land. Desirable locations are filling up and bidding up. So housing markets in specific locations can fluctuate dramatically from the averages. Our local town saw a 20% increase in real estate prices last year.
Your Specific Real Estate Return Assumptions
While I don’t assume those kinds of returns going forward, my best guess is that our area will outperform inflation, and possibly even the stock market, for several years, if not longer. That’s admittedly a bet on our unique local circumstances: A small, highly desirable vacation town, with limited available open space, where properties are being bid up by wealthy newcomers from the densely populated cities of California and Texas, escaping the pandemic and working remotely.
So my best guess is that, for this recent deal of ours, we will come out ahead on both ends of the equation. Our expenses will go down, and our investment returns will go up. Obviously that makes any deal a winner, and would greenlight a more expensive home. But I will readily admit that’s just a guess. I have no idea, in reality, what markets will do over the long haul. And, our long-term frugal instincts always kick in and tend to prevent us from buying more house than we need.
You Can’t Count on Appreciation
In recent decades, in many areas of the country, it’s been a losing bet to assume your house would appreciate faster than other investment assets.
In my article on Investing in Real Estate, I relayed our personal experience with our family home in Tennessee:
“We paid $137,000 for our house in late 1996 and sold it for $245,000 in mid-2013…. It appears we came close to doubling our money! Sounds pretty good. But when you run the numbers, that turns out to be only about a 3.6% annual return over the 16-1/2 years we owned the house. “
“…looking over all of our house-related transactions, on the low end I’d say we made at least $30,000 of capital improvements during our tenure, and on the high end, possibly as much as $50,000. So approximately 30% to 50% of the “growth” in our property wasn’t really growth at all, but was just our additional capital investment.”
“Once I run those numbers, our return on the house was actually only about 2.5% on the high side, or about 1.9% on the low side. By comparison, according to the Bureau of Labor Statistics, inflation over the time we were in the house ran at about 2.4%. So, at best, we barely outran inflation!”
Chris, in his article on Home Ownership for Early Retirement described even flatter growth:
“We built our home in 2005 for approximately $250,000. Since then we have done several costly upgrades totalling over $20,000. This brings our cost to over $270,000 before accounting for routine maintenance, property taxes, mortgage interest, and other expenses associated with home ownership. Twelve years later, comparable homes in our area are selling for $240,000-$260,000. Even without factoring in real estate commission and taxes on the sale of our house, we have virtually no chance of recouping our initial capital investment, let alone making money on the transaction.”
All of which is to say, no matter how much cash you have, depending on the growth dynamics in your area, you can’t necessarily purchase a house betting that appreciation will bail out your lifestyle in the long run.
Pushing the Limits on Cash Flow
Is cash used to buy equity in real estate really “spent”? No. Such transactions are more accurately viewed as a transfer from one asset class to another. You still own something valuable. Real estate is such a common and well understood asset class that the financial industry has created a slew of ways for you to tap the value inside it. For example, that equity could be accessible to you, with some expenses, via a home equity line of credit (HELOC), or a reverse mortgage.
So, could you, in theory, put all of your net worth into your dwelling, then use one of those financial instruments to pull out the equity as needed for living expenses? This would, in theory, let you live in an arbitrarily large house, or at least one as large as your net worth.
HELOCs and Reverse Mortgages
The answer with a HELOC is simple: HELOCs require regular repayments. Without income or assets outside of the house, you would have no way to finance the loan. You can’t use up all your liquidity on real estate and then use a HELOC to bail yourself out.
Reverse mortgages are trickier. They are structured so that no repayments are required while you remain in your home. There is even a “tenure” option that will generate payments for life. So, in theory, you could dump an arbitrarily large sum into a house, then remove equity for living expenses as long as you lived in it. In practice, I suspect that’s unworkable. For starters, reverse mortgages don’t actually let you tap all of the equity in a home. A “principal limit” is computed based on several variables. In the examples I’ve seen, the accessible principal might initially be around 50% of the home’s value, and the related tenure payments are modest, not enough income to cover the typical retiree’s living expenses.
About Reverse Mortgages
Let’s dig a little deeper into reverse mortgages. Even if they don’t promise an unlimited line of credit in retirement, they can potentially leverage your home equity to provide essential lifestyle insurance.
