Early Retirement Lesson #3: Home-Buying and Mortgage Advice

housemoneyHere’s another installment of what I would tell my kids about pursuing financial freedom (if they weren’t still in diapers). Previous topics have included the importance of savings rate and whether to focus on earning more or spending less. This time, I wanted to talk about buying a home and mortgages.

Should you buy or rent? Now, there are many buy vs. rent calculators. Here is the best one in my opinion. But as they say garbage in, garbage out, so be careful. Your answer will strongly depend on unpredictable things like future investment performance and/or home price appreciation. In general, the longer you plan on staying in a geographical location (say at least 5-7 years), the better it is to buy your own place. But if you are the nomadic type and want to travel the world, then renting can work out to be much better. In my experience, buying a house often ends up a lifestyle-based decision and not just about the numbers.

If you decide to buy, my opinion is that you should adjust your mortgage size and term to coincide with the date of retirement. I define retirement as when your expenses are exceeded by your non-work income like pensions, Social Security, annuity payments, stock dividends, rental income, or other investment income. Example scenarios:

  • If you love your job and plan on working for the next 30+ years, then go ahead and get a 30 year mortgage. Maybe you have a job that you could work part-time or isn’t very stressful. In this case you have lots of human capital and a long stream of future work income. Take on the 4% interest rate fixed for 30 years, and over time your salary will rise with inflation while your payment stays the same. Be sure to buy a house that you can afford while still investing for retirement. If anything, you could do a DIY biweekly payment plan and pay off that 30-year mortgage in under 24 years.
  • If you have the early retirement bug and want to retire in 15 years, then you should find a home that you can afford with a 15-year mortgage. The interest rate will be lower and as long as you can swing the payments in the beginning, you’ll quickly get used to it. The hard part is to find an affordable home with those higher monthly payments. The hardest part is to be satisfied with it as you’ll have the option and expectation from others to spend more. This is why I think the 15-year mortgage is a powerful tool for aspiring early retirees. It forces you to commit to a long-term lifestyle that fits your goals. Buy a house at age 25, and you’ll be done by 40.
  • Let’s say you receive a monetary windfall (inheritance, huge raise, IPO) and all of a sudden an early retirement is on the table. I wouldn’t necessarily pay off the mortgage completely if you aren’t ready to retire yet. You’ll want to balance the opportunity to invest in potentially higher-returning investments (stock mutual funds, dividend-paying stocks, other real estate) with pursuing the benefits of having a fully-owned house (less stress, less leverage, lower required monthly expenses). My solution would be to pay enough of the mortgage down such that with your usual monthly payments it advances your mortgage payoff date to match your retirement date. If you won the lottery and that date is tomorrow, then yes pay it all off!

One of my reasons for matching mortgage payoff with retirement date is psychological. When you are working, your paycheck is the same every month. This matches well with a fixed mortgage payment. But investment income is often variable. If the tenant in your investment property decides to squat and you have to spend months going through eviction proceedings, your rental income may drop to zero for a while. Many experts now recommend a dynamic withdrawal strategy from your investment portfolio, which would also result in a variable income. But mortgages are like an alligator. You must feed it; if you don’t then it eats you. Other expenses like travel and dining out, those can be adjusted. So I don’t like the idea of having a mortgage in retirement, especially if it is a large percentage of your overall expenses.

However, paying off the mortgage too early can also cause regret if the stock market is rising while you’re piling money into a 4% mortgage. If you are still in the accumulation phase, at times like now you’ll be reminded that you could be investing your paycheck in the market generating higher returns. But if you’re retired, that meant your nest egg was already big enough. If the market goes up, your next egg goes up and you are happier. If the market drops, hey, you already have a paid-off house. So that is why I don’t recommend paying off the mortgage too early, either.

Finally, early retirement with a paid-off house is great because lower expenses means smaller withdrawals from your portfolio, which also means a lower overall tax rate. In fact, with a mix of Traditional and Roth IRAs, we’ve seen that a couple could withdraw over $50,000 a year and still pay zero taxes on retirement. A lower income can also help you qualify for things like health insurance subsidies.

