Today’s case study is from a friend who reached out to me for some help and analysis. For the purpose of the study, we’ll call them Thorvald and Oceania.
Thorvald (35) and Oceania (33) are married, ten year corporate professionals, well on their way to financial independence, and debating buying their first/dream home. Thorvald has invested significantly in his career, graduating from two prestigious schools with marketable degrees and growing his salary while extinguishing over $185,000 in student loan debt. Thorvald and Oceania are both six figure earners and enjoy their jobs and financial independence is a goal, but do not necessarily have a goal of attempting to retire early. They live in a large city and it is unlikely they would move as long as their careers are still active.
Thorvald is a corporate mid-level executive earning in the upper 200s / low 300s with some variability (bonuses for moving employers, restricted stock vesting). Oceania currently earns $118,000 and both have the potential for upward trajectory.
Cash & Buffer Savings: $8,000
Emergency Fund Money Market: $50,000
House Down Payment Money Market Fund: $150,000
Retirement Accounts: $618,000
The Dream House:
“We have never owned a home. We are currently renting an apartment for $2,200/mo. Both of our jobs are in a major metro area and we value living close to work and close to the city. Our initial targeted budget range was around 600k, which is about what it would cost for a home meeting our criteria in the locations ideal for our commutes. We’ve looked for a while at the minimum range, but everything has qualified as “doable”. They were nice, but not anything that motivated us to jump out of our apartment and go purchase.
We’ve now set our eyes on new construction, which would be in the range of $800,000. We’ve found exactly what we want, but are struggling through the idea of spending this much money for a house.”
Here is My Question:
“If you were in this situation, and wanted this house… what would you do? What factors would you consider? What knowledge are we missing? We are trying to balance financial responsibility/conservativeness with lifestyle enjoyment. We have killed it for the last 15 years… career, income, debt reduction, etc. Is this a good “ROI” from those efforts or is this an incredibly unwise financial move that we should avoid?”
It looks like Thorvald and Oceania have their sights set on a big milestone. They have both worked successfully over the last decade and made huge strides in both their income and balance sheet. Let’s unpack the various parts of these questions.
#1: Let’s talk about the economics of housing:
It doesn’t take a long case study to say that leaving a $2,200/mo apartment and moving into an $800,000 house is a more expensive financial decision. (b/c it is – The two property types are different). That’s not the question that was asked. The question in the case study is *how much* this decision would really impact them financially and look at all of the factors before making a quality of life decision.
What is the “income” and what are the expenses related to a home?
Net Positive Effects to Cash Flow
- Rent Saved. You have to live somewhere and by virtue of owning a home, this couple is allocating what they would have spent in rent towards the home purchase.
- Price Appreciation: The underlying property may increase (or decrease) in value. This is driven by either the property’s underlying rental value and the market rate of return required by investors or its value to a future owner occupant.
Cost of Capital: The new home costs money and is usually financed with debt and equity. The cost of capital is:
- The interest expense on the mortgage
- The opportunity cost on the equity
Property Taxes: The city/county wants its annual bill for upkeeping the services around your property. Roads, fire, police, and maybe even a bloated administration all go into this bill.
Homeowners Insurance vs. Renters Insurance: Insuring a dwelling plus contents costs more than insuring just the contents.
Repairs & Maintenance: In my experience the repairs and maintenance on properties has been as follows:
New – 5 Year Home: 0-0.5% of Value/Year
5-20yr Home: 0.5% – 1% of Value/Year
20+yr Home: 2% of Value Per Year
Some of the repairs are bigger expenses while others are recurring maintenance (HVAC annual checkup/cleaning, pest control). Fortunately since Thorvlad and Oceania are looking at a new home, they can skip by most of these costs thanks to a builder warranty and buying a new product. As long as the builder stays in business and honors their warranty, their early experience will be similar to renting.
This is basically the cost to keep up the exterior of your property to city and/or HOA standards. There are also HOA fees involved as well. This is mainly the cost of yard maintenance (cutting, watering, annual landscaping). Some of this can be done by the homeowner, then it becomes an opportunity cost with time.
