Five Fundamentals of Fiscal Fitness #4: Own the Right-Sized Home (and Mortgage)
This article, “Own the Right-Sized Home (and Mortgage),” is the fourth in a five-article series that discusses the Five Fundamentals of Fiscal Fitness, designed as a basic starting point to help you take control of your finances. If you do nothing else, following the Five Fundamentals will help you ensure that you are able to live within your means. There should be more to your financial plan than the Five Fundamentals, but following them allows you to move beyond living paycheck to paycheck, and focus on longer term financial goals, such as retirement.
There is a direct correlation between responsible home ownership and long term wealth accumulation. In 2013, Thomas J. Stanley, author of Millionaire Next Door, wrote an article about the top 10 asset classes that millionaires invested in. Using IRS estate returns data from 2007-2009, he discovered that millionaires were more invested in real estate (investment & personal real estate accounted for 26.9% of total net worth), than any other asset, including stocks (public & private stock combined for 27.1%), retirement accounts (11.4%).
In this article, we’ll discuss:
- Impacts of the military lifestyle on home ownership & when it makes sense to buy a home
- Why you should own a home if you’re able to
- Why you should have the right-sized home mortgage to go with your home
- What the right-sized home mortgage looks like
- Why you should always have a home mortgage, even if you can afford to pay it off
We’re in the military…isn’t home ownership more complicated for us?
Before I get too far into this article, let’s clarify one thing: I understand that in the military, we move around a lot. The question on whether to buy or rent becomes a lot more complicated because we generally relocate very often (my tours have never been longer than 3 years, and we’ve had several 1-year PCS moves). Generally, you should not buy a home under the following conditions:
- You don’t plan to live in the home for at least 5 years
- You aren’t comfortable being a landlord if you needed to be one
Enough said. Let’s assume that you’re picking the location to settle down, and you’re trying to decide whether to buy a home or not. While it might not be a good idea to buy a home immediately before your transition, let’s go through the reasons why buying a home makes sense for long-term financial success. Then we’ll attempt to define what a ‘right-sized home’ should be for your situation.
Why is it important to own the right-sized home?
There are several reasons why owning the right-sized home should be a fundamental part of your long-term financial plan. These reasons include:
- Using leverage to build value over time. What’s leverage? It’s debt, just like credit cards and consumer debt. However, having a home mortgage allows you to use leverage to your advantage. In this case, you’re using leverage to buy a house, which you’d never be able to do on your own, and pay it off over a very long time. At the end of a 30 year home mortgage, you’ll have zero debt, and your house will have appreciated over time. We’ll discuss this in more depth.
- Long-term appreciation. While a lot of us are still stinging from the housing crash, the fact still remains that house prices generally rise over time. Have you ever seen people paying off the last year of their home mortgage? Their mortgage payments seem so ridiculously low compared to the current value of their property.
- Inflation hedge. Because you get to lock in a mortgage payment for up to 30 years, having a mortgage is a great inflation hedge. Rents go up over time, even if you’re a long-term tenant (unless you live in a rent-controlled area, and I’m not sure where you would find one nowadays). The only thing that will go up in your home mortgage payment is your property tax and/or insurance costs. If you’re a tenant, you’re paying those costs too…you’re just paying whatever your landlord is able to pass on to you.
- A home is the only investment that you get to enjoy while using it. How much do you get to appreciate a stock or Treasury bond? You don’t. However, you’re able to use a home while it appreciates in value.
- Tax advantages. While lower mortgage rates and rising standard deductions do make this less compelling than it used to be, having a tax-advantaged housing payment can make a big difference for a lot of homeowners, especially if you have other itemized tax deductions, such as:
- Charitable contributions
- Medical expenses (in excess of 10% of your adjusted gross income). This might not be an issue for most military families, but post-military, this becomes a huge deal, especially for families who suddenly become responsible for their parents’ care, or who have significant medical needs.
- State income or sales tax. While you get to take the larger of the two, residents of states without an income tax automatically get to take advantage of sales tax deductions. This comes in especially handy when you’re talking about huge purchases, like a car or furniture.
Additionally, you’ll most likely be able to take advantage of Section 121 tax exclusion upon the sale of your home. If you met the criteria for Section 121 tax exclusion at one time (having lived in the home for two years out of a five year period) the IRS allows a deferment of up to 10 years if your military career forces you to move more than 50 miles away.
What Does the Right-Sized Home Mortgage Look Like?
Before we proceed, let’s clarify the difference between what a right-sized mortgage is, and what the lenders will let you borrow. Although mortgage underwriting standards have improved since the housing crash, loans are still issued by banks who want their money back, and are trying to ensure your ability to repay them…not necessarily to help you build long-term wealth. There is still a risk that you’ll be allowed to borrow more money than is prudent for your situation. Here are a couple of guidelines:
- Buy a home that’s about 2-3 times your annual income. On the West Coast, Northeast, or Washington D.C. you might have to adjust this to 3-3.5 times your income. This might sound overly conservative, especially in today’s low interest rate environment. However, buying too much house can be worse than not buying a house at all. Before the housing crash, I’d heard stories of people buying houses 5-6 times their income…that’s just not sustainable for most people in the military, regardless of the interest rate environment.
