I think it was Ben Stein who, when asked about the key to financial success in life, replied “one dog, one house, one wife.” You may see the wisdom (and wit) in that, but it may not be quite that simple.
We make financial decisions almost every day – most are minor, some are major. And it’s the major ones that have the greatest impact on retirement stewardship. (By “impact,” I mean their effect on our ability to be able to “retire with dignity.”)
One of the biggest challenges we have with God-honoring retirement stewardship is that we can be tempted to define and construct our lifestyle by how we look, where we live, and what we drive. The problem is then compounded by the fact that we may end up using debt to fund our chosen lifestyle, sometimes more debt than we can handle, with very little flexibility to permit giving, saving, and investing.
The remedy to that problem, of course, is to keep our lifestyle spending at a level that is below our income. But this can be difficult as we are tempted to do just the opposite – we can feel pressure to spend more than we earn, and especially to increase our lifestyle disproportionally to rises in our income.
The 4 Most Important Decisions
There are lots of important decisions in life: who to marry, what kind of career to have, where to live, etc. In this 3 part series, I am going to discuss the most important financial decisions that you will make that impact retirement stewardship. The younger you are, the more critical these decisions are – in the short term, but especially over time. Poor decisions early in life can have a big impact later on.
Here they are:
- House Purchase Decisions
- New Car Purchase Decisions
- Lifestyle Decisions
- Saving and Investing Decisions
I will tackle the house decision in this first article (especially since, as I write this, its home buying season), the new car decision and lifestyle decisions in the second, and the saving and investing decision in the third and final article.
Important Decision #1: The House Purchase (or, the Bigger House Purchase)
I have worked with couples who look at their finances and decide that they are spending too much on housing expense. There may be other factors, but typically that is because they own more house than they can reasonably afford – i.e., the total cost of ownership (mortgage, taxes, insurance, maintenance, utilities, etc.) is simply too high as a percentage of their net (“take home”) income.
Unless they increase their income, or significantly reduce spending in other areas, they have few options to address the problem. The most drastic solution is to reduce their total housing expense by downsizing. But this can be very difficult as they would have to sell their current house, purchase another (presumably smaller) house, and then move their family and all their belongings.
Selling a house and buying and moving to another one can be very time-consuming and stressful, but sometimes it’s the only solution.
So, the house purchase decision is one of the most critical financial decisions you will ever make. Not only does the price of the house dictate your largest debt obligation (assuming a mortgage), but the larger and more costly the house, the greater the other expenses—utilities, property taxes, insurance, furnishings, repairs, and maintenance.
If you decide to purchase a house, there can be a lot of pressure to buy too much house for your budget at three critical stages in life. The first occurs when you are just starting out, and the second comes later on, typically in mid-life. The third comes when you are retired.
The First Major House Decision
First, when you are just starting out, you may be tempted to buy more house simply because it’s easy. The mortgage companies may be willing to lend you more than you can handle, and they offer other incentives like low down payments, “creative” interest rate buy-downs and adjustable rate options.
In the past, your total mortgage expense (mortgage, property tax, and insurance) could be in the 35 percent to 45 percent of pretax income range. That could easily equate to more than 50 percent of take-home income, which is pretty high. Personally, I like Dave Ramsey’s recommendation that your mortgage expense (principal, interest, taxes, and insurance – PITI) be no more than 25 percent of your monthly take-home pay, but admittedly that is very conservative. (He also strongly recommends a 15-year mortgage, which I also wholeheartedly endorse, especially if you are purchasing when you are in your 30s or 40s, or later.)
You may also be tempted to buy more house than you can handle because you think you will be able to “earn” your way to affordability. You may also view the use of “leverage” (i.e., using borrowed money) to increase your equity as a positive thing. But this is based on an optimistic view of your future earnings and the future of real estate prices. The risk you take is that these things may not happen as planned.
Here are my recommendations for making that first house purchase decision:
First and most important, if both spouses are working, never buy your first home based on both of your incomes. Make sure you buy a home that will work into your budget on the income of the husband only, should the need arise.
Then, if the wife gets pregnant, there won’t be the pressure of having to go back to work right after the baby is born. It is much easier to move up slowly in house size and price than to move back. It’s okay to start out with a “starter home!” Many young couples today want to skip the starter home and get to the dream-house stage way too soon.
Second, since many couples today are well educated and will be in the workplace early in their marriages, I recommend that the wife’s net income (after taxes) – or at least most of it – be saved. Simply act as if it is not there and save it. This will allow you to buy more house using only the husband’s income or to buy the same-sized house with a greater down payment, reducing the subsequent payments. (Remember, our conservative goal is to be able to take out a 15-year mortgage while keeping the mortgage payment under 25 percent of take-home pay.)
