Sweat the Big Things. Part 1: Housing - The Broke Professional

Sweat the Big Things. Part 1: Housing

This may be a bit much for your family of 3

 

The first personal finance book I ever read was The Automatic Millionaire by David Bach.  It was a great intro to personal finance and I would recommend it to anyone looking for a great personal finance book.  One idea the author introduced is called the Latte Factor.

The Latte Factor is the idea that if you cut out your daily $5 latte and instead invested that money in stocks, you would have hundreds of thousands of dollars available to you at retirement.

And it’s true!  If you invest $25 per week into a stock portfolio with a 7% return, after 25 years you will have $72,947.  This doesn’t take inflation into account, but not bad for skipping your daily coffee fix.

The problem is, millions of people have read The Automatic Millionaire, but millions of people are still spending $5 (or more) on their daily coffees.  Lots of people actually enjoy their lattes so giving them up consistently for decades is just not gonna work.

The Latte Factor essentially shows that cutting back on little things and then investing the difference can produce wealth.  And it certainly can.  But it’s not enough to change behavior since it takes decades to see any progress.  And even though $73,000 after 25 years is nothing to sneeze at, many people will need at least $1 million+ in retirement savings to have a similar standard of living as their working years.

That $73,000 suddenly doesn’t seem that impressive after decades of sacrifice.  So what’s the solution?

Focus on the Big Things

People would do better to focus on the big wins in life rather than focusing solely on little things like lattes.  This is especially true for professionals with high incomes but low net worths.  Saving $25 a week as a student would be huge.  Saving that much for a professional making six figures?  Doesn’t move the needle.  With higher incomes you need to set your saving sights a little higher.

There are three big things everyone should focus on:  Housing, transportation and taxes.  If you’re intelligent in these 3 areas and avoid the big mistakes, you will have more wealth than you can handle.

(This post will just focus on one of the big three:  Housing.  Stay tuned for upcoming posts on the other two)

Housing

Buying a home will be the biggest purchase most of us will ever make.  We will probably buy multiple homes during their lifetime, so getting this transaction right will set you up for financial success.

And getting it wrong will have you in a financial hole for your entire life.

There are three main factors that you need to focus on when buying a home:

1.  Credit Score:  Some people can buy a $500,000 house outright with cash. I plan to be one of those people but am not quite there.

Until that happens, me and most people in the country need to borrow money from a bank to buy that house. This type of loan is called a mortgage (which literally means “death pledge”)

Mortgage interest rates are pretty low nowadays, but to get the lowest of the low rates you need a great credit score.

Notice I said GREAT credit score and not just good. Having a great credit score can sometimes save you an entire point on your interest rate, which could result in tens of thousands of dollars of savings over the life of your death pledge.

If you don’t have a great credit score, read this and work on it.  Barring a history of bankruptcy or some major bills in collection, everyone should be able to increase their credit score year after year.

2. Down payment: Having a 20% down payment for your home purchase does three amazing things:

-Disqualifies you from having to pay Private Mortgage Insurance, which is usually about 1% of the purchase price of the home per year.

PMI, as it is known around the block, is what the lender will charge you in case you can’t come up with a traditional 20% down payment.  This goes straight to the lender’s bottom line and may or may not be tax deductible for you.  In any case, it’s a payment you can do without.

-Gives you instant equity in your home. This makes it pretty certain, though not a guarantee, you’ll make a good profit once you sell the house down the line. Not having enough equity will affect you during a housing downturn, like the one we had in 2008.

If you have little equity and your house loses 30% of its value, you are either stuck living there for a long time or have to go through a foreclosure or short sale to sell the house.

-Makes your monthly mortgage payment more affordable.  If you have a 20% down payment, it reduces the amount of mortgage you need and will give you some room to negotiate interest rates depending on your credit score.

If you stretch for a home by getting a low down payment loan, you are increasing your monthly payment which is holding you back from your other financial goals as well.  Plus, you’ll be paying the aforementioned PMI on top of everything.

Physician loans are a slight exception.  They allow you to get a home with a very low down payment without having to pay PMI.  On the flip side, they tend to charge slightly higher interest rates than traditional loans.

3.  Use numbers, not emotions, to buy a home:  Buying a home can be a highly emotional decision.  And that’s just how the home buying industry wants it.

There are many parties that end up making a lot of money from the sale of a home.  The bank that issues your mortgage makes interest off of you.  Your helpful and friendly agent also makes a nice percentage of the sale price.  Builders and contractors also make some nice money.  The only one not making money is you, the home buyer.

There is a whole industrial complex whose sole job is to make buying decision emotional for you.  That’s why they have certain types of lighting and music in stores.  The know emotional customers are overpaying customers, and that will keep the profits rolling in.

The best way to combat this is to work backwards by finding out what you can afford and looking for the best homes in that range.  This should be done before you look up homes or talk to an agent.  Model homes and home buying websites will try to make all their homes glamorous and “must haves”.  Starting your home search based on those false notions will lead you to pay more than you can afford.

A conservative rule of thumb I like is that your mortgage payment shouldn’t be more than 25% of your gross income.  So if you gross $5,000 a month, you shouldn’t be spending more than $1,250 on your mortgage.

And always remember to add 1% of the purchase price of your home as an annual maintenance cost.  Because maintaining a home will cost you, even if it’s a new home.  Many home buyers don’t account for this in their budget, and it can be a rude awakening that can slowly chip away at your checking account.

Your Home Will Make or Break You

As I said before, buying a home will probably be the largest transaction you will ever make.  This is one transaction that will make or break your finances.

By keeping a high credit score, having at least a 20% down payment and not buying a home beyond your means, you will save thousands upon thousands of dollars over the life of your loan.  Investing these type of savings can produce hundreds of thousands of dollars in retirement funds.

And that will buy you a lot of lattes.

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Comments

  1. Spot on. People buying more house than they can afford (with more borrowing than they can pay) is pretty much what led to the 2008 financial crisis.

    • This is true. You really have to look at your own finances in a bubble regardless of what’s going on in the world or what banks are offering you. If the economy is booming and home sales are increasing, but your budget doesn’t allow for a large mortgage payment at the moment, then you can’t afford a home.

  2. I agree with Miguel that buying more house than you can afford is a major problem. So is buying more house than you need, which you allude to in the picture of the mansion for the family of three!

    The additional carrying costs of a house with a lot of unneeded space can really add up over time. In addition to a larger mortgage payment, you’ll likely be paying more in taxes, insurance, maintenance, repairs, etc. every year as long as you own it. That extra bedroom “just in case we have a bunch of visitors” sounds nice, but costs a lot of money over time!

    • Exactly right and these are additional costs that you don’t have to worry about as a renter. That’s why renters have to think long and hard about going into home ownership. While interest payments are usually tax deductible, the tax savings can be wiped out by extra maintenance costs if you’re not careful.

  3. This is spot on. Buying our first starter home was definitely our biggest money mistake for most of the reasons you listed (no down payment, high interest rate, etc). We learned since, but that has definitely set us back financially in some ways.

    • The important thing is that you guys learned from it. Most people make the same hasty home purchases over and over again which can make financial independence out of reach.

  4. Great post! When we buy a huge house we can barely afford, we end up sacrificing just to keep up with the payments. Also spaces get filled with furniture we hardly ever use and sometimes we end up resenting that especially when we realize how much of a return we could have made investing the money that paid for that sq footage. One solution I’d offer for someone who’s stuck in a big home is to rent a part of it out or use AirBnB 🙂

    • Thanks yeah a house isn’t at fun when it starts taking up such a large percentage of your income. Renting your home is a good idea. Might as well make some income off the house!

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