It's the American Dream to own your own home. But, it's not always the best financial choice.
I’ve received several calls lately from the children of clients who were looking to buy a house. They wanted to talk about taking money out of an inheritance to pay for it, and were wondering if it was a prudent move.
Back home in Illinois farm country where I grew up, I heard a constant mantra as a kid: Save some money, buy some land. As I grew, the “land” morphed into a house, and I bought a house first chance I got.
With 15 years as a financial professional and working as a fee-only, fiduciary financial planner, I now see it a little differently. Today, I'm not a big fan of a young person, or a couple, rushing to buy a house.
Can I afford to buy a house?
Let's look at Tony and Angie. They were getting married and thought they should buy a house. Right now, they live rent free at his mother's home. They both have jobs but don't make a ton of money. They have about $1,000 in savings, and they have some bills:
Tony has:
- $25,000 in college loans at 4.5% -- to pay off in five years = $467 per month.
- $6,000 on his motorcycle at 6% -- to pay off in five years = $116 per month.
- $10,000 on his truck at 5.5% -- to pay off in five years = $191 per month.
- $250 per month in credit card payments.
Angie has:
- $10,000 in college loans at 4.5% -- to pay off in five years = $187 per month.
- $4,000 on her car at 4.75% -- to pay off in five years = $75 per month.
- $400 per month in credit card payments.
Their total debt service right now is $1,686, plus a few basics like:
- Food
- Fuel
- Cable
- Insurance
- Entertainment
So the idea of adding another monthly payment for a mortgage (maybe $1,500 per month), plus maintenance of the property, seems a bit premature.
I recommended they take a pass on the house. Instead, I recommended they:
- Leave the inheritance in the IRA that Tony inherited. It can grow tax free and will give him a great start on retirement savings. I estimate that this IRA (worth about $60,000 now) will be worth $530,000 when he is 65.
- Continue to live with mom rent free until they get the bills paid off.
- Build up an emergency savings of about $50,000 that could be used for a down payment on a house when the time is right.
- Focus on paying off the debt as fast as possible using a system such as this:
- Pay closer to $2,000 a month against these loans. That's $314 extra against principal each month -- $3,768 a year.
- Start with the smallest loan and kill it off. Then direct that payment to the loan with the highest interest
- Repeat.
If they wait to be debt free before they buy a house, then they will have more cash flow cushion to pay for the furniture, appliances, landscaping, deck, garage, or whatever else comes along with that house.
Investing strategy
This advice is based on the importance of positive cash flow and monthly liquidity to a successful financial life. It just makes everything easier.
But, there is another argument in favor of leaving $10,000 invested in the inherited IRA instead of investing it in a house. It's a lousy investment.
Homeownership may be a smart "investment" for your health, stability, or family life, but the stock market is a much better investment.
The Schiller housing price index for the inflation adjusted return for residential real estate has averaged around 0.1 percent over the last 100 years. So a house worth $5,000 in 1913 would be worth $5,620 in 2017, adjusted for inflation.
By contrast, the historical rate of return for the S&P 500 with dividends reinvested is about 10 percent since 1928. If you adjust that for inflation, it's more like 6.8 percent. So a stock worth $5,000 in 1913 would be worth $4,681,449 in 2017, adjusted for inflation.
If you are looking for a forever home to raise a family, buy a house. But if you are struggling to pay your bills and want to do something smart with your finances, pay off your bills and build up an emergency savings fund.
If this article has you thinking about buying a house, contact my office at rdunn@dunncreekadvisors.com. I am always happy to meet with people who are working on their financial plans.
Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.