To illustrate, if the husband’s income will support payments on a $150,000 mortgage and you save $50,000, you will have two options. You could buy a $200,000 house and keep the mortgage at $150,000 by applying the $50,000 to the down payment. Or, you could borrow only $100,000 by putting down $50,000 on a smaller $150,000 house. The smaller mortgage will reduce the monthly payments, giving you more discretionary income to spend, save and invest, and give.
If you go with option two, you may not have as big a house, but you will be giving yourself much more wiggle room in your budget.
Third, don’t assume renting is always bad. For decades, conventional wisdom said that buying was almost always the smart choice. After all, when you rented you were just “throwing money away,” while when you bought you were “building equity.” But that assumption was sorely tested during the Great Recession and the decision is not as straightforward as it once was.
There is no one-size-fits-all answer to the rent vs. buy question – you have to run the numbers. And performing a precise analysis can be quite complex. That’s because mortgage expenses and their tax implications can be complicated. Other variables, such as interest rates or how long you will own a home are pretty unpredictable.
Aside from the intangible benefits of home ownership, which can be significant, you mainly have to compare the total cost of renting with that of owning. Rental expenses are pretty straightforward, whereas owning is not.
You know precisely how much renting costs – it’s your monthly rent payment. Sure there are other costs for things like utilities, but they would be the same as owning.
I need to point out, however, that rents have been increasing, even as house prices have remained relatively flat. According to commercial property tracker, Reis Inc., the average U.S. rent has climbed about 15 percent since 2010. That is about 4 percent higher than inflation. Note also that this has been during a time of very low mortgage rate, which can make home ownership less costly.
The challenge is determining the true cost of home ownership. You need to come up with what could be called the effective monthly cost of home ownership that you can compare head-to-head with renting.
Here is a list of the expenses that have to be considered on the buy side of the equation:
- Transaction costs – these can be in the thousands, but you need to amortize them for the time you plan to be in the house to understand the effective impact.
- Property insurance – typically paid monthly with the mortgage; exclude insurance on valuables, etc., as you would have those when you rent as well. If you rent, you will have renter’s insurance on your belongings but not the residence itself.
- Maintenance – this can be more than you think if you consider things like AC or roof replacements down the road. These also need to be amortized as well.
- Property taxes – also typically paid with the mortgage, into an escrow account. The taxes themselves are usually paid annually.
- Homeowner Fees – some neighborhoods have these, and some don’t. They are typically paid monthly or quarterly directly to the HOA.
- Interest/opportunity costs – this is usually not considered by most people. It mainly applies to those who are paying cash for a house or making a large cash down payment. If you do that, your money isn’t available for other purposes, such as investing. (For example, $100,000 invested at 5% would return $417 per month.)
- Tax savings – typically none from renting, but can be significant for home buyers, especially in the early years of a mortgage due to higher interest payment. (Certain real estate taxes are also deductible.) The lower your tax bracket, or the longer you own, the less the tax benefits become.
You need to run the numbers for yourself, but as a general rule of thumb, it cost approximately $1000 per month per $100,000 in cost for the home. So, if you want to live in a house costing $250,000, your total cost would be about 2.5 times $1000 or about $2,500 per month. If you can rent the same property for less than that – which is indeed possible in some areas of the country – then renting may be a better decision, especially if you don’t plan to live in the house for very long.
Many times you are better off to rent longer so you can save a greater down payment and thereby reduce your mortgage payment which, in turn, maximizes your flexibility. Some couples may be better off renting indefinitely, depending on other factors.
The Second Major House Decision
The second time there is a great temptation to buy more house is about eight to fifteen years into a couple’s work and marriage. Several things converge during this time frame to create what often seems like an acute need for a different (and usually larger) house.
First, all the children have typically been born by this time. Not only are all the children on the scene, but they are growing and needing more room. (This can be a legitimate need, by the way, especially for large families.)
At the same time, there can be the temptation, usually in the form of “peer pressure,” to buy something nicer to “keep up with the Joneses.” Since some of your friends have larger, nicer homes, you can begin to feel a greater need for one as well.
Interestingly, it is during this time that your family budget may be starting to get some margin in it, perhaps as a result of an increasing salary over the years while still living in the older, less-expensive house. But then you go out buy the big house and stretch your finances all over again and end up spending the rest of your children’s formative years (the next eight to fifteen years) under financial pressure again. (This is also a time when the expenses associated with the children are increasing as well.)