Reverse mortgages were developed for worthy purposes, but they unfortunately developed a bad reputation. They are a complex tool and, like any tool, should only be used where appropriate. Even with a reverse mortgage, you must have other liquid assets to maintain your property and pay taxes. Some early customers weren’t adequately informed about the costs and risks, spent their equity unwisely, and wound up losing their homes.
But a new round of government regulations in October 2017, plus analysis from retirement researchers such as Wade Pfau, have shown that reverse mortgages have a role to play in ensuring retirement income using home equity. Wade’s book, Reverse Mortgages, provides an introduction to reverse mortgages and an extensive summary of related research results.
Benefits and Downsides of Reverse Mortgages
Like an annuity, or bonds, or any guaranteed income, a reverse mortgage can reduce sequence of returns risk for the rest of your portfolio in retirement. In other words, if the market dips for a period of time, you can shift your withdrawals from damaged stocks to more stable assets, until the market recovers. Because of the nature of withdrawal math, this is particularly critical early in retirement.
In simulations of retirement income, the potential protection against sequence of returns risk turns out to be probably the single most important benefit of a reverse mortgage. Even if you never use it in practice, it could be worth opening a reverse mortgage early in retirement, just to have access to that line of credit, if needed during a market downturn.
Of course reverse mortgages have their downsides. They are complicated and do have some risks. Upfront costs can approach $20K. And coordinating retirement income with a reverse mortgage is non-trivial and has to be revisited annually in the context of market conditions.
Bottom line, the main benefit of a reverse mortgage is probably the flexibility to avoid selling other assets when markets are down. Though Wade does write, “For those upsizing with the financial resources to manage this sustainably and responsibly, the HECM for Purchase [a type of reverse mortgage] could allow for a more expensive home…”
The Critical Assumption Underlying a Reverse Mortgage
Even if you don’t want a more expensive home, Wade’s simulations prove that a reverse mortgage can insure your retirement lifestyle, allowing for higher spending and/or a larger legacy over a range of retirement scenarios.
But, as much as you may be attracted to the idea of a guaranteed line of credit in retirement, be sure to understand one critical assumption underlying the use of a reverse mortgage:
You are free from the burden of repayment only so long as you remain in your home. Tapping all the available equity, without other resources on hand, assumes that you will stay in your home until the end of your life.
But, based on my admittedly unscientific survey of the elderly I know, I think that’s unrealistic for the majority of financially comfortable retirees. In most cases I’ve personally witnessed, as people get into their 80’s, they decide their quality of life would be higher in a senior or assisted living situation. If they’ve sucked all the equity out of their home via a reverse mortgage, they could have trouble making the move.
Long term care at home is an appealing goal, and something we hope to implement in our lives as we age. But needing to stay in your home for your financial plan to work, is a dubious bet, in my opinion. So a reverse mortgage must be managed carefully, if most of us are headed for senior living anyway. In that case, having to sell your home with a reverse mortgage on it, you could lose much of your equity and have nothing left over to pay for the transition.
A Rule of Thumb?
In recent years, as relatively frugal early retirement renters, our housing expenses have averaged only about 21% of our budget. Our rental represented a significant downsizing from our original family home, and proved a little tight for us over the long haul, hence the recent home purchase.
For those financing a house based on their income, the mortgage industry will generally approve loans for which mortgage payments represent no more than 28% of gross income. Though, as we’ve discussed, this could be on the conservative side, since the industry is dealing with the abilities of the general public to manage their financial lives.
In Reverse Mortgages, Wade Pfau writes, “The Center for Retirement Research at Boston College analyzed numbers for retired couples aged sixty-five to seventy-four in 2010 and found that housing expenses represented 30 percent of the typical household budget.”
Last fall, when I was trying to decide how much house we could afford, paying cash, I did back-of-the-envelope calculation. I then ran the Pralana Retirement Calculator. Eventually, I settled on a plan where real estate in various forms could represent up to one-third of our net worth. My calculations, and my “gut” feeling, indicated that more than that represented undue risk for us. Other financially independent friends have confirmed a similar ratio.
