How to Consider a Mortgage in a Financial Independence Calculation
I’ve said it once and I’ll say it again: While I’m thrilled this blog has a shot at helping others, I am – at heart – a selfish creature. Writing these articles mostly serves as a way for me to publish my own thought experiments and, consequently, force my own hand at figuring out how these types of major life decisions will impact my own financial independence calculations.
So while one could perceive that as a shortcoming of this blog, I invite you to see it as the opposite: I’m looking out for #1, and therefore really putting my back into the research and methodology here (since it directly impacts me).
Feel better? Great. Let’s get into it.
For the purposes of today’s post, we’re talking about:
A “typical” home-buying experience: Buying a house you can afford that’s already “livable,” so to speak, and not intended to function as a rental. In other words, you aren’t going to “force” appreciation by buying a fixer-upper, and you’re not using it to generate passive income via renters.
While you totally can (and should!) do those things, I don’t think that’s how most Americans buy homes, so I want to look at the “baseline” experience, if you will – from there, we can always build on later and look at how those two approaches outlined above could shift the narrative.
As I think through factoring a mortgage into a FI calculation, there are a few things that come to mind immediately:
Using a chunk of your net worth for the initial down payment, thereby lowering your net worth in the short-term
The opportunity cost of that chunk of your net worth (in other words, what your down payment would’ve turned into had it stayed invested)
The ongoing cost of your monthly payment over the next 15 or 30 years, depending on the length of your mortgage (but theoretically, afterward you’d be home-free – literally)
Two things jumped out at me immediately:
Because we know home ownership has a shit ton of other hidden costs associated with it that are typically proportional to the value of the home (property taxes, insurance, maintenance, repairs, renovations, building a skateboard ramp in the backyard for your snot-nosed kid), buying a home has the potential to really throw a wrench in your financial plan. After all, when we’re calculating our FI number, we’re using our annual spend to determine how much we need to invest to be #free. If property taxes in my town are 2%, the difference between a $300,000 house and a $600,000 house is $6,000 or $12,000 in property taxes – a $6,000 per year annual difference means my FI number has to be ($6,000 * 25) $150,000 more in order to for me to be work optional, since I’d need $150,000 invested to throw off that $6,000 difference each year in annual returns. The TL;DR: Spending as little as possible to be happy in your home is a baseline principle here. We ain’t swinging for the fences.
I feel like half my life on personal finance Instagram is #respectfully arguing with people in my DMs about why your primary residence isn’t an investment in the traditional sense. I’ve written about this ad nauseam (just check out the “Cars & houses” section of this blog). However, we all need a place to live – but it’s worth noting throughout this exercise that, while your home is an asset that will hopefully, likely appreciate, it’s a bit of a phantom presence in your net worth. In order to actually realize any of the gain or value, you’d have to sell it and – that’s right – not live in it anymore. The TL;DR: It’s not liquid in the same way that your investment accounts are liquid, so treating your home equity like it’s money in the bank isn’t really accurate for the purposes of financial independence.
The last thing I’ll tack on here is closing costs. Closing costs can be thousands upon thousands of dollars, and they don’t go toward the value of the home – they’re just the cost of doing business. Buying a home you don’t intend to stay in very long can rack up more in closing costs than it’s worth.
Jumping into an example
I’ll be the first to admit that I basically paid engineering students to do my calculus homework for me in college because my brain doesn’t work well in the theoretical, mathematical realm. When it comes to personal finance, I can scrape by (because the stakes are so high!), but it helps me a lot to use hypothetical examples to make these types of scenarios more tangible.
Let’s apply some basic best practices to a hypothetical situation.
Best practice: Not spending more than 30% of your total net worth on the down payment
Frankly, I hate espousing “laws” of personal finance with no basis in anything other than, “Well, that’s just the rule of thumb!”, but to me, this is a starting point.
The idea here is that we don’t want more than a third of our net worth being tied up in our home equity, because (as we already noted) it’s illiquid.
Really, the key here is to use as little of our net worth as possible to hit the “20% down” mark and avoid PMI (that’s insurance a lender will charge you on top of regular insurance if you put down less than 20%; while I know there are certain groups that can avoid it like doctors and military members or first-time home buyers, for the purposes of today, we’re going to pretend PMI is a thing).
If our hypothetical couple has $350,000 between them, 30% of that net worth is $105,000.
The couple shouldn’t spend more than $105,000 on a down payment. $105,000 is 20% of $525,000, so $525,000 is theoretically the most they’d be able to “afford.”
But remember, we aren’t really trying to max out our budgets here. Let’s dial it back a little and shoot for, say, 20% of our total net worth as the down payment: $70,000, or a 20% down payment on a $350,000 home.