- Use your VA mortgage, but be prepared to put 20% down anyway. By having access to a VA mortgage, you’re in a great position to have a home mortgage. For a first home, you might not have enough for a 20% down payment, but you should try to put something down anyway. Having a down payment in place (and skin in the game), can help you keep perspective on how important your mortgage should be. If you’re in your second (or subsequent) home, you probably can use the proceeds from selling your first home as your down payment…also known as trading up.
- Have a 30-year, fixed rate home mortgage. You can talk about having a 15 year mortgage, and that’s well and good. However, look at it this way: by having a 30 year mortgage, you can pay close to the same interest rate as a 15 year mortgage, then put the difference into long-term savings. You’ll come out better over the long run financially, especially if you put the difference into your Thrift Savings Plan or IRA. Just think…you’re paying 3-4% in interest and investing in an expected long-term return of 7-8%. That’s exactly the same game that banks play, and it’s the one time you get to turn the tables in your favor.
- You might have more than one home over the course of your military career. Those of us with families might balk at having a home that’s 2 times our annual salary, due to schools, size, and all the other factors that make us look at homes outside that range. However, I started off as an E-1, and in my experience, we all close out our military careers in a different place from where we started. If I had to do it over again, I definitely could have started off in a one-bedroom townhome, then used the proceeds to trade up to our ‘first’ 3-bedroom single family home, then parlayed that into our current house. After our kids are grown and out of the house, we’ll be able to use our home equity to move into our ‘retirement home,’ closer to the water. Being able to ‘trade up’ over the course of your career allows you to maintain the proper-sized home for your particular situation. You’ll probably find yourself wanting to trade up when your home’s value is around 100% to 125% of your income…feel free to do so if your situation supports it.
- But my BAH is so much higher than this. Shouldn’t I look for a bigger (or better house)? The guidelines that I outlined have nothing to do with your housing allowance, or what your friends and peers are doing. This is intentional. Housing allowances fluctuate, and are not a good long-term barometer of how much house you can afford. You also might find that with home ownership, you’ll have expenses that you never worried about as a tenant.
- Maintenance. You should budget about 1% of your home’s cost for annual maintenance…not home improvements, just keeping appliances in place, making repairs, etc.
- Keep in mind property tax and insurance costs.
- Other impacts. To find the right-sized home for our situation, we ended up with a lengthy commute to MacDill AFB, which adds tolls, gas, and vehicle wear-and-tear to our costs. However, we made that decision with a long-term perspective, since we knew that we would focus on our post-retirement life in our local Westchase community after my retirement.
Why You Should Always Have a Home Mortgage
There are many people who will argue with this point, and that’s perfectly fine. However, having a mortgage, even in retirement, is financially prudent, if nothing more than the following reasons:
- Opportunity cost of money. There are many people who put extra money into paying their home mortgage down, and tell everyone they know that they should do the same. Yet, every dollar that you put into your mortgage is doing two things:
- Paying down the lowest-cost debt you can have.
- Not being invested in your TSP, where it can work for you.
- Accessibility. If you saved up every dime to pay off your $500,000 house, that’s great! However, unlike your investments, the only way to access your home’s value is to either take out another home mortgage or sell your home. That’s perfectly fine, if it’s a part of your broader plan, but it doesn’t make sense to have so much of your net worth locked up in your home if you can’t use it to enjoy life. Having a mortgage allows you to put more of your money into savings accounts or more liquid investments.
This article is meant to be purely a guideline for how you can establish long-term wealth while maintaining a military lifestyle. You might disagree with some of the principles I’ve laid out here. While they have worked for the vast majority of people who have used them, they might not be practical for every military situation. You might consciously decide that getting into the right school district, or living downtown, or living closer to your work are worth paying more for your home. That’s perfectly fine. In my personal situation, I’ve found that over the years, we’ve made that decision several times for each of those reasons. We also discovered that we might have been a little better off financially if we didn’t feel the need to ‘keep up with our peers.’ However, if you’re starting from scratch and looking for some home ownership guidelines, I hope you’ll find these to be pretty useful.
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Caveat: Five Fundamentals of Fiscal Fitness is a money management philosophy created by Bert Whitehead, a prominent thought-leader in the fee-only financial planning world. Bert’s philosophy has been standardized by the Alliance of Comprehensive Planners (ACP), a non-profit membership of like-minded, fee-only financial planners dedicated to helping clients avoid the pitfalls of the financial services industry. Disclosure: I am a dues-paying member of ACP, and fully believe in the five fundamentals of fiscal fitness. Please feel free to contact me with any questions you may have about ACP and its philosophies.