Short version to my kids: If you want to retire early and don’t move around much, buy a modest home where you can afford a 15-year mortgage payment and save at least 25% of your income. If your lifestyle entails lots of moving around, rent and save 50% of your income.

(Related: Pay Off Mortgage Early vs. Save More For Retirement? Digging Deep Into The Details)

Comments

  1. Would your advice change at all if the 30-year mortgage rate were closer to 7%?

    • I haven’t thought it all through, but initially I would say no. Bonds and stocks should adjust their returns accordingly to beat inflation. If rates go down, you can always refinance like we’ve seen. My first mortgage rate was closer to 6%.

  2. Hmmm. I usually agree with most of what you post, but I definitely have to chime in on this topic. I would add many more disclaimers to renting vs buying. You make it seem like a lifestyle choice but I don’t believe that it’s that simple.
    I see renting as a transitional period where renting makes sense as a plan B, and not the best choice. For example, someone moves to a new city, or you move for college and then expect to chase down a job elsewhere. Some markets may be way too expensive to buy vs rent, but that does not mean that it is still not better to buy.
    You argue that sometimes investments are better than home ownership, so you don’t want to tie up money in a home. Yes, ok, but much more volatile typically. For any investment you can see periods of great returns normally followed by declines. The same is true for a home but you can’t live in a stock or mutual fund.
    I do agree that for buying a home you need to be in a certain frame of mind. You should be staying put for some time, 7 years sounds about right, and you can’t get in over your head on the mortgage. All that being said I fail to see when renting is better than owning other than in a transitional period of your life. I can see college students, and retirees, and when there is no other choice, but why rent otherwise? Why would a thirty or forty-something choose to rent? Financially speaking I just don’t see it.

    • I think moving around every 5 years or so is a lifestyle choice, and know lots of people who haven’t lived 5 years in a row in the same place who are over 40 years old. Like I said, you can run the calculators and if it is a slam dunk somewhere then your decision is clear, but in an expensive place like San Francisco Bay Area or New York City, renting is usually better financially unless you’re there for a good long while.

      • I agree, it is exactly a lifestyle choice. My argument is exactly that… a lifestyle choice is much different from the better choice financially. Of course, except those exceptions you listed, such as in those few markets where renting is cheaper than home ownership. The key here is that lifestyle choice is not a good comparison for calculating the best financial move, if anything it’s the other way around.

        • Hmm, it may be a lifestyle choice to move every 5 years but in my experience it is also usually career motivated. People just don’t work for the same company in the same place for 20 years anymore. If you choose the best career option (best prospects, best salary/ownership), that often involves moving. But if you really want to stay in a geographical location you will often have to take a less-optimal financial/career move. Which is the better decision financially then becomes a bit hazy.

          • Yes, understood. Professionals may find more lucrative positions elsewhere but how many blue collar workers move away for higher paying work? Also how lucrative must the salary bump be to offset the years of renting? It may or not be entirely true that you will have to settle for a less-optimal financial position if you stay put, keeping cost of living in mind. Of course the type of job you have will likely validate or nullify the previous statement. Clearly there are examples that we can both think of that would swing one way or the other. My concern was simply stating them as equals you can buy a home or rent forever and they are both practically just as good. A better statement is that in some niche cases renting can be better but as a rule of thumb, more often than not, owning will likely generate the most bank for your buck.

          • iKomrad says:

            It’s a mixed bag for me. I used to move every 3 years ( usually more often, move onto the military base and move off during those 3 years ) , then I moved for school, then for work, then for money after the dotcm bust bankrupted me, then for several moves for work, my next 2 moves which are in 14 months period are to a larger apartment for breathing room and then to a house once I have a down payment saved.

            I move every 1.5 years on the average and I’m over 40. I’m the kind of person who will take a contract job on the other side of the country , most recently overseas, with only 30 days notice and then switch to something else. At some point I’ll settle down, but right now I still find it exciting to learn new technologies and work in different market sectors that force me to learn new skills.

  3. I think another big part of the equation is how “DIY” you are. When you buy, the house is your responsibility so when (not if) things break, are you going to have to pay someone to fix it, or can you do it? Buying a newer house can reduce the risk but there is always risk. Knowing that $$$$$ fix could happen at anytime can effect a decision of buying or renting where the fix is the owner’s problem.