Put it all together, and I’ll suggest that one-third of your net worth is a reasonable upper limit when buying a home without a mortgage. Spend less than that, and you’ll likely have a comfortable cushion for the other major expenses — transportation, food, and luxuries — in retirement. Spend more than that, and you may be threatening the long-term viability of your retirement plan. Finally, a reverse mortgage, used sparingly and prudently, can provide you with some flexibility and cash flow to shore up that plan, if needed.
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[The founder of CanIRetireYet.com, Darrow Kirkpatrick relied on a modest lifestyle, high savings rate, and simple passive index investing to retire at age 50 from a career as a civil and software engineer. He has been quoted or published in The Wall Street Journal, MarketWatch, Kiplinger, The Huffington Post, Consumer Reports, and Money Magazine among others. His books include Retiring Sooner: How to Accelerate Your Financial Independence and Can I Retire Yet? How to Make the Biggest Financial Decision of the Rest of Your Life.]
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Whenever I read about homes as an investment with “return”, I always wonder how people plan on realizing that gain?
When you sell that $200,000 house for $500,000, what are you going to do then? You have to pay for new housing somewhere? Was your housing the only housing in your area that appreciated in value/cost? Of course not.
Reduce housing costs by moving to a cheaper location? By downsizing your living situation? Ya know what, renters can do that too?
Access the “gains” by taking out a HELOC against the increased equity? That’s just taking on new debt.
Unless, I missed it, the entire section on the home price appreciation didn’t discuss this quandary at all.
Jay,
Those are all good points. We’ve covered them previously.
https://www.caniretireyet.com/home-ownership-investment-portfolio-financial-plan/
https://www.caniretireyet.com/downsizing-5-years-later-any-regrets/
https://www.caniretireyet.com/geoarbitrage-retire-sooner/
https://www.caniretireyet.com/renting-vs-buying-true-cost-home-ownership/
Best,
Chris
I had paid off my condo prior to retiring at age 62 (not so early retirement, “came late to the game”). It has been good not to have the mortgage payment included in the housing line item of my budget. I am postponing SS benefits until age 70 by withdrawing from my Trad-IRA and 401k. I don’t think I will need the equity in my real estate investment until I age out in my 80’s, as referenced in your article. I appreciated the detail information about the Reverse Mortgage. However, I have been wondering if drawing home equity out now through a Reverse Mortgage would be smarter than currently drawing down on “paper” investments (IRA AND 401k). In essence swapping cash flow from a Reverse Mortgage versus cash flow from Trad-IRA/401k. What would be considerations for such a retirement strategy? I suppose it would be a comparison of rate of return on investment versus cost (interest and fees) of Reverse Mortgage. What do you think?
My $.02 is that this is a great time to be selling off assets that are by conventional measures overvalued. Where the reverse mortgage can be valuable is if asset values drop, thus requiring you to sell more assets to produce the same amount of cash. Having the ability to utilize the capital that would otherwise be tied up in your home would allow you to avoid this risk. However, it comes with its own set of risks and costs as Darrow laid out in the post. For more detail, you may want to pick up Pfau’s book and do a deeper dive on your own. Hope that helps.
Best,
Chris
I had the same question about how much to spend on a house if I can pay cash and was frustrated with lack of answers in the internet. I think you should spend no more than a bank would lend you and enough so that you are comftable staying in the place for at leat 5 yeras. Use (implicit rent – costs of owning) as return you get on buying a just-enough house, if you buy more house than just-enough then budget the dfference in inputed rents as pure consumption.
Arek,
As someone who recently bought our home with cash I would agree that the key thing is to buy a just enough house and not push the financial limits if possible. However, I’ll point out that we are intuitively very conservative with housing and we were lucky to find a location that suits our needs and wants that is affordable. This article prompted me to look at our housing spending. Our home makes up only about 17% of our net worth and our annual housing expenses (taxes, insurance, utilities) only about 10% of our spending. with real estate markets rapidly increasing in many parts of the country, that’s just not realistic for many people so having some other metrics to use for comparison is useful.
Best,
Chris
I appreciate your well thought out and researched article. I recently went through this home decision process. Using a much less sophisticated process, I evaluated expense differences as well as the interest paid on my mortgage. At the time I lived in California, so I had a large interest payment (this amount aggravated me each tax preparation season, especially with the deduction limit placed on Federal taxes). The factors that drove my ultimate decision (I moved out of state) were availability and cost of homes I desired in the new location and the amount of cash generated from the sale of my home. I used 95% of that amount to purchase a home for cash. Another factor driving my decision was the lack and cost of home loan options if you do not have a source of income. So in the end, I lost a house payment and transferred my equity from old home to new home.
