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!
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.
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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