Friction/Transaction Costs to Liquidate:
Converting a home back into liquid assets is expensive. You can expect this to average 8-10% of the value of the home between real estate commissions (the 3%/3% extortion by the MLS monopoly), concessions to a seller, and any required updates to the house. The lower price point houses may not have as much in concessions if they have a good rental value while higher end houses tend to need the latest trendy kitchen and bathrooms (which seem to have to change every decade, even though how we use those rooms does not).
Rough Estimate of Ownership Cost: $800,000 Purchase
Interest $640,000 @ 3.75%: $24,000: I’m using the starting point of the mortgage and counting the first year’s interest expense. I am not counting the principal payment as an expense since it is essentially forced savings.
Property Taxes: $17,600. The property taxes in the area Thorvald is looking run 2.2% of the assessed value of the home each year.
Opportunity Cost (3% on 160k): $4,800. The down payment amount will be made by moving liquid investments/savings into the home, removing the ability to earn interest and capital gains on the money. I’ve discussed this issue with Karsten @ Early Retirement Now and believe the interest paid by corporate bonds would be a good rate to use for opportunity cost (he politely disagreed with me earlier when I used the S&P 500 in my own analysis.
Insurance Difference (renters to homeowners): $1,800. Moving from renters insurance to including an $800,000 property comes with a cost increase. I encourage the couple to get a quote on homeowners insurance during their due diligence period.
HOA Fees: $1800 annual, the actual association fees from the house they are considering.
Monthly Upkeep/Utilities: This is the increase in monthly costs, primarily in utilities and maintaining a yard. For the purpose of this, we’re going to estimate $2,500/year – in exchanges with Thorvald they intend on picking a low maintenance/low water option for the yard.
Annual Maintenance: $450. This is fairly small for a new home, one visit a year from the HVAC technician to clean the units and a visit from pest control.
What is the total difference in cost?
Housing Cost: $52,950
Today’s Rent: $26,400
This gets to the decision Thorvald and Oceania must make: Will home ownership bring an incremental $26,550 in value per year to them? Is this value worth any additional months/years they would need to commit to work for financial freedom?
Now let’s look at the financials. Just how big of a “setback” is this to Financial Independence?
Thorvald and Oceania earn $390,000/year and currently spend a bit over $80,000. For the purpose of this case study, we are going to assume $100,000/year in expenses and a target FI (fatFIRE) goal of $2,500,000 outside of equity in their home. This would support a healthy spending level including supporting their dream home. To accomplish this, we are going to exclude the $160,000 in cash earmarked for a downpayment from the analysis. If they purchase, this money becomes home equity and grows slowly. If they keep it in cash/money markets, it will also grow slowly and ultimately this fatFIRE goal shown will be $2,5000,000 in their main portfolio and another $200,000 or so in either bonds/cash or home equity.
Breakdown Income / Tax Estimate
|Thorvlad & Oceania|
|Take Home Pay||$264,000|
This is the rough estimate of the couple’s take home pay. Taxes include both Federal Income Tax and Social Security/Medicare. They are fortunately high income earners in a state free of state income taxes (note the property tax rate, they will still be paying, just in a different manner).
*Actual take home pay/taxes may vary a little for their situation, Thorvald is utilizing a Roth 401k, which reduces net savings by around $6,200/year. Oceania is close to the FICA cap, which also could cause a slight change in the tax calculation.
Here is my estimate of their annual savings:
After Tax: $184,000
With Home Purchase:
After Tax: $157,450
This couple’s savings rate is overwhelming in either scenario. They are saving roughly 59% of gross income today and if they purchase the home, the savings rate drops to 53%. This is an incredible amount of money and either way they are well on their way to financial independence.
So what is the impact of this to reaching their fatFIRE target?
Let’s look at an estimate of how their portfolio will grow at 8% returns and lowering their savings rate with the purchase of the home:
|Year||Starting Balance||Returns||Contributions||Ending Balance|
Thorvlad and Oceania reach their fatFIRE number a few months shy of six years. We’ll estimate it at month sixty eight.
