House Hacking

Posted On October 22, 2021 By Scott Stratton, CFP(R), CFA In Financial Planning /

If you are looking to buy a home and want to really grow your wealth, consider house hacking. Our ability to save, invest, and grow real wealth begins with a very simple premise. You have to spend less than you make. It couldn’t be more simple, but that doesn’t make it easy.

For most people, your three biggest expenses are housing, taxes, and cars. If we manage those three expenses well, you may be able to save a significant amount of your income. The more you save, the faster you grow, and the sooner you might reach your goals. Read more: Five Wealth Building Habits

The problem is that most Americans are doing the opposite and creating a lifestyle which consumes 100% of their income. And then there is nothing, zero, left to invest.

House Hacking gives you an incredible opportunity to reduce your biggest expense, in some cases, down to zero. Here’s how. Instead of buying a single family home, you buy a duplex, triplex, or four-plex. You live in one unit and rent out the rest. Your tenants will cover much or even all of your mortgage. You can live there with little or no monthly expenses.

With a house hack, you are freeing up your income so you can save and invest. You can pay off your credit cards. Maximize your 401(k) and Roth IRAs. Start saving for college in a 529. And it’s all because you were willing to live in a multi-family home rather than spending thousands every month on a single family home.

The Details

Sure, house hacking isn’t going to be for everyone. But maybe you want to ask how this might work, if you were to consider it. Although you are buying a multi-family building, you are going to use the house as your primary residence and live there. That means you can still use an FHA mortgage and not have to get a more expensive mortgage for a rental or investment property. With an FHA mortgage, you can put as little as 3.5% down with a FICO score of just 580.

Of course, if you have 20% to put down, you could also do a conventional mortgage as a primary residence. Or, if you’re a veteran, you might be eligible for a VA loan with zero down.

Once you have the property, you can split costs between the area where you live and the area which you rent. This means you can also enjoy some of the tax benefits of being a landlord. Let’s say for example, that your building is 3,000 square feet and you live in 1,200 feet and rent out the rest. You occupy 40% and have 60% as a rental.

Then you can look at your costs, such as insurance, utilities, repairs, taxes, etc. For your bills on the whole house, you can allocate 60% of those costs against your rental income on Schedule E. For the 40% where you live, you can also qualify for the Section 121 capital gains exclusion, when you sell.

Living with other people in the same building might not be your dream situation, but if you can make it work, there could be great benefits for you financially. When you manage your biggest expenses, it becomes easy to have money left over to save and invest. Put your savings on autopilot. Maximize your 401(k). Put $500 month into your Roth IRA to get to the $6,000 annual limit.

Who Can Do a House Hack

House hacking certainly makes sense for a first time home buyer, a single person, or a young couple. That’s probably the typical situation. But it could also work well for older investors who want to turbo charge their savings while they are still working. And if you could reduce your monthly housing cost from $2,000 to $200 or $0 a month, would that change when you will be able to retire? Probably. A house hack might enable you to retire at 55 versus 65. Under the 4% rule, reducing your expenses by $2,000 a month means you now need $600,000 less in your nest egg to retire.

Most of us will resist making a sacrifice to be able to save. Still, if you have an open mind, a house hack might be a brilliant way to save and invest. While your friends and colleagues are barely saving anything, you might be able to put away 50% of your income while your tenants are paying down your mortgage. If you can invest $2,000 a month for 10 years, at a 7% return, you could have $344,000. That might be worth a small sacrifice.

Housing is an expense. Your house should go up in value over time, but the expenses of interest, taxes, insurance, and upkeep are not building your wealth. What if you get someone else to pay for your house? When you reduce those expenses, you are giving yourself a tremendous opportunity to save and invest in appreciating assets. If that is important to you, look for creative ways to cut your biggest expenses!

Have you done a house hack? I’d love to hear from you about your experiences. Send me a note!

Your Home Is Like A Bond

Posted On January 15, 2020 By Scott Stratton, CFP(R), CFA In Financial Planning /

You’re doing well. You’ve got your emergency fund, you’re maxing out your 401(k), and you don’t have any credit card debt. At this point, a common question is: Should I send extra payments to my mortgage? And with markets near their highs, maybe you’re even wondering, Should I pay off my mortgage?

There are a lot of emotional reasons to pay off your mortgage. You could own your house free and clear and never have to worry about a mortgage again. You could reduce your bills in retirement. Investments carry uncertainty, whereas paying down a debt is a sure thing. Those are typical thoughts, but that’s not necessarily a rational answer.

Maximize Your Net Worth

In financial planning, our goal is to determine the solution which maximizes utility. Will I have a higher net worth if I pay off my mortgage or invest the money?