    BTW, great post. I have told my parents in the past that I wish they would have been more open about financial things while I was growing up. They always kept that info between themselves (salaries, investments, etc) and just told my sister and I “put XX% in the bank” While that is decent advice, it’s only part of the equation and I had to learn the rest on my own. I think one issue with my generation is laziness on not wanting to learn what they don’t know, especially about money. Luckily I had the desire and am way ahead of my peers on retirement and finances, but parents really have a great opportunity to help jump start that education.

    • Very true about the DIY, I had to learn to do a lot of the little things myself after being a renter for a decade and not having to do anything at all. I still don’t consider myself handy, but at least I make 4 trips to Home Depot and curse at stuff for 48 hours before giving up. 😉 Maintenance costs should definitely be taken into account.

  4. Property taxes are also important to bear in mind. Where I live in north Texas the property taxes are in the 2.17% range (no income tax, high property tax) and on average close to $4,500 a year. In addition to maintenance, as Brett says, there’s also the cost of insurance for your house and HOA fees in many cases.

    It still makes sense to buy in many cases, but a lot of the time it’s not nearly as “slam dunk” a case as many think it is.

    • If you think hoa fees and property taxes are not factored into your monthly rent, then think again. A renter will always pay for the landlord’s property taxes, hoa fees, and insurance, and their profit, of course.

  5. ” … buy a modest home where you can afford a 15-year mortgage payment and save at least 25% of your income. Or move around, enjoy the flexibility of renting forever, and save 50% of your income.”

    I just don’t see how this is possible in an expensive major metropolitan area, like any decent part of Los Angeles, without having an hour commute or more to your job each way.

    • It isn’t. So then don’t live in expensive metro area. Like spending vs. your income (i.e. you can’t have everything you want), the same is true with location. I am from LA as well, and I made a choice to leave LA to work in Vegas and buy a great house for cheap, pay no income taxes, etc. I would rather rent my “fun” and take weekend trips to LA, than pay a ton for the privledge of retiring 10 years later than I can here.

      For the 90% of jobs that exist everywhere (i.e. not Tech in the Bay Area, Finance in NYC, etc.), there really is no good financial reason to live in one of those overpriced areas.

    • It will certainly be quite difficult unless you have an above-average income. I am not on the “early retirement is easy” bandwagon. But I also don’t think it is impossible.

  6. Great philosophical level post, Jonathan. I’m coming up on my three year mark at my current duty station and will have to move soon. I have tremendous respect for military families that can buy a property every time they move and rent it out when they leave. However, I don’t think that’s the way for us. Since we’ll have to move every 3 years for at least the next 20, I think renting is the way for us and probably should be for most military families.

  7. Now that I’ve owned a home, I’m over it. Time to go back to renting a nice new apartment so I don’t have to deal with home maintenance and HOA politics.

  8. You advice to your kids is definitely the more conservative approach. As others have stated, I’ve saved lots of money by buying vs. renting. It’s all a matter of financial perspective, right?

  9. Long time fan of your website – one of the first PF websites that I ever started following. One thing you don’t address is paying off the mortgage early (January of this year) has done a couple of things for me: 1) I can supercharge my retirement savings – the mortgage payment can now go into savings and investment (I was already maxing out the 401k and Roth IRA, including the 50+ aspects) and maybe even more importantly, and 2) The psychological effects. The knowledge that I don’t have a mortgage gives me as sense of independence and accomplishment that I did not have before, which carries over into other areas of my life and work. It is enough that it blows away any concern about whether I would have been better off investing the extra money in the stock market. I plan to work another 6-9 years, retiring in the 60-63 range.

  10. Another factor to consider here is home appreciation. Depending on a myriad of factors, when you sell your house, sometimes you pull a substantial nest egg out of it. You can keep some of that nest egg if you downsize to a less expensive place for retirement.

    I’m a big fan of 15 year mortgages. Look at amortization tables to understand how quickly you build home equity. Many people caught under water during the housing crisis (owing more than the house is worth) could have been saved if they had 15 year mortgages, where the accumulated equity fat could “absorb” the loss. As you said, it forces you to buy less home than you can afford, and that is a good thing.

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