But….if they delay the house and stay a renter, it’ll buy their financial freedom quicker, right? Well, sort of. Let’s look at what happens if they stay the course:
|Year||Starting Balance||Returns||Contributions||Ending Balance|
Under this scenario, they reach the same result around month sixty three. The cost of this home purchase comes out to about six months worth of working in order to reach their fatFIRE target.
The other way to look at this is what is the cumulative five to six year impact of making this expense decision. We will compound out the difference in investments over the next six years:
|Year||Starting Balance||Returns||Contributions||Ending Balance|
This means the cumulative impact of this purchase decision over the next five to six years comes out to cost the couple between $155,000 and $195,000. This is just under one half of their annual income.
So what is the financial verdict?
$194,796 is a lot of money! Does this purchase make a huge difference at their income level and savings rate? Not really, especially if the couple isn’t trying to hit the eject button on work as soon as possible.
Other Home Purchase Considerations:
Buying a house is easy, selling a house is difficult. If the couple decides they want to reverse this decision in the first couple years, it will cost them a lot of money. The market Thorvald lives in is ground zero for the antitrust/collusion lawsuit against real estate agents. He will at a minimum have to pay 1.5%-2% to the listing agent and 3% to the sellers agent. That along with any concessions puts the minimum price to sell the home at 7% or so of the sales price i.e. $56,000 on an $800,000 house.
In a normal market, that $56,000 slowly goes down as inflation helps boost the price of the home. This needs to be considered if there was ever an opportunity to move. This decision essentially has a $56,000 “break penalty” that slowly declines over time
ARM vs. Fixed Rate Mortgage:
I would inquire about both a 7 year and 10 year adjustable rate mortgage in addition to looking at a 30 year fixed product. On the last house I purchased, the 7 year ARM was 2.875% while the 30 year mortgage was 3.875%. The ARM also had a reset clause, where it could only increase a maximum of 2% for the next seven years. This meant I was getting a loan that was 2.875% guaranteed for the first seven years with a guarantee not to go above 4.875% for the next seven years. The loan also had a maximum lifetime cap on it.
I chose the 7 year arm on a mortgage of just over $500,000. Why?
The 30 year mortgage meant I was paying around $33,500 over seven years for insurance against the chance interest rates go up by 1% higher than the 30 year mortgage rate for years eight through fourteen. For me, it made no sense to pay $33,000 for a risk I really didn’t need to insure against. This was because:
- I was already close to financial independence
- I knew my income trajectory and could throw significant sums of money at the mortgage if needed
- I knew if I stopped working we would sell the house
- The house did not have rental potential
I’d encourage the couple to explore a 7 or 10 year ARM and compare its rates against a 30 year conventional mortgage. Specifically inquire about what type of caps come on the loan for future rate increases, then decide if it is worth paying a premium on a 30 year fixed to insure against the risk of rising rates after year seven. If the spread is a half a percent or higher, the ARM is worth consideration.
Headwinds Against Price Appreciation:
This house needs to be purchased because it is their dream home, not because of price appreciation. Housing has historically increased slightly faster than the rate of inflation, suffering a cycle in the last twenty years that has included a rapid price increase, a rapid price decrease, and a resurgent price increase. It is unlikely housing will be this volatile going forward, but there are a couple factors to be aware of that will produce headwinds against prices moving more than +1%/-1% of the rate of inflation:
- Financing: A large portion of the price increases since the 1970s have been due to changes in financing. Longer terms, lower rates, and looser qualification requirements all helped home prices. I think it is unlikely we’re going to see mortgages longer than thirty years, rates lower than today, or the banks/government attempt to reduce borrowing standards further.
- Birth Rate / Immigration: The United States is at its lowest birth rate in 32 years and continues to struggle to figure out immigration policy. This ultimately slows the demand with less new home buyers.