I think the HELOC and Reverse Mortgage sections are great. I had considered using a HELOC to make an all cash offer on a vacation rental and then decided against it.
But the potential to use a reverse mortgage to reduce sequence of return risk in early retirement is something I hadn’t considered and will look into a bit.
Especially since the alternative is to change my allocations to be more conservative, but I don’t love that idea even if there appears to be froth in the markets. We just don’t know what will happen and having an additional tool at our disposal could be worthwhile and allow us to stay the course.
AR,
I wrote about using a HELOC that we took out on our previous home to finance buying our new one rather than going through the effort of originating a mortgage that we planned to pay off as soon as we sold our old house. https://www.caniretireyet.com/lessons-landlord-real-estate/
That worked out exceptionally well for us. HELOCs and reverse mortgages can be valuable tools to have in your arsenal to utilize the equity in your home. That said, any time you utilize debt you’re taking on additional risks. I whole heartedly agree with Darrow’s recommendation of doing this only if you’re making a fully informed decision and are comfortable with the worst case scenario coming to fruition.
Best,
Chris
I have a question regarding the rule of thumb of “i/3 of your net worth as a reasonable upper limit” when buying a home without a mortgage. Simply for sake of discussion, say my (paper)net worth is $3,000,000. $100,000 in cash, $1,900,000 in stock/bond funds, $1,000,000 in 401k/IRA accounts. One-third is $1,000,000. However, taking cash from stock/bond funds and 401k/IRA accounts will likely have substantial tax implications. The consequence being that net worth that can be accessed is not $3,000,000. In a situation like this, how would you – or other readers – suggest adjusting rule of thumb to avoid transferring to much capital (on percentage basis) into a non-mortgaged house?
By the way, I really enjoy the columns and accompanying replies / opinions.
Good question Chris and that’s why it is proposed as a “rule of thumb” as opposed to a hard and fast rule. My first thought is that depending on your location $1M can be a lot of house. So if possible, I would first try not to push towards that upper limit if I could be happy with less. If you are set on a market where $1M is what it would take to get a house that you’re comfortable in, then you would need to look at the most tax efficient way to tap your resources. This would probably be a case for a mortgage if it is at all possible to get one as taking a lump sum of $1M to make a cash purchase would almost certainly create a substantial tax burden. Reading other people’s comments, and this prior post (https://www.caniretireyet.com/getting-a-mortgage-when-you-have-assets-but-no-income/) about getting a mortgage with assets but no income, this may be a reason to be planning ahead and secure your mortgage while still working if it at all makes sense and is possible vs. waiting until you leave your career and income behind.
Hope that helps.
Chris
I am in escrow on a house I am buying for my daughter and her family. If you dont know yet, youll find that buying a house while retired can be a real challenge.
I found that most major banks wont lend to retirees unless you can document systematic withdrawals from an IRA, 401K, or Annuity,and of course show enough income. I had to switch my monthly withdrawls from a regular investment account to my IRA account even though I showed I had been taking systematic withdrawals for 3 years. Your 1,000,000 portfolio doesnt count as much as having steady W2 income. One formula I read about for figuring how much your portfolio will count toward a monthly income is 1000000 x 70%÷ 360= $1944 per month. You have a better chance with a W2 and no portfolio apparently!
I did find a lender willing to consider alternative income sources. Theyre out there and the common thread is that they keep their loans in house. So for those of you early retirees feeling really good about your status this is one area where you’ll realize banks are cautious.
I had the same challenges when shopping for mortgages after my retirement. One lender initially told me recently that they can use asset-based mortgage, and then told me that it’s not possible because of new regulations published on Dec., 2020.
May I ask which lender is still willing to do asset-based mortgage? Assume that’s what you mean on alternative income sources. Thank you so much!
Mitch,
Thanks for taking the time to share your experience and insights.
Best,
Chris
I think people also look at the tax break in interest and property taxes. But I agree with you that the benefit, even with those breaks, does not look that great with my situation.