The answer, then, is it depends. It depends on the rate of return on your investments compared to the rate you are paying on your mortgage. If your mortgage is 3% but your cash is earning 0.5%, you would be better off paying down the mortgage. (Assuming you still kept sufficient liquidity for emergencies). On the other hand, what if your mortgage is 3% and you could be making 7%? Then, you would maximize your net worth by staying invested and not pre-paying your mortgage.

Most people would prefer to be debt free. However, if you can invest at a higher return than you borrow, you will grow your net worth faster. I don’t think of a home as being a great investment. Houses generally keep up with inflation, but have returns similar to bonds, or slightly less.

Home Versus Bonds

Looking at the Case-Shiller 20 City Home Price Index (which includes Dallas), the overall rate of return since 2000 was 4.02%. Let’s look at an actual bond fund, not just hypothetical indexes. An investor could have earned 5.15% a year in the Vanguard Intermediate Term Bond Index fund, since fund inception in 2001.

The money you put into your house, will likely behave like a bond, although possibly with more volatility. Over a long period, it should keep up with inflation, or if you’re lucky, a little better than inflation. (See below for my concerns about home prices, or thinking of a home as an investment.)

I do believe it is realistic, based both on historical returns and projected returns, to anticipate a return of 5-8% from a diversified portfolio containing 60% or more in stocks. That’s not guaranteed, but if your time horizon is twenty or thirty years (i.e. same as a mortgage), it’s a reasonable assumption. And the longer the time period we consider, the greater likelihood of a positive outcome from stocks.

While it is important to consider the overall levels of risk and return of your portfolio, a portfolio is made up of specific segments. Today, the yields on high quality bonds are very low. With the 10-year treasury yielding only 1.25%, there’s not much return to be had in bonds.

Using Cash or Bonds to Pay Down Mortgage

Let’s consider an example, using round numbers for simplicity. Let’s say you have a $1 million portfolio in a 60/40 portfolio: $600,000 in stocks and $400,000 in bonds. You also have a $200,000 mortgage at 3.5%. The expected returns (hypothetical) for stocks is 7% and for bonds 2.5% today. That would give the overall portfolio an expected return of 5.2%, which is higher than your mortgage rate.

On the bonds, though, the expected return of 2.5% is less than your mortgage cost of 3.5%. If you believe that today’s low yield environment is likely to persist for a long time, it might make sense to take $200,000 from your bonds to pay off the mortgage. That would leave you with a portfolio containing $600,000 of equities and $200,000 in bonds, a 75/25 portfolio.

The new portfolio would be more volatile than the original 60/40 portfolio, but the dollar value of your stock holdings would remain the same. And your net worth will grow faster, since we paid off debt at 3.5% with bonds that would have yielded only 2.5%.

Provided you are comfortable with having a more volatile portfolio, you might maximize your net worth by withdrawing from bonds but not from your equities. This means increasing your equity percentage allocation. However, I wouldn’t sell stocks to pay down a long dated mortgage. Consider the math on that decision carefully.

Additional Considerations

There’s a lot to evaluate here, so it is important we discuss your individual situation and not try to simplify this to some type of universal advice or rule of thumb.

If your choices are to send in extra mortgage payments or do nothing, then yes, send in extra payments. That’s better than spending it!
Are you choosing between extra payments versus another investment? Then, consider the long-term expected rate of return of the investment versus the interest rate of the mortgage.
While bond yields are low today, it is possible they could rise in the future. If you have short-term bonds you might gradually reset your yields to higher levels. A fixed mortgage, however, will stay at the same rate for the full term of 15 to 30 years. Now is a great time to borrow very cheaply. If we have higher inflation in the future, it will benefit borrowers and penalize savers.
You can invest outside of a retirement account. In fact, if your goal is to retire early, become a millionaire, or create a family trust, you need to do more than just a 401(k). Some people stop after funding a 401(k) and think they don’t need to make any additional investments. Paying down a mortgage is not your only option; consider a taxable account.
A mortgage is a form of forced savings. If you have a monthly mortgage of $1,500, maybe $500 of that is interest and the remaining $1,000 is building equity in your home. If you pay off your mortgage from investments, you will save $1,500 a month. You will feel wealthier because you improved your cash flow. But if you don’t invest that $1,500 a month going forward, you will likely just increase your discretionary spending. Be careful to not miss that opportunity to increase your saving.

