Home prices are soaring in many parts of the country, with sellers receiving over the asking price in what essentially amounts to an auction sale process. In market conditions like these, it’s easy to get caught up in the moment and pay more for a home than you had originally intended. Yet if you are in the market for a new home, it’s important to not sabotage your financial future by buying more home than you can afford.
Increase in costs
Buying a more expensive home increases your cost of living in important ways, several of which you may not have considered.
With a more expensive home, you will likely need a larger home loan to complete the purchase, even assuming you roll all your current home equity into the new residence. With a larger loan comes larger monthly loan payments, which is an obvious cost increase. You will eventually pay off the loan, but in the typical case, you just committed yourself to higher payments for the next 30 years, or until you downsize later.
A less obvious cost increase comes from increased property tax. In most jurisdictions, property tax is based on home value, and so with a more valuable home, your property tax will increase, possibly substantially. In California, the increase can be extreme. For example, a home purchased in Santa Clara County, California, for $425,000 just over 20 years ago and currently worth about $1.3 million has an assessed annual property tax of about $8,200 per year. If that home were sold, the new owners would pay property tax of about $15,600 per year (on a newly assessed $1.3 million value). If the current owners decided to move up and buy a larger home worth $2 million, their property tax would increase from their current $8,200 per year to about $24,000 per year—over three times the amount they are currently paying! Property tax is particularly onerous because (1) it generally increases each year and (2) it continues for as long as you own your home. Unlike your home loan, property tax never gets paid off. That higher level of expense continues indefinitely, potentially requiring you to work longer and accumulate more savings to support the extra expense in retirement.
The transaction costs of selling your current home are another set of expenses many people don’t think about when moving to a more expensive home. Selling your current home typically will cost 5% to 7% of its current value. If your home has increased in value, you may also owe capital gains tax on the appreciation. You may have less home equity available to roll into your new home than you are expecting due to the leakage from real estate brokerage commission, other transaction costs, and taxes.
Two more expenses that aren’t often top of mind are homeowners’ insurance and home maintenance. You will probably get a quote for new homeowners’ insurance while buying the new home, so that increase in expense will be visible. Home maintenance, however, is more obscure; you don’t know exactly what will be required. But it’s a good idea to budget for increased home maintenance costs on the new home as well. While maintenance costs can vary widely depending on the age and construction of the new home, a reasonable estimate is 1% of the property value. Once again, this expense is based on property value, and a more expensive new home means this expense climbs up. If the new home is newly constructed, maintenance expenses may be low for the first several years. However, if the new home is older and the prior owner did not maintain it well, there may be extra deferred maintenance costs you will need to pay that could easily exceed 1% per year, especially initially. This is one reason it’s so important to have any property you are considering purchasing inspected, particularly if you’re buying the property “as is,” which has been more common in the current frenzy.
Another cost to consider is renovations and improvements. While they may not be absolutely necessary, it’s common to want to change finishes and make other improvements in a new home to suit your tastes. You may not know what you’ll want to change until you’ve lived in the new home for a while, which makes these costs hard to predict. If you have a larger renovation planned, you may have extra moving and storage costs as well. And don’t forget new furnishings. Sometimes the old furniture just doesn’t quite fit the new home or the move points to how worn out it is.
Decrease in investments
In addition to the direct costs of owning a more expensive home, there are also indirect costs that can negatively impact your overall finances.
By spending more on a home as described above, you will probably also be reducing your ability to save and invest (if you aren’t able to reduce your spending in other areas to compensate). By saving less money now, you accumulate less money for retirement or other important intermediate financial goals, such as saving for the kids’ college education. Because money grows exponentially, your lost investment income can be substantial over time.
Another way to think about it is this: in buying a more expensive home, you are shifting your assets from “working assets” to “lifestyle assets.” Working assets include your taxable investment accounts and retirement accounts. These are assets that are earning money for you—they are working now so later you don’t have to. Lifestyle assets, such as your home, are “use” assets. You use them for living. They don’t necessarily grow like investment accounts, and they aren’t available to pay for living expenses in retirement. Finding the right balance of working and lifestyle assets is important for meeting your long-term financial goals.
It’s true that your home may increase in value, particularly in some markets such as California. However, to access the appreciation in your home value, you will need to sell the home. Unlike an investment portfolio, homes are not divisible—you can’t list just the living room for sale to raise cash in retirement. For that reason, it’s best to think of your home as a lifestyle, or use, asset and not a working asset.
How to make the call
In summary, buying a more expensive home has two main impacts on your finances: (1) increasing your annual housing-related costs and (2) reducing the amount of money available to save and invest, thereby reducing the total value of your investments over time (potentially substantially).
Even though online calculators might say you can afford a bigger home, and your lender says you can qualify for the loan, the reality is by overreaching to buy a bigger home, you may be inadvertently pushing out your retirement date, or worse. A financial planning technique known as scenario analysis can help ensure you don’t pay more for a new home than you can afford over the long term, and you don’t pay an amount that would prevent you from reaching important goals, like paying for the kids’ college or retiring on time. From there, you can make a thoughtful decision you won’t regret down the road.
Parkworth Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. To discuss your new home purchase and its impact on your long-term investment results and overall financial health, schedule a complimentary consultation.
