Housing costs

Housing Costs

Housing costs

Buying a home is one of the biggest financial decisions an average person would make in their lifetime. There is a lot to consider, so I’ve decided to structure this post to follow a chronological order of housing challenges following a young college grad from graduation to retirement. Obviously, this won’t fit everyone’s situation, but at least it will give us a blueprint for a discussion and we’ll be able to tackle the important issues along the way.

We’ll take a look at housing costs calculations. We’ll discuss buying vs renting,  how much money to put down when you buy, and how to calculate how much you can afford to pay. We’ll also take a look at whether and when to pay down your mortgage ahead of time and more. The age brackets below are completely arbitrary and serve only as a way to frame the discussion.

Housing options for a young professional

Age 21 – 25: You’ve graduated from college, it took you a little while to find a job, but you’re finally financially independent. Congratulations and well done! Now is the best time to move back in with your parents! I’m serious. Financially, this is a win-win scenario. You can help out your parents with some bills, groceries, etc, while saving and investing for the future.

Age 26 – 30: OK, you love your parents but you’re ready to leave the nest for good. You’re not ready to settle down just yet, so let’s discuss renting. Sure, everyone wants a trendy place in the city all to themselves, but the best approach here is to find roommates to split the costs. How much can you afford to pay? Shoot for your rent to be no more than 25% of your take home pay (that’s after tax), provided you have no other revolving debt (car payments, student loans, credit cards). If you have other revolving debt, then factor that in into 25% cap. Continue saving and investing the rest. Don’t blow it all on boozing and whoring.

Age 31 – 35: Another milestone – you are married, engaged, or in a committed relationship. Both of you are advancing in your careers. Both of you have some money saved and invested and you could potentially pull a trigger and buy something (a house in the suburbs, a condo in the city, etc) … or you can continue renting. This is where things get interesting.

  • First, if you’re buying a house to live in, you need to stop thinking of it as an investment. Even if your house goes up in value, the only way to cash out is to sell it and downsize (move to a cheaper area or buy a smaller house / condo, or both). Otherwise, your money is tied up and you’re stuck paying higher property taxes assuming your house has gone up in value and that’s a big ‘if’.
  • Second, a lot comes down to timing. Historically, in US, housing prices have gone up on average of 6.4% from 1968 to 2004 (that’s 36 years of consecutive growth), until the housing bubble. “After that, the markets experienced an unprecedented decline. Nationally, prices fell in 2007. They fell again in 2008 and yet again in 2009. By mid-2010, housing prices had fallen back to 2004 levels in a stagnant market. What had for decades seemed like a one-way ticket to growing profits had fallen by more than 30% in just a few years, according to Standard and Poor’s data.” (Investopia) And these numbers don’t factor in inflation and rise in the square footage of new homes being built, which would paint a much bleaker picture.
  • However, the biggest consideration when it comes to real estate comes down to location. Prices can be rising in one area and declining  in others at the same time. Some areas weren’t that affected by latest housing bubble bursting while others were devastated.

When you’re ready to pull the trigger, hook up with a trusted real estate agent, and do some research. Look at historical prices in the area you’re looking to buy, zooming in at the last few years. Get comparisons to similar homes in the area. Assess how the prices held up during the bubble compared to national average. Obviously you want to find a fair price but also to avoid buying at the top of the bubble, which is hard to predict at a specific moment in time. Also, you can look for up-and-coming areas. The point is, do your research, and don’t go into it blindly.

So, how much house can you actually afford?

Most lenders use 36% as an upper threshold when assessing total debt to gross (pre-tax) income ratio. So if you’re earning $60K (gross), your monthly debt payments (including mortgage, auto, student loans, credit cards) should not exceed $1800. Assuming you have no other debt, you mortgage would be $1800, which with a 20% down payment and using 30 year mortgage at 4% would amount to $350K home using this calculator.

Let’s look at these numbers a little deeper… $60K annually, is $5K monthly. Let’s say after all the deductions, your effective tax bracket is around 20%, which leaves you with $4K a month. Subtract $1800 from it and all you’ve got left is $2200. Now subtract property taxes, utilities, groceries, childcare, and you’re not left with much to save and invest.

With that in mind, I recommend a more conservative approach:

  • Aim for 25% as your monthly debt threshold
  • Use net (after-tax) income rather than gross income for your calculations
  • Take a 15 year mortgage rather than 30 year so save on interest charges
  • Plan to put down around 20%. Here are the reason why

So, factoring all of this in and using $60K example above, you’d be able to afford $200K home with a 15 year mortgage at 4%, with monthly payment of around $1100 and 20% down. I realize that this is a very conservative approach, but I believe that it protects you from overstretching yourself and will definitely pay off in the long run… Wrong choice of words here, actually it will pay off twice as fast. I suggest you use an online mortgage calculator to play with different numbers.

Should you pay down your house faster?

Age 36 – 50: At this point you’ve been living in your house for some time and you continue to save and invest for an early retirement. Let’s assume that you have a decent chunk of cash in the bank and you’re itching to pay down your mortgage early. Although being free of consumer debt is an excellent goal, I believe a better investment would be to put that money to work.

Here is a simple example. Let’s say that you have $100K left on your mortgage and you want to pay it off in a lump sum. Over a period of 10 years at 4% interest, you would have saved $21.5K in interest payments. However, if you were to invest the same $100K in S&p 500 index fund for 10 years at about 9% (historical rate of return), you would earn $52K. If stock market is not for you? How about buying a multi unit rental property that can generate some additional cash flow. The point is that you can put your money to work, but yes, there is risk involved.

Age 50+: You’ve paid off your house and can either continue living in it or can downsize and invest the difference. Things to consider are property taxes, family situation, financial situation, and personal preferences. If your kids are off to college and you’re financially free, you might decide to relocated to an area with a lower taxes, better climate or closer to your family. If you’re kids are still in school, and you like your area then why bother. This is a great place to be in and there are plenty of good options to chose from.

Final thoughts

As I said in the beginning, buying a home is a huge decision and there is a lot to consider. So let’s summarize the key points:

  • Don’t rush into it. Move in with family, sub-rent and save.
  • Your home is not an investment
  • Aim for 25% as your monthly debt threshold (including your mortgage, auto payments, etc.)
  • Use net (after-tax) income rather than gross (before-tax) income for your calculations
  • Take a 15 year mortgage rather than 30 year so save on interest charges
  • Plan to put down around 20%. Here are the reason why
  • Don’t rush to pay down your mortgage. Invest extra money you have

As always, your feedback is very welcome, so please feel free to share your thoughts in the comments section below.

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