In the last post I advocated saving a 20% down-payment and putting no more than 25% of your take-home pay towards your mortgage. I also advocated using a 15 year fixed loan to reduce your interest rate and be able to pay off the house before your kids start college. Some readers took exception to limiting the mortgage payment to 25 % of your take-home pay. After all, the standard mortgage has been 30 years, and even in these low-interest rate times 30-year mortgages are more common than 15-year mortgages. Raising a 20% down-payment, which is needed to avoid paying mortgage insurance each month, is also no longer the norm. Individuals instead typically take out two mortgages (one which provides the 20% down-payment, and then a second that pays for the rest of the house), put almost nothing down, and go ahead and pay mortgage insurance. This allows individuals who cannot come up with a down-payment to get into a house right away and start “living the dream.”
A couple of generations ago people started out in small homes or even rented an apartment for a long time before buying a home. Many couples today, however, are looking for their first house to have everything that the home they grew up in had. A large backyard. Three or four bedrooms. A bonus room. An office. They therefore want to jump right into a $200,000 mortgage, but certainly don’t want to wait until they can save up $40,000 for a down-payment. Loan agencies that qualify individuals for huge loan limits certainly don’t help.
Despite this advice being out-of-the-norm, I still advocate for a 20% down payment and a mortgage no bigger than 25% of your take-home pay. The reason for this is that unless you limit your expenses you will not have money to save and invest. To illustrate this, take the tale of two guys. Both guys are 21 and make $50,000 per year and put away 15% for retirement. After funding their 401K’s and paying taxes they have take-home pay of about $32,500.
The first one, Joe Average, buys a home with a mortgage of 35% of his take-home pay. He takes out a 30-year mortgage on a $204,700 home. His payment is $948 per month on a 3.75% fixed rate loan. He is very normal in his choice of home but abnormal in that he does not take any equity out of his home – he just pays his payments until he pays it off at age 51. After that, he invests his mortgage payment, getting an average return of 12%.
The second guy, Crazy Fred, opts for a home with a mortgage of no more than 25% of his take-home pay. He therefore finds a first home for $94,700 and a mortgage payment of $677 per month on a 15-year fixed loan. Because of the shorter term, his interest rate is 3.5%. (Note that he could have also opted for paying rent for the first ten years and little would have changed financially, which might have been the thing to do if none of the homes for under $100,000 were in safe neighborhoods.) He saves the extra 10% and invests, earning a return of 12% on his investments. After ten years he takes the money he has built up through investing, sells the home he has, and uses the home equity he has built up ($57,486) and the money he has saved through investments ($95,926) and uses the money for the down-payment on a bigger home. Not wanting to increase his mortgage payment, he takes out another 15-year loan for the same amount ($94,700), meaning that his new home is worth $248,000. In other words, he puts $153,300 down on this new $248,000 home.
Here are the amounts Joe Average and Crazy Fred will have in investments and in home equity during their lives:
|Joe Average||Crazy Fred|
|Age||Home Equity||Investments||Home Equity||Investments|
So, at 51 years old, when Average Joe is just paying off his $204,700 home, he only has the equity in his home. Crazy Fred, on-the-other-hand, is paid off his $248,000 home four years earlier and has built up more than $412,000 in investments.
In ten more years at age 61, Average Joe has built up a respectable amount in investments since he has been contributing what he used to contribute to his mortgage to investments (meaning he is not sending kids through college or anything). Crazy Fred, however, now has more than a million and a half-dollar net worth, including $1.4 million in liquid assets that he can use to generate about a $60,000 per year income easily. This is in addition to his retirement savings and his job. Note that Crazy Fred continued to contribute only 10% of his pay to investments when he paid off his home, so he also had his $677 per month that he was paying for his mortgage to spend as he wanted.
By the time they reach 71 years of age, Average Joe has finally become a millionaire, but just barely (not counting his retirement savings, which also would have been a few million dollars since he was putting away 15% per year). Crazy Fred, however, has more than $5 M just from the money he made from investing rather than buying a big house to start.
But wait, Average Joe made more in equity because he had a larger loan, right? Assuming that the price of the two homes went up 5% per year, Average Joe would have made $2,143,377 in appreciation on the home value. Crazy Fred would have made about $1.5 million between his two homes. So yes, Average Joe would have made more on home appreciation, but only $600,000 more. This is nowhere near enough to make up for the $4 M difference from investments.
So, is it normal to buy a $94,000 house instead of a $200,000 house? No. Are there plenty of excuses to buy the larger house to start? Of course. But this is why most people don’t become wealthy. Two individuals can have radically different outcomes given the same middle class incomes. The difference is that those who become wealthy don’t settle for the excuses and do what is needed to save and invest. Everyone else doesn’t.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.