Author: wizardpc

Dr. Thomas Stanley had a post yesterday about the houses that millionaires live in, and his figures may shock you.

It seems that a whole lot more millionaires live in houses that cost less than $300,000 than those who live in homes that cost more than $1 million.

The median home price for the millionaires in his study was 1.49x yearly earnings. If you think about it, that’s kinda low for most people. Using this number, someone who makes $100,000 a year would live in a house that costs only $149,000. A quick look around the web shows people recommending 2x-3x annual income as the commonly accepted number.

I don’t want the commonly accepted number, because the common man is broke. I’d rather use the exceptional number used by the millionaire!

Let’s look at this ratio in the context of this post. If you’re annual taxable income is $100,000, then according to PayCheckCity.com your take home pay will be about $6100/month. A $149,000 with 20% down means a $119,200 mortgage. If you get a 15 year mortgage at today’s rate of 3.5%, that breaks down to $852/month. Let’s say that adding taxes (lot’s of taxes in this case) and insurance puts you at $1100 per month.

That’s about 18% of take home pay, which is less than the 25% maximum Dave Ramsey suggests. For the record, ours is about 14% of our take home pay.

Just one more thing to think about when purchasing a home.

First, let’s do a quick review of The Baby Steps:

1. Save $1000 as a starter emergency fund.
2. Pay off your debts, smallest to largest. Pay minimum payments on everything except the smallest, and absolutely freaking kill the small one.
3. a) Put 3-6 months of expenses away into a Money Market. This is your fully funded emergency fund.
   b) Save for a 20% down payment on a house, plus all closing costs and moving expenses, including all that furniture you want to buy.
4. Invest 15% of your gross pay into retirement accounts.
5. Save for your children’s education.
6. Pay off the house.
7. Put your former house payment into mutual funds.

Saving for retirement is Step 4. You shouldn’t be doing any retirement savings before finishing you’ve paid off all your debts and have a good emergency fund. If you were a renter when you started, you’ve put down 20% on a house or bought one outright. Now it’s time to save for retirement. This is where it starts to get fun.

Note: I am not a Certified Whatever Planner. Get a professional to help you out. Use what I have here as a starting point.

You want to start wherever you have a match. After that, you want to go for after-tax retirement vehicles and then pre-tax ones. Once you get to 15% of your gross pay (not your take-home pay), you stop. For now. When we get to Step 7, you max out everything you can.

Let’s talk a bit about pre-tax and after-tax retirement. In a pre-tax account like a traditional 401(k) or a traditional IRA, your contributions go into those accounts and are not hit with an income tax. So, if you make $50,000 a year and contribute 3% to your 401(k), the entire $1500 is deposited. If you also put $1500 in a traditional IRA, then you get a $1500 tax deduction (I think. I don’t use one, so I don’t have experience with how that works). Those investments are taxed when you pull the money out.

With an after-tax account, the contributions are made with after-tax dollars, but you’re not taxed again when you pull the money out. It grows tax-free.

Now, which would you rather pay taxes on? The smaller amount that you actually invested, or the giant amount you get at the end when you factor in compound interest? Charles Schwab has a great tool that shows you the difference. I encourage you to do your own research here, but you’ll probably come to the same conclusion I did. My father didn’t, because he was sure that the government would change their minds later and decide to double-tax the after-tax investments. That’s not really a rational exercise because if you follow that far enough then you shouldn’t be investing at all because the government will eventually go full-commie and take everything anyway. Some people do have that attitude, you know.

Anyway.

When picking investments, diversity is your friend. Single stocks are not diverse. Just ask former Enron or WorldComm employees about what happened when they filled their 401(k)s with company stock. Single stocks are too dangerous to rely on, but you can certainly play with them.

Mutual Funds are where it’s at, so that’s all I’m going to talk about here. Mutual Funds are basically collections of hundreds of different stocks. They are automagically diverse, but usually they invest in companies that are somewhat similar. You want to get several Mutual Funds so that you can diversify your diversity 😀

There are several different categories of Mutual Funds, and your information packet you get from HR or your investment guy will separate  the funds you can choose from into these categories. I usually pick the top performing fund from each category, as long as it is at least 5 years old. My preference is a fund that has better that 13% return over 30+ years, but you don’t always have that option. Investing is the long game, so only look at the lifetime returns. Who cares if the fund made 30% last year if it’s had a -50% return since 1992? More realistically, you might see a 3% lifetime return, and that is still terrible.