What happens next?
Well, a few things:
We’ve put $70,000 down, so our (liquid) net worth drops down from $350,000 to $280,000.
Of course, we’re building equity in a home.
Using national averages and a Zillow mortgage calculator, I’ve learned that my hypothetical couple’s monthly payment on this home would be $1,595, broken down like this:
$1,180 toward mortgage principal & interest
$292 in taxes
$123 in insurance
But for all intents and purposes today, it doesn’t really matter how it breaks down: All that matters is that we have to spend about $1,600 per month on our housing, or $19,200 per year.
Quick tip: To see how something affects a financial independence number, just multiply the annual cost by 25. That’s how much needs to be invested to produce enough in investment returns to pay for it. $19,200 * 25 = $480,000, in this case.
Now, the kicker here is that it’s likely that couple would be paying at least $1,600 in rent anyway – this isn’t a new or novel cost, per se. It’s just money that would’ve been spent on rent that’s instead being spent on a mortgage and the associated costs, so it’s not like we’re adding $480,000 to an existing FI number.
It’s possible they were spending more or less on rent before, but remember: The house is going to introduce ownership costs that are new and novel, so even if their monthly payment is lower, it’s still worth budgeting in extra for repairs, etc.
So what does this tell us?
A “future value” calculator becomes our best friend here.
For the sake of simplicity (though you could plug in your own real numbers for an accurate depiction), let’s pretend our couple was spending $1,600 on rent anyway. In other words, their monthly costs didn’t change because they bought a home, they just lowered their net worth.
So let’s say this couple needed $480,000 in their FI number to produce their $1,600 per month in “income” for their housing, and maybe they spend another $3,000 on other stuff, bringing their monthly “spend” to $4,600 total.
That means their FI number is $4,600 * 12 * 25 = $1.38M.
This is where you’ll have to just go with the flow of the example
For the sake of fleshing this out, let’s pretend this couple can afford to invest an additional $60,000 per year.
In order for this to be accurate, that would mean they’d need to (combined) make about $115,000 after tax, since they’re spending $55,200 per year. That means their average salaries (between them) would probably be roughly $70,000 each, for level-setting.
In the example where they buy the house and drop from $350,000 to $280,000 in net worth
They could hit FI ($1.38M) in 10 years, assuming an average rate of return of 7%.
In the example where they don’t buy the house and just rent, but their net worth stays at $350,000
They could hit FI ($1.38M) in 9 years, assuming an average rate of return of 7%.
Record scratch: It’s just a year difference?
Let’s break this down. This couple only spent 20% of their total net worth on their home, thereby only shaving off a fifth of their invested assets to pour into the home. The other crucial thing here is that they bought a home with a monthly payment of around $1,600 total, and in our example, we assumed the couple that didn’t buy was renting for an identical amount (thereby giving the two scenarios the same “FI” number to strive for).
So you may look at that and think, “Well, shit, might as well buy the house, right?” I mean, that’s what I thought at first glance, too.
But here’s what I always come back to: When you flesh these two scenarios out to #completion, the not-super-realistic-but-still-ideal outcome is that you’d end up owning the house outright and living in financial independence with basically no housing payment, therefore cutting back on your monthly costs by a sizable chunk, where the couple who was renting would have to keep renting indefinitely. One couple would lower their housing costs significantly after 30 years, and the other wouldn’t.
In this example, the couple with the house would likely still need to pay their $282 in taxes and $123 in insurance every month indefinitely, but they’d recoup about $1,200 of their monthly payment after paying off their 30-year mortgage.
Do you see the writing on the wall here?
Most people don’t stay in the same house long enough to own it outright
And if I’m just buying homes and then selling them before I own them outright, I don’t see how it’s any different from renting – sure, I may make a little on the appreciation even after I pay the bank back (or a lot, if I time it correctly), but remember those phantom costs? It’s hard to quantify how much of that appreciation is truly profit after you consider all the money you have to sink into a home over the years. That’s not a knock on home ownership, it’s just reality.
Side note: We’re living through a truly unique time period right now with an extraordinarily hot market because of a housing shortage. While some will certainly get lucky selling their homes right now at inflated values, it’s not something you’d want to bank on down the line because it’s admittedly a bit of a fluke (and the obvious caveat to selling your house in a hot market is that you then have to buy in that same hot market since you, you know, need a place to live, which eats into your gains and locks you into another mortgage that’s inflated thanks to the aforementioned hot market).