One other thing that the Millennial FIRE folks do is house hacking, which turns it into a whole different ball game.
Thanks for the article.
I had paid off my condo prior to retiring at age 62 (not so early retirement, “came late to the game”). It has been good not to have the mortgage payment included in the housing line item of my budget. I am postponing SS benefits until age 70 by withdrawing from my Trad-IRA and 401k. I don’t think I will need the equity in my real estate investment until I age out in my 80’s, as referenced in your article. I appreciated the detail information about the Reverse Mortgage. However, I have been wondering if drawing home equity out now through a Reverse Mortgage would be smarter than currently drawing down on “paper” investments (IRA AND 401k). In essence swapping cash flow from a Reverse Mortgage versus cash flow from Trad-IRA/401k. What would be considerations for such a retirement strategy? I suppose it would be a comparison of rate of return on investment versus cost (interest and fees) of Reverse Mortgage. What do you think?
“I’ll suggest that one-third of your net worth is a reasonable upper limit when buying a home without a mortgage.”
Thanks for this data point. We are looking to relocate in a few years and I was trying to pinpoint a gut feel for what we were comfortable with and I came up with around 20% – 25%. But that’s based on what we can get at our target location. That said, if push came to shove and we relocated to a high cost area, we probably would go as high as 30% to get what we like (within reason) since we would be spending so much time at the house in retirement.
Great article, Darrow. So did you ultimately decide to pay in full for your home (no mortgage)? And either way, how did you decide between paying in full versus obtaining a mortgage (presumably at today’s low interest rates)?
Casey,
That was addressed here: https://www.caniretireyet.com/my-investment-portfolio-2021/
Best,
Chris
Your article brings up the subject of leverage, but not to the extent that I would like to see. I’ve yet to read any article on the subject of mortgage vs no mortgage address the fact that a mortgage is probably the safest form of “investing” leverage that a normal person can engage in. Even if a person puts down 20% and the house merely appreciates at the rate of inflation, there exists an initial 5:1 leverage, so the real return is 5 times inflation. Naturally, the leverage factor is reduced over time as the principal balance is reduced. As long as a person doesn’t buy too much house using a fixed rate mortgage, the risk should be minimal. Also, as has been pointed out in many articles, the payment is made with depriciating dollars.
As I have recently retired and will pay off my home in the near future, I’ve pondered that old adage of “don’t have a mortgage in retirement”. Part of me wonders whether it is smart to have $700-800,000 tied up in an ill-liquid asset. The house will continue to appreciate relative to its value whether I have my own money tied up in it or a combination of mine and the banks.
Darrow, what are your thoughts?
Phil,
Your thought process makes sense. It’s just important to understand that no decision is without risks AND rewards, so it is wise to consider them fully.
To your point about being able to leverage up the benefits of a mortgage, particularly in times of extreme low interest rates, it is worth considering that the downside of this strategy is that you create a monthly liability that must be paid from this cash that is invested elsewhere and it will come due each month even if the investments are down in value. Only you can decide if that makes sense for your individual situation.
The other point to consider is the impact on health care expenses if using ACA subsidies as an early retiree or on Medicare as a traditional retiree. In either of those cases, your medical insurance expenses are related to the income that you need to generate. If you have a large mortgage payment each month, you give up flexibility on how much income you can generate because you have to generate enough to pay the mortgage. Thus you may push yourself into higher marginal tax brackets and this can also cause you to pay thousands of dollars more in health insurance premiums every year as you lose subsides. Someone with a paid off home can live the same lifestyle with a lower monthly/annual income need while paying a far lower effective tax rate and not being penalized with higher health insurance costs.
It’s a complex issue that requires zooming out to see the big picture and while “rules of thumb” are certainly helpful, you really need to consider your personal financial and psychological situation to make the best decision for you.
Cheers!
Chris
Barring multiple years of large Roth conversions early in retirement (which I am in the process of analyzing),we will be up against RMDs that will create Mediscare penalties anyway. And, if there is no issue generating the income to easily make a mortgage payment and you remain within a reasonable marginal tax bracket, it might be worth considering.
I have also had this debate within myself (not including any leveraging advantage) about whether to pay cash for automobiles or finance with the 0% rates that many manufacturers are offering. Granted, we drive the wheels off our cars.