On Home Values

Your home value will increase the same whether you have a mortgage or own it free and clear.
There are significant expenses in being a home owner which make it a poor investment, including property taxes, insurance, utilities, and repairs or improvements. These costs are not included in a home price index. Read more: Inflation and Real Estate
Selling costs can also be significant, such as a 6% realtor commission. I bought a house for $375,000 in 2006 and sold it in 2017. After paying closing expenses, I received $376,000. That’s not a good return, and those amounts don’t include the improvements I made to the house.
If your primary goal is to grow your net worth, consider your home an expense and not an investment. If you aren’t going to stay for at least five years, rent.
After the Tax Cuts and Jobs Act, most people cannot deduct their property taxes and mortgage interest. This is especially true for married couples. So, forget about having a home as a great tax deduction; most taxpayers will take the standard deduction.

At best, you might consider home equity to be a substitute for a bond investment. Given today’s very low yields, you could reduce bond holdings to pay off a mortgage. Your home is significant part of your net worth statement. It’s often one of your biggest assets, liabilities, and expenses. Think carefully about how you manage those costs. Genuinely analyze how different decisions could impact your net worth over ten or more years. That’s the approach we want to use when asking, Should I pay off my mortgage?

Tracking Home Improvements

Posted On August 6, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning /

When you eventually sell your home, it may be helpful to have a record of your home improvement expenses. Because people often own their homes for decades, this is an area where a lot of records and receipts are lost. Here is what you need to know about tracking home improvements.

Primary Residence Exclusion

At the time of a home sale, the difference between your purchase price and your sale price is a taxable capital gain. Luckily for most people, there is a significant capital gains exclusion from the IRS: $250,000 (single) or $500,000 (married), for your primary residence. If your gain falls below this amount, you will not owe any taxes. In order to qualify, the property must have been your primary residence for at least two of the previous five years, and you must not have taken this exclusion for another property for two years.

If you make a capital improvement (described below), that expense increases your cost basis in the home. But because of the large exclusion ($250,000 or $500,000), many people don’t even bother to keep track of their home improvement expenses. That may be a mistake. Here are a number of scenarios which could be a problem:

If you get divorced or your spouse passes away, your exclusion will decrease from $500,000 to $250,000.
Should you move and make another property your primary residence for four years, you will lose the tax exclusion on the previous property.
If you own your property for the next 30 years, it is possible your capital gain ends up being higher than the $250/$500k limits. These amounts are not indexed for inflation.
Congress could reduce this tax break, although it would be very unpopular to do so. They are not likely to change the definition of cost basis and capital gains.

Capital Improvements

What constitutes a Capital Improvement which would increase your cost basis? In general, the improvement must be permanent (lasting more than one year), attached to the property (not removable or decorative), and add to the value, use, or function of the property. Maintenance and repairs are generally not capital improvements unless they prolong your home’s useful life. The IRS provides the following specific examples of expenses that are Capital Improvements:

Additions, such as a new bathroom, bedroom, deck, garage, porch, or patio.
Permanent outdoor improvements, including paved driveways, fences, retaining walls, landscaping, or a swimming pool.
Exterior features, such as new windows, doors, siding, or a roof.
Insulation for your attic, walls, floors, or plumbing.
Home systems, including heat/central air, wiring, sprinkler, or alarm systems.
Plumbing upgrades such as septic systems, hot water heaters, filtration systems, etc.
Interior improvements, including built-in appliances, flooring, carpet, kitchen remodeling, or a new fireplace.

While there are many expenses which count as improvements, repairs and upkeep do not. Painting, replacing broken fixtures, patching a roof, or fixing plumbing leaks are not improvements. Also, if you install something and later remove it, that expense may not be counted. For example, if you install new carpet and then later replace the carpet with wood floors, you cannot include the carpet expense in your cost basis.

Gain or Loss?

For full information on calculating your gain or loss on a home, see IRS Publication 523. While most homeowners are focused on mitigating taxable gains, I should add that if your capital improvements are significant enough to make your home sale into a loss, that loss would be a valuable tax benefit as it could offset other income. Here’s an example:

Purchase Price: $240,000
Capital Improvements: $37,400
Cost Basis: $277,400

Sale Price: $279,000
Minus 6% Realtor Commission: -$16,740
Closing Costs: -$1,250
Net Proceeds: $261,010

LOSS = $16,390

If you just looked at your purchase price and sales price, you might think that you would have a small gain (under the exclusion amount), and there was no need to keep track of your improvements. However, in this example, you don’t have any gain at all.

Unlike other receipts, which you only need to keep for seven years, you do need to keep records of your capital improvements for as long as you own the home, and then seven years after you file your tax return after the sale. Even if you think you are going to be under the $500,000 tax exclusion, I’d highly recommend you keep track of these capital improvements which increase your cost basis.