The shitty thing is that it often doesn’t even make sense to pay off a mortgage any faster, because your interest rate is likely lower than the average stock market return and – as a result – your extra #fundz will go further in the stock market anyway.
Key takeaways
I suppose if I ever found myself in a position where I lived somewhere that I could buy a home I’d actually want to live in with numbers that worked out like the above, I’d be interested.
The hard thing is, I’ve never lived in a city where I could get anything remotely attractive for $350,000. The “Zestimate” for the home we’re renting in Colorado right now is $895,000. The ramshackle huts down the street from our apartment in Dallas were $500,000+.
To find something at $350,000, we’d have to move far away from the types of areas we like to live in at this point in our life, and that’s not necessarily a compromise I’m willing to make yet. That said, it’s also worth divulging (in transparency) that our rent right now is $3,000 per month; nearly double that of the example rent in this scenario. It’s certainly not the most “FI” choice.
(And to be clear, I’m not suggesting anyone compromise on housing if they don’t want to – I’ll be the first to admit that it’s $3,000 very well-spent for the quality of life it provides.)
I’ve always found that renting enables you to live in homes much nicer than those you could actually afford to purchase outright; the breakdown for the house we’re living in now would’ve been $178,000 down and a monthly payment of $3,700. Instead, we get to live in it with no money down, $3,000 per month flat, and no obligation to pay for the landscaping, a future broken hot water heater, roof repairs, or other [insert miscellaneous repair costs here].
This is why real estate is a hyper-regional choice. In cities where the cost of real estate is only 80% as high as the national average, you can get a palace for $350,000 and it may truly make sense (the counterpoint is that you could also probably rent extremely cheaply, too, but again – the headline here is that running the numbers is worth 20 minutes of your time).
The important thing: Buying a home you can truly afford won’t really slow your progress to FI, but it probably won’t end up helping it, either
I mean, come on: 9 years vs. 10 years? Who cares? Because our hypothetical couple chose a property that was technically worth the same as their total net worth, it didn’t really make a difference in their investing timeline (assuming their rent was the same or more than their monthly payment for the house, as in the example we saw today).
And if you’re in a rare circumstance where you intend to stay in a house for the next 30 years to the point that you own it outright and don’t have a housing payment anymore, you could find yourself in quite the sweet position. My parents lived in the home I grew up in for 26 years before they sold it, so they almost owned it outright – but it didn’t appreciate by very much in that time, so they mostly broke even.
But I suppose – in practice – I’ve always found renting a more realistic option with practically zero phantom costs or impact to your net worth. You can predict with perfect precision what your rental costs will be: Rent * 12. No roof repairs, broken garbage disposals, or broken pipes to speak of. That’s someone else’s problem.
(Although, your rent will likely go up every year, which is a fair complaint that people have – to that, I say, if you’re down to move, you can always find a cheaper place elsewhere. That’s where the “convenience” vs. “money” starts to come in, and you have to make choices that align with your income and goals. For the last five years, I’d move or negotiate any time they tried to raise rent and kept my housing costs about the same every year. This year, I decided I made enough money to justify the better place.)
If you’re always going to have a mortgage payment because you plan to buy but never plan to own a property outright, you’re really just renting your home from the bank
They own it, you make payments, and you hope that when you sell it, you make enough on the sale to recoup your initial down payment and then some. That has always felt risky to me, but I suppose I’ve never been truly incentivized to buy.
That’s the thing about the “appreciation” conversation I’ve never really understood:
Even if you make $100,000 on the sale of your home, you probably put $50,000 down (at least), and you have to go find somewhere else to live now. That money just shuffles to the next place. It feels like you’re just moving around the same pile of money from property to property, not actually pocketing the difference and benefiting from it. But what do I know? I’ve never owned a home.
Concluding with a reminder about opportunity cost
Man, when I set out to write this, I promised myself it wouldn’t become another Renter’s Manifesto. Another one bites the dust.
Oh, and the last piece to close us out: opportunity cost.
Our couple who didn’t buy? Their original $70,000 down payment, left in the stock market to compound over a few decades at a 7% average rate of return, would turn into $568,000 after that 30-year mortgage period is up. I think that appreciation is pretty hard to beat. *winks
Quick note
Before you send me a fiery DM, recall that I just admitted I rent a $900,000 home for $3,000 per month – so I’m not exactly putting my money where my mouth is. I understand that people making irrational housing decisions for the sake of their quality of life, and I’m doing it, too. A lot of my housing discussions are more theoretical in nature, but know this: If I buy a house, I’m going to try to follow this example CLOSELY. No more than 20% of my net worth for the down payment and attempting to keep my total monthly payment in line with what I’d be paying in rent.