Your matching plans will come from your employer. You don’t get much choice here, but you will should get to choose among several mutual funds. You will likely be limited to the funds offered by the company your employer chooses to administer their retirement plan. For example, my choices are limited to about 30 of the over 7,000 mutual funds in existence.

There are two types of 401(k)s: Traditional and Roth. Both allow an employer match, and in both cases the match will go into a Traditional 401(k)  as a pre-tax investment.

If you get a traditional 401(k), contribute up to the match and then start funding a Roth IRA. If you’ve fully funded the Roth IRA, go back to the 401(k) and contribute more. Let’s go through an example of what this would look like:

Lets say you make $60,000 a year and your company matches the first 2% of your contributions. Fifteen percent of $60,000 is $9,000, so need to walk through our options until we hit that number. We start where we have the match, so there’s $1200. Next, we move to the Roth IRA. For 2011, you can contribute $5,000 to the Roth IRA. You fully fund that at $416/month. Now we have $2800 left that we need to invest, so we go back to the 401(k) and add another 4.7%.

You end up with 6.7% going into your 401(k) and 8.7% going into your Roth IRA. You also get an additional 2% put in by your employer as a bonus. We don’t count that in the 15% number because employers will sometimes decide not to match that period.

If your employer offers the Roth 401(k) option, take it. If you do, and the fund choices are excellent, and you don’t already have a Roth IRA, just put the entire 15% in. Otherwise, do the same thing here that we did for the traditional 401(k).

Those are the basics. Get with your local investment guy and start cracking!

In Monday’s post I covered the parameters for getting a mortgage. Most people don’t want to save up for a house, because it takes a long, long time. This post is math-heavy, so just be prepared for that.

Let’s say that three years later you decide you need to sell. Because things in the housing market have been totally jacked up for the last couple of years, let’s just assume you can sell the house for the same $187,500 you paid for it. You’ll need to pay the realtor 6% and you’ll probably have to pay 3% towards the buyers’ closing costs. That leaves you with about $170,625 you get from the sale.

With the 15 year, you have $124,621.27 left on your mortgage so you walk away with a check for $46,003.73. Including your down payment, you’ve paid $75,120 in to the house. You have a loss of $29,116.27. That’s about $810 a month.

With a 30 year, you have $141,153.02 left. You get a check for $29,471.98. You’ve paid $62,520. Your loss is $33,048.02. That’s about $920 a month.

At the five year mark, the numbers are a $43,418.54 loss for the 30 year and a $36,438.31 loss for the 15 year. That’s $725 and $610 monthly.

How much is your rent that you think you’re throwing away?

Put another way, to break even on your $187,500 house five years later, you’d have to sell it for (adjusting realtor fees and closing costs for the higher prices) $236,000 if you had a 30 year, or $229,000 if you had a 15 year. If you paid cash, you’d only need to sell it for $206,000 to break even. These figures don’t account for other costs such as property taxes or new roofs. The first $250,000 of capital gain is tax free assuming you’ve lived in the house three of the last five years, so that doesn’t apply here.

The point of all of this is this: Your house probably isn’t an investment in the short term, or at least not as good of an investment as you think. In order for you to break even, your house would have to annually grow in value at 5.5% for the 30 year, 4.4% for the 15 year, or 2.0% if you paid cash. I want you to get a house. I really, really do. I just don’t want you to get a house prematurely because you think it’s cheaper than renting.

Step 1: Determine your maximum price
When we started looking for a house we didn’t have much of a down payment. We were still socking away money because we had moved the Debt Snowball payment into the Emergency Fund payment, so switching to the Down Payment Fund was easy. Didn’t feel a thing. Remember the formula for getting a mortgage is at least 20% down and a payment no more than 25% of your take home pay. You have to meet both criteria. At this point in our process, the down payment was our limiting factor. The good news is that every payday we upped the maximum price of houses that we were looking at since we were increasing the Down Payment Fund. Add $1,000 to the fund, and you can look at houses that cost $5,000 more than last time.

We started off looking at some really, really cheap houses. We were looking at houses in the $80,000 range in a market where the median home price is $200,000 just to give you an idea. (One quick note: At the time, no lender would give a mortgage less than $50,000. Your minimum price would then be about $65,000 to account for your down payment.) As our down payment grew, our maximum home price grew as well. Eventually, we would have gotten to the point where our down payment would be more than 20% in order for us to keep the mortgage payment at an acceptable level.

