Ask around, and you'll likely discover a consensus that a good way to sock wealth away for retirement is to buy a sizable home and enjoy living in it for many years, while it appreciates in value considerably. Then, at or near retirement, you sell it and downsize and, to a great degree, live off the equity that it generated.
It seems to make sense, but I recently ran across a compelling contrary argument made by Jonathan Clements in The Wall Street Journal. He offers this example: You're 35, you want to retire at 65, and you buy a $400,000 home with a $300,000 mortgage. You invest your extra money in stocks and funds. This is his "small-house strategy." With a $400,000 home, I thought this was going to be the "big-house strategy," but I was wrong. In the big-house strategy, you opt for a $1 million home with a $900,000 mortgage, and at age 65, you downsize into what would today be a $400,000 home.
Which is the more effective option? Here's how Clements evaluates them:
To make sure today's real-estate junkies don't quibble too much, we'll make the assumptions favorable to the big-house strategy. For starters, let's assume you could get a 30-year fixed-rate mortgage at 6.5%. The $900,000 mortgage would cost you some $5,700 a month, versus $1,900 for the $300,000 mortgage. [He also ignores commission costs and some other not-so-inconsequential expenses, such as capital gains taxes.] Meanwhile, we'll peg your home's price appreciation at 5% a year, versus 3% for inflation. That two-percentage-point annual real return is right in line with the historical average.
Clements then cites financial consultant Charles Farrell, whose calculation showed that, "at age 65, your $1 million home would be worth $1.8 million, figured in today's dollars. At that point, you sell it and buy that $400,000 home. Because smaller homes would also be appreciating at two percentage points a year above inflation, a $400,000 home by then would cost roughly $700,000 in today's dollars. That would leave you with $1.1 million for retirement living expenses."
How does that compare with the small-home approach? Well, he takes the difference in mortgage payments in the two approaches and imagines that it's invested earning a rather conservative 2.2% above inflation. In 30 years, you'd have around $2 million, nearly twice as much as you'd get with the big-home approach. There are other considerations, such as mortgage interest deductions, IRA contribution deductions, capital gains taxes, and maintenance and upkeep costs for either home. Clements' bottom line is that the small-home approach is a hands-down winner.
What should you do?
His arguments make a lot of sense to me -- but I don't think one size fits all. Rather than plan to sell your McMansion tomorrow, take a little time to crunch some numbers. After all, each of us has a personal situation that's at least somewhat unique. Chances are that your small-home and big-home possibilities are valued closer to $300,000 and $600,000, respectively, instead of $400,000 and $1 million. Your credit rating will dictate how good an interest rate you can get on mortgages for either option. Consider what taxes you'd face with either scenario, and how much it would cost you to keep a home of either size in order. Think about what kind of returns you might conservatively expect from your stock, bond, and/or fund investments. Think about how rapidly you expect real estate prices to rise (or shrink!) in your region. Factor in any other considerations you can think of, and then see what you think.
If you're interested in home-buying and home-owning issues, visit our Home Center, which features lots of money-saving tips and even some special mortgage rates.
You might also want to check out these articles:
- Buying a House Is Easy!
- So You Want to Be a Landlord?
- Make Money as a Landlord
- A Mover's Survival Kit
- 10 Things to Know About Mortgages
- 10 Home Enhancement Tips
To learn more about how to set yourself up for a more comfy retirement, check out our Rule Your Retirement newsletter, which happens to be the retirement guidance source that I refer to most often and which you can try for free.
Here's a sampling of some very useful articles from past issues:
- In the January 2006 issue, Robert Brokamp tackled asset allocation and explained how we can "avoid Uncle Sam's grabby hands." He listed a host of popular investments, such as bonds and dividend-paying stocks, in order of tax efficiency.
- In the May 2005 issue, readers were taught how to withdraw money prudently in retirement, so as to make that money last.
- The October 2005 issue delved into dividends and offered some recommended dividend payers. (Robert also discussed dividends in this article and this one, mentioning firms such as Johnson & Johnson, Intel, Home Depot, Coca-Cola, and Procter & Gamble.
These articles may also be of interest:
- Can You Retire in 2016?
- Prepare for a Gruesome Retirement
- $1 Million May Not Be Enough
- 9 Retirement Killers
Selena Maranjian 's favorite discussion boards include Book Club, Eclectic Library, Television Banter and Card & Board Games. She owns shares of Inside Value recommendations Coca-Cola and Home Depot, as well as Income Investor selection Johnson & Johnson. Intel is also an Inside Value recommendation.For more about Selena, viewher bio and her profile. You might also be interested in these books she has written or co-written:The Motley Fool Money GuideandThe Motley Fool Investment Guide for Teens. The Motley Fool is Fools writing for Fools.