- Baby Boomer / Inventory Issues: There appears to be a mismatch of inventory demand and supply in the resale market that will only get worse. Larger and older homes may not have the same appeal in the future as they do today. This probably is less of an issue in an employment hub than it is in vacation / retirement destinations, but there has been a disconnect between housing supply and demand, especially with new construction.
- Local Issues: What is the local market like? How strong is the employment market? Are there any employer concentrations? What is the scarcity or abundance of additional land for new home construction?
How stable is their income and how much do they enjoy their jobs?
This is my biggest question for anyone to consider in this scenario. Today both Thorvald and Oceania enjoy their jobs. Thorvald enjoys “the game” of business and individually either of their incomes could fully support $100,000 in expenses. They have already saved over $700,000 in accounts outside of the money needed for a downpayment by their early to mid 30s – Millionaire and financial independence is already guaranteed in the future as long as they let don’t make withdraws from the accounts and instead let compounding returns run their course. This falls back to relying on the math behind saving the first $500,000.
The Cost of Furnishing:
The couple should consider how much it’ll cost to furnish the house. It could be anywhere from $0 (between what they already have plus dumpster diving) to $50,000 if they want to hire a designer and outsource that process. This adds 0-2 months to their timeline depending on which route they go.
What is my final opinion to their questions:
I’m glad they reached out to me, we were in a similar position in late 2015 when we purchased our “dream home” in a great location near my office. Our assets were a little higher and income was lower at the time, but we were in a strikingly similar position. I enjoyed where I worked, who I worked for, and enjoyed the game of business. My spouse was on a career break/early retirement, but also had the ability to earn around $100,000 if necessary. This allows me to have a pretty informed opinion on this:
Why would I encourage waiting:
- In an ideal scenario, I would say this is the type of purchase someone should make *after* they’ve already reached a leanFIRE number, just to avoid the feeling of being trapped if something went downhill with the jobs. Priorities can change and this purchase involves a pretty stiff penalty to reverse. This does cause some drag on their FI number
- I’m also not a fan of the post-purchase cash reserves. We had 1.5x living expenses in taxable accounts after we purchased our home while Thorvald and Oceania would be much thinner. Fortunately in discussions with Thorvald, the house would be constructed after contract, so there will be 4-6 months to help replenish liquid reserves before the mortgage starts.
- I have some concern they’ve never lived in a large, single family home vs. an apartment. Is it possible for them to find a luxury house to rent at the higher expense rate without incurring the kind of penalty that is involved in reversing a home purchase decision? They could decide living in a single family house is not for them..
Why do I think the purchase is fine in the grand scheme of things?
- This purchase really isn’t a huge increase in costs relative to the couple’s financial position. Their financial independence timeline increases by 10%, but that 10% is still only six months worth of time. Thanks to a strong investment in human capital, they are on track to reach fatFIRE in a decade and a half of working.
- They enjoy work. Oceania works for a company she loves while Thorvald loves the challenge of the corporate ladder. It is unlikely both of these opinions would change in the next five years. Even if the opinions do *completely* change, six months worth of work isn’t a huge tax to pay for something that increases their enjoyment today.
- fatFIRE isn’t the end all. In exchanges with Thorvald about expenses, he identified multiple items that could be reduced for a more traditional FIRE budget if the small chance of their opinion on work changing. They are thirty six months away from a traditional FIRE budget ($1,500,000 to $1,75,000) under either scenario. A significant portion of his compensation (like mine was) is in the form of restricted stock. It vests on a date and that date is the date you walk away in a FIRE scenario. The small change in savings rate doesn’t change the stock vesting date, so the time worked for a traditional FI date doesn’t change. (This was the situation we were caught in – I hit my FI goal in July, but had another vesting date in March and wasn’t going to walk away from that much money. Due to that compensation structure, I could have spent a little more along the way without any impact to my walk-away date).
The purchase will have a minimal impact on Thorvald and Oceania’s goals. There’s a marginal benefit to kicking this purchase down the road for 2-3 years until their next worth is in the $1.5mil range, but if they believe this will improve their quality of life today, then the purchase doesn’t substantially change their outlook for financial independence.
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