This can have a particularly negative impact on retirement stewardship because you are entering your peak earning years when you should be saving at least 15 percent of your total income for retirement, or more if you started late.
One of the best things you can do at this point is to bite the bullet and decide to live in your older, smaller house a few years longer. Instead of having a larger percentage of your earnings allocated to a newer, more expensive house, you have more discretionary funds that can be invested for retirement, given away, or spent on family enrichment activities such as vacations, ball games, and the like.
I also strongly recommend that you avoid succumbing to the “house illusion.” The simple fact is that most of the big houses that “the Joneses” are living in (as well as the fancy new cars they drive) are not paid for. As a matter of fact, they may have less equity in their homes than you have in your older, smaller home. If they have any glitch in their income (such as the husband losing his job or having to take a pay cut, an unexpected medical issue, or the wife becoming unable to work) then the whole thing comes falling down like a house of cards – they lose everything. (This is exactly what we saw during the “Great Recession.”)
The bottom line is this: Don’t be house-poor! You don’t want to have to work 60 hours a week to make the monthly payments and keep the place up with no money and time left to do anything else.
Now, just to be clear, I am NOT saying that you should never buy a bigger house. However, consider purchasing a new house only when you have adequate savings, so your family’s monthly expenses will not be significantly increased, your mortgage payment is no more than 25 percent of take-home pay, and if possible, you can handle a 15-year mortgage. In addition to keeping your expenses in check, you also position yourselves to have a paid-for house before you retire.
For example, let’s assume you live in a $150,000 house with a $120,000 mortgage and you can easily manage the payments on your current income. If over an eight- to fifteen-year period, you can save $50,000 (in addition to your emergency fund and saving for college and retirement), then you could choose to buy a $200,000 house. You could put the additional $50,000 plus $30,000 in equity into a new house, and effectively your payment is the same.
Obviously, a more expensive house will have some additional costs that should be taken into account, but the biggest outlay is the mortgage. You will be effectively restarting your mortgage and will be paying more interest per month unless you opt for a 15-year mortgage.
Of course, if you can pay cash for the house, the size is irrelevant except to the extent that size and value impact other expenses (taxes, insurance, maintenance, utilities, etc.). What is relevant is maximizing your flexibility and options – that’s what wise retirement stewardship is all about.
The Third Major House Decision
The third major decision comes as you are nearing, or are in retirement. It is, in many ways, just like the first, except in opposite ways.
Instead of trying to decide how big a house you can afford, you may start thinking about how small a house you can get by with. Also, instead of thinking about whether to buy, you may be trying to decide if renting might make more sense.
These decisions are typically precipitated by the downsizing and/or relocation questions. You may want to reduce expenses, move closer to children, enjoy a change of climate, simplify your lifestyle, generate some retirement income from the sale of your principal residence, move to a smaller and easier to manage property, etc.
Of course, you may want to stay right where you are; in fact, most do. But if so, you may need to make some changes to your current residence to ensure that you can “age in place.”
If you made the right decisions in stages one and two, you should retire with a paid-for house. Of course, as discussed above, the mortgage is not the only expense associated with home ownership. You still have to consider taxes, insurance, utilities, maintenance, etc. If you need to reduce expenses in those areas, downsizing is a good way to do it.
Downsizing is also a good way to generate additional income in retirement by tapping into your home equity.
To illustrate, let’s say you own a home valued at $250,000. You could downsize to a smaller house (or perhaps a rental). If you can sell the house for $250,000 and buy a small condo for $150,000, you could invest the difference of $100,000 and perhaps generate $4,000 in additional income a year. If you rent a small apartment, you could invest the entire sum of $250,000, which could generate an additional $10,000 per year.
Downsizing from a large house with a high mortgage payment, especially if it eliminates the monthly payment, can be a very good idea. That’s because it can significantly reduce living expenses and may free up some equity to generate income, depending on the cost of the replacement house. Downsizing from a smaller, lower cost house that is paid for may be less beneficial unless the taxes, maintenance, and insurance are disproportionately high.
My personal preference would be to go into retirement with a paid-for house and then to tap the equity later on for additional income only if it’s an absolute necessity. That will preserve your equity for future needs such as health care or long-term care expenses if required. However, if ongoing “carrying costs” for a paid-for house are too high, consider moving into a lower maintenance/insurance/tax cost situation.
What decision “stage” are you in?
Regardless of your age, you could be at one of these major house decision points. If you make wise house purchase decisions, you will significantly enhance your overall preparedness for retirement, which is one of the main things that retirement stewardship is all about.