Monday, May 7, 2007

A bigger house does not guarantee a richer retirement

I have seen alot of discussion on various blogs about the virtues of renting vs. buying -- should you buy a house, or should you rent an apartment, ostensibly for a lower monthly cost and a much lower down payment.

Another twist to the home ownership discussion is "Should you buy big or small?" Or, "Should you buy beneath your means, at your means, or above your means?" There are some people that actually use their primary residence as the main part of their retirement strategy - buy a very big house, hoping that the real estate boom continues (ooops), and then trade down to a smaller house at retirement, living off the gains of your big house. Let's explore whether this will work or not.

In our example, you're 35, you have a $400,000 home, and have a $300,000 mortgage. "The small house strategy" would have you staying in this house, paying down that mortgage over the next 25 or so years, investing your spare cash in stocks, mutual funds, and the like. Your other option would be "The mansion strategy." You sell your small house, roll the $100,000 in equity into a $1 million house, leaving you with a $900,000 mortgage. At age 65, you would then sell your mansion and move back into a $400,000 house.

Which strategy would leave you more prepared for retirement? The numbers are as such: on the mansion, you're going to have a monthly payment of approximately $5,700/month. Remember that borrowing $900,000 easily qualifies as a "jumbo mortgage," which carries a higher interest rate than a conventional mortgage. When selling the small house, you would incur commissions on the sale, somewhere north of $20,000. Also, when selling your mansion in the future, unless the real estate world gets turned totally upside down, you'll be incurring commissions to sell that house too. In 25 to 30 years, your $1 million house would be worth, let's assume, $1.8 million. So you would incur almost $100,000 in commissions on the sale of the mansion (perhaps you could swing a deal to lower that). When it's time to trade down 25-30 years from now, your $400,000 will likely cost at least $700,000, assuming a 5% annual appreciation (many of us are not getting that now, but it's the historical average).

Overall, with the big house strategy, you'd be left with roughly $1 million for retirement. That's before any capital gains you'd have to pay on the sale of the mansion, and it's before any mortgage interest tax deduction that you received over the years. $1 million! But the picture is not so rosy. First off, you will face a gargantuan mortgage payment each and every month. If you can truly afford that, good for you. But if you're using this large home as a retirement vehicle in the first place, you are probably going to scraping by. I also didn't take into consideration the additional cost of upkeep on a mansion. You'll pay higher taxes, homeowner's insurance, utilities, yard care, maintenance, etc etc. Everything will cost more with the mansion, and probably proportionally more than it would with the small house.

The other option would be to stay in the smaller house. You'd be socking away your excess cash in stocks, mutual funds, IRAs, and your 401(k). You'd probably end up seeing about a 7% average annual return on these investments. But even if your returns were a mere 2% above inflation (currently at 3%), you'd still end up with almost $2 million at age 65. Twice as much as the big house strategy! If you did earn that 7% return, you'd have roughly $3 million at age 65.

True, with the smaller house, you'd have a smaller mortgage interest deduction. But you'd have a larger deduction by maxing out your 401(k), something we're assuming you could not do if you were living above your means in the mansion. And you would have ongoing expenses and a mortgage payment, just like you would in the mansion. But they would clearly be more managable. My uncle lives in a big house on a few acres, and the upkeep on the place is killer. Not only the yard and the pool, but just the upkeep on the systems of the house. Great house, but you truly have to be able to afford it to live there.

There is one big plus of going with the mansion strategy - you get to live in a mansion for the next 30 years. But our example assumes you'd have to leave that place in your mid 60's, and would you honestly be able to do that and not miss living that way?

So the small house strategy wins big here. Do not buy above your means - at least buy a place at or below your means, and leave yourself a healthy chunk of cash each month to invest. The markets are the ticket to retirement, not a large house.

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