Ignoring retirement stage of life, I would like to see a rigorous analysis of the buy vs rent decision that includes this leveraging advantage. I’ve never seen an article on this subject that accounts for this and it’s far beyond my analytical capabilities. It has to be a large “advantage”, especially with today’s low interest rates and the fact that very few people put down more than 5%. At a minimum, I speculate that most people end up living for free, excluding maintenance and improvemen expenses.
I’ve always tried to avoid debt as much as possible and have tried to make extra principle payments. However, I’m starting to wonder if having a few hundred thousand in mortgage debt at a low rate is a good hedge on inflation. No matter how high inflation goes, the principle on my mortgage remains the same (minus my payments). If future dollars are worth significantly less due to inflation I’ll still be making the same payment with less valuable dollars. The hope being that my other assets (including the house) would rise in value – kind of like short position on the mortgage. If we get hyper inflation and assets drop in value, then it doesn’t matter because we’re in a depression and we’re all screwed anyway!
Your logic makes sense. Just realize that every decision comes with risks and benefits. Scroll through the comments and you can find where this has been discussed.
Best,
Chris
There is another retirement home ownership scenario that I haven’t seen in articles similar to this. Our house is paid off. From a local credit union we pulled a 50% LTV, interest-only payments, 2.75% (Prime minus 0.5%) HELOC for a $95 fee. This is a standby line of credit that we can tap instead of having to sell assets in a down market. When the market recovers we can sell some assets and pay off the HELOC. This is a very low cost way to address sequence of returns risk.
We looked at reverse mortgages and decided they were rather nasty. In addition to the factors you point out above, there would be closing costs of $10K-$11K.
Chuck,
I’ve touched more on HELOC’s here. I agree in theory that this makes sense. One caveat is that banks can pull back lines of credit when you would want to use it such as in this scenario. I don’t believe that is a common practice, but it definitely happened in 08-09 when banks were struggling and didn’t want more liabilities on their books.
Best,
Chris
Reading your linked article on home ownership knocked a couple of brain cells together. As mentioned in the article, we also view our home equity as Long Term Care “Insurance.” The HELOC could be used as a bridge while moving to more supportive living and then selling our home. It would make the timing of moving and selling much less challenging.
(Additional Note – The credit union HELOC could be increased to 80% LTV just by paying $500-$600 for title insurance.)
I have wrestled with this a lot. I think there are really a few considerations at play. If you’re in your accumulation years and aiming for early retirement then keeping that front-end ratio to 28% of your gross income is going toward housing. Add on top of that maintenance and utilities (more for a bigger house, obviously) and people get pinched in ways they failed to foresee. But housing is also something more than a financial decision, it’s psychological and emotional and can be a great decision for your family and less so for your FI.
Dan,
I agree that overspending a little on a house can be a great psychological and emotional decision, but I would add the caveat that people often focus on the wrong things when making this decision. Too much emphasis is placed on bigger/more rooms, nicer finishes, etc. which quickly become the new norm and typically don’t move the needle on long-term happiness. Too little emphasis is placed on finding the right location regarding access to the things you love to do, being in the right community of people you want to spend time with, etc.
Cheers!
Chris
While one year away from my planned retirement day, I’ve decided to start looking for a home that would be more amenable to my family’s retirement. My wife has had some mobility issues and owning a home with multiple levels has caused some hardship for her. Affordability is a primary consideration, but I feel that if I found the right property, I could stretch just a bit. What I tell myself is that after working for 50 years, now is my time to fulfill many of my long-awaited dreams and finally enjoy where I live. The rush-rush of the working world will hopefully be replaced by more tranquility and visual beauty. Properties with views of the mountains or lakes go for a premium but to replace the small view of the mountains we currently have for our neighbor’s window is not an option. It seems like a lot of retirees have this same dream, considering the inflated housing costs we are experiencing.
David,
I wish you well in your search for a new home. This may help you get your search underway. https://www.caniretireyet.com/where-should-you-retire/
Cheers!
Chris
Awesome article. Downsizing our house has been one of the best decisions we’ve made on our FIRE journey. We went from an expensive place in a super high cost of living area to a modest (but still nice!) house in a medium cost of living area and our ability to save has increased so much!