We made an important decision here, by the way. We have several friends who had bought houses based on both spouses working, because they knew that mom would always want to work. Then, they got pregnant. Mom changes her mind and wants to stay home but can’t because they can’t afford the house without her income. Given the choice between continuing to work or moving to another, cheaper house, every couple chose to have mom continue working. After seeing that happen, we decided to base our maximum mortgage payment on my income only. If Mrs wizardpc decides to not go back to work after lilwizard comes home, it’s totally okay. If she does go back, that’s okay, too! Right now the plan is for her to work part time, but the important thing here is that it’s her choice, and she has that choice because we opted for a smaller mortgage. The best thing about getting out of debt is that you have more choices. Anyway, just something to think about.

So let’s say your take home pay is $4200 per month. From yesterday’s numbers we know that means your maximum mortgage should be about $150,000. To hit your maximum, you’d need to buy a house for $187,500 and put $37,500 down.

“But what if I want a $200,000 house?”

Well, since you’re maxed out on your monthly payment, your down payment has to be larger than 20%. In this example, you’d need to put down $50,000.

So you wind up with two formulas. The first one is:

House Price = Down Payment x 5

Use that formula until you get to the maximum loan amount you’re comfortable with. Once you hit that point, your new formula is:

House Price = Maximum Loan Amount + Down Payment

I feel like I should remind you that your down payment is not everything you have saved up to this point. Your down payment does not include your Emergency Fund! Your down payment does not include any closing costs, loan fees, or moving expenses! You have to save for those, too! Your realtor will be able to give you a good idea what to expect for those costs, but an extra 5% of purchase price is probably a safe number.

The temptation to use some of your Emergency Fund money to pay for closing costs or as part of your down payment will be strong. DON’T DO IT! You may move in to the house and have the heat go out, or the pipes may freeze, or you might accidentally flood the bathroom! Your transmission might die! If you spent your Emergency Fund, you’ll have an even bigger problem!

Now that you know what your maximum price is, you can actually start looking at homes.

Step 2: Determine your minimum requirements
Talk this one through with your spouse, because otherwise you might be looking for two different things. Your requirements may change as your maximum price goes up. For example, when we were looking at $80,000 houses our square footage requirements were much smaller than when we were looking at $145,000 houses. Number of bedrooms, bathrooms, garage spaces, etc. When we started I think my only requirements were three bedrooms in a neighborhood that didn’t scare the crap out of me.

Step 3: Getting professional help
At this point, you should have a buyer’s agent. A buyer’s agent is your realtor. They may or may not also sell houses. Getting an agent will allow you to get inside homes and they will also help navigate the paperwork when it’s time to buy. They’ll also do the negotiations. Get a buyer’s agent. This is non-negotiable.

You’ll also want to get pre-approved for a mortgage at this point. You’ll lock in your rate when you pick your house. Get with a local mortgage broker so you don’t have to do everything by fax.

You’ll probably want to interview several agents and brokers.

Step 4: Finding houses to look at
This is where having really good requirements helps. Your agent will be able to sign you up for daily emails of every house that either comes on the market or has a price change that meets your requirements. You may also check out your local MLS. Here in the middle Tennessee area, that’s RealTracs. It’s a very powerful service with lots of granularity. Sites like Zillow may or may not include the entire MLS listings for your area. Ask your agent.

The internet is your best friend here. We literally investigated every house in an eight county area. On the first pass, we verified that the requirements were okay. On the second pass we verified that the location was okay (ie not in a scary neighborhood, or not so far from work that the commute would be excruciating).

Your agent and broker may also know where to get lists of bank-owned properties. There are so many foreclosures out there that you’d be stupid not to at least look at them.

Step 5: Looking at houses
Once we had a list of houses, we mapped them out. We usually did this on Friday night, and on Saturday morning we would leave with our map and printouts of all the houses we wanted to look at. I think we typically drove by 20 houses in one day. Doing this also allowed us to expand our knowledge of which neighborhoods were safe and which ones were scary, helping to limit our searches later.

If any of the houses excite you and your spouse, call your agent to schedule a showing.

Your agent will also probably try to get a list together for you and show you a bunch of houses at once. The agent will actually be able to take you inside, whereas when you go looking by yourself you’ll just see the outside.

I think we looked at houses for 4 months before we actually bought one.

Step 6: Getting the house
Once you’ve found a house, it’s basically up to the professionals you’ve hired to take you through the process. If you found good ones, this will be a smooth process. If not, well…you have my sympathies.

In any case: Congratulations!

Tomorrow I’ll cover some of the math showing why keeping a mortgage–even a 15 year one–makes your home a bad investment.