A nice house can ruin your fatFIRE aspirations
If you follow the blog regularly, then you know that I am doing my best to Retire at 50 with as comfortable a lifestyle as possible. As much as I respect the determination of the frugal FIRE (Financial Independence Retire Early) crowd, the truth is that I’d like to be able to have a nice House, fancy vacations, and maybe even a sports car. I could cut my expenses and retire earlier, but with only one life to live I’d like to have my cake and eat it, too (as much as is possible). This means focusing on income, being diligent about saving, and investing smart.
I’m not alone. In fact, many of my friends and co-workers are at least theoretically attempting to achieve early retirement of some kind. Since people know I write the blog, I often get into conversations about finances, investing and, real estate. Recently I was talking about the real estate market with an acquaintance I met through work. As we were discussing the insane prices for real estate in the Bay Area, he happened to mention that if it weren’t for his home, he would have been able to retire early.
That’s when I dug in to get the rest of the story…
Buy the cheapest house you’ll be happy with
Not the most expensive house that you can afford
Your housing decisions will define your ability to retire early
The friend I was speaking to is in sales management at a tech company in San Francisco. By all accounts, he is an incredibly intelligent and “smart” person, who has managed to move up the ladder in a highly competitive job and industry year after year. In his current role, he pulls in over $750,000 a year, and he has been earning high six figures for quite some time.
With that kind of income over that time frame, you would assume he would have been able to save a significant chunk of change over time. But, at 48 he is unlikely to ever be able to retire early.
He lives pretty large, as you might expect from a sales guy. His young kids are in private schools. He has a nice car, fancy watches, and the same for his wife. But the real FAT for him is housing. He has a $2m+ place in Cabo and a $4m+ house Bay Area as his main family home, both bought within the past 5 years on typical terms (but largely financed).
The bottom line? His PITI costs are close to $20k per month. He still saves in his investment account and maxes every retirement account he has, but with $240k-ish in annual mortgage payments, and other significant lifestyle expenses, he is having trouble setting aside the massive chunk of change he will need to retire early. Using the 4% as a guideline (which basically says you need 20x your annual expenses in long term investments in order to retire), he would need to save close to $5m just to cover his housing costs.
Although housing is the largest chunk of his expenses, it is by no means the only expense he has to pay. His kids private school, as an example, will probably end up costing him $500,000 or more by the time they are through college. All in all he’d probably need somewhere between $6 and $7m saved up to retire early with his current expenses and lifestyle.
He didn’t share all the details, but I get the sense he has more like $1-2m saved. It’s a great start, but that’s all it is.
Housing choices are stickier than you might imagine
You might be thinking that this is an imaginary problem. He can just downsize his main home, or sell the Cabo place and retire. That’s what I said, anyway.
As he started explaining in more detail, it became clear that things are a little more complicated than they seem. The kids are best friends with the neighbors kids. Their commute is less than 30 minutes, and school is only 5 minutes away. Plus, they designed the house from scratch as their “forever house”, which is ironic since it’s probably the biggest reason he has to work for the foreseeable future.
That leaves the Cabo place. Unusually for second home owners, they actually use their home a fair amount, at least 10 weekends plus a two week vacation per year. They rent it out to offset costs, but have had some bad experiences, so now they only rent to friends three or four times a year.
Of course they could sell or downsize either one of their homes and retire early, but as with all lifestyle inflation it’s much easier said than done. They like their houses. They like their life. So they’ve chosen to keep working until a normal retirement age and keep their housing situation as is.
Don’t feel sorry for my friend, but only buy as much house as you need
At this point I should probably be clear that my friend wasn’t complaining - he’s happy with his choices and he understands that he is fortunate to have what he has. But what he did say to end the conversation was much more interesting.
He said if he had to do it all over again he would have tried to spend at least $1m less on their main house and $750k less on the Cabo place, setting their lifestyle at a lower level from the start and making a quasi-early retirement at 55-57 a possibility.
Although it would feel like a huge downgrade if they made those choices now, it probably wouldn’t have changed their lives much if they had made more affordable choices in the beginning. But, they bought the max of what they could afford (maybe over), and he’s gonna be slugging it out till he’s 65 or the kids are off to college and they can downsize or move full time to Cabo.
How much house can you afford if you want to FIRE?
At this point you may be wondering how much house you really can afford. Traditionally, there have been a few schools of thought on the topic.
If you walk into a bank, the discussion will immediately swing to how much money you can afford to borrow and service. Mortgage brokers and banks are incentivized to try to get you to borrow as much as they can legally lend you, so it’s easy to walk in and end up getting financing for way too much house than you would otherwise want (financially speaking). Obviously, the “how much you can get approved for” method isn’t the best.
Some people say that you want to have your housing costs equal to a third or less of your take home pay. If we look at my friend who is taking home around $750,000, we can assume he pays at least $300,000 in taxes per year, leaving around $450,000 net. With mortgage costs of $240,000 -and maintenance costs of $10-$20k per year on top of that- he is a lot close to 50%. By all accounts, he is spending much more than he should on his housing.
To be fair, the 30% rule is more reasonable for the rest of us who aren’t making as much as he is. When you are making close to a million dollars a year, you are never going to need to spend 20% of your income on food and clothes, so it leaves a higher percentage for other things.
Because of this I like to take a different approach when it comes to figuring out how much house I can afford. It has nothing to do with how much I make, or how much money the bank will lend me. Instead, I step backwards and approach the subject from a different angle.
Step 1: Determine net income
This is obviously the easiest step, but don’t write it off. How will your income change over time? Don’t assume raises will come out of nowhere. Have a keen eye on any variable compensation like bonuses, stock, etc that you have recently been paid that you may not have in the future. You won’t be able to perfectly guess what your income will look like in the future, but be conservative.
Then, subtract your expected taxes to arrive at your net income.
Step 2: Subtract your retirement and investment savings
If you are making decent money, you should be maxing out every tax advantaged savings account you have including IRA’s, 401(k)s and even HSAs. Once you have done that, you will likely need to save even more on top if you want to retire early. I have a full chart that I’ve made showing the total amount that I should be at every single year until my fatFIRE date at 50.
You might need to save extra to catch up, so be sure to include that in your number as well.
Step 3: Subtract your living expenses
After you have arrived at your actual net income, which I define as income after taxes, retirement and investments (ITRI), you can subtract your expenses for utilities, food, clothes, fun, vacations and other miscellaneous expenses.
Step 4: Subtract to arrive at your maximum total payment
After you have subtracted your living expenses you have arrived at the yearly amount that you can safely spend on mortgage, interest, taxes, insurance and the maintenance on your home. If you have a large down payment, you may be able to afford more home than you would otherwise based on this number.
The bottom line: save as much as possible, buy the cheapest house you can
After reading all of this, it should be clear. For anyone that wants to farFIRE, the only way to get ahead is by reducing housing expenses as much as possible.
Also, Other Real Estate Posts
Investing in real estate when real estate is expensive
How to find a condo to remodel
Crowdfunded real estate
How to avoid PMI (Private Mortgage Insurance)