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How Much is Your Home Really Costing You?

I discussed in my last post, “The First Rule of Real Estate Investing,” that your personal residence is not an investment. Your home should be considered a consumer item just like your car, your washer & dryer, or anything else you buy for personal use. The reason I state this is because of all the operating expenses required in owning a home. So before moving on to real estate investing I thought it important to provide some thoughts on how the cost of your personal residence can impact your retirement planning and your retirement income.

First, because your home is for personal use and not an investment, you should try to minimize your housing cost in the same way you try to minimize your other costs of living, e.g., transportation, food, or vacation. In other words, you should buy the least costly home that will adequately serve the needs of your family. I know everyone wants the prestige of a bigger house in a good neighborhood with good schools. I am not saying you should not consider these things, but, in my opinion, in the past decade many people have gone overboard on the size and cost of their home (perhaps the recent housing bust has tempered this trend). I am not here to tell you how big a house you should have, but you need to be aware the cost of owning and operating your home will impact your retirement planning. For most Americans, if you expect to have any hope of retiring someday, you need to control your biggest monthly expense in order to be able to dedicate the necessary amount of money every month toward retirement.

Your situation could very well be that having a larger house was necessary while you were raising your children. But now the children are gone and, even though you don’t need the big house anymore, you want to keep it for the memories or in case your children come back to visit. This is fine if you can afford it. However most Americans will find it difficult to afford to keep their large family home and still retire. In any event, if you are at or near retirement with a home that is paid off or almost paid off, let me provide you another way to think about the cost of your home and how it relates to your other retirement assets.

How Much is Your home Really Costing You?

Let’s say you are a couple nearing your retirement date. You have a family earned income of $100,000 and have total retirement financial assets of $800,000. Your children are grown up and gone. Your 3,000 square foot family home is paid off and worth $400,000. Therefore, your total net worth including your mortgage free home is $1,200,000 (I am assuming here the couple has no other debt).

Let us also assume the following annual costs to own and operate your home.

In this example, your mortgage-free home will still cost you $13,000 per year for as long as you own your home. And this cost will increase each year with inflation. But what does this really mean to your retirement assets?

I am going to convert this $13,000 per year home ownership cost into a lump sum to determine how much assets you need to set aside at the beginning of your retirement in order to fund the annual $13,000 cost. I will use the inverse of the 4% rule to establish this amount. If you are not familiar with the 4% rule, you should read this previous blog post where I describe the rule in detail.

Applying the 4% rule means in order to generate the funds to cover $13,000 annual home ownership costs, you will need to set aside $325,000 of your retirement funds. Adding the $325,000 to the $400,000 value of your home gives $725,000. This means that $725,000 or 60% of your $1,200,000 net worth is being claimed by your housing costs in retirement.

Furthermore, if $725,000 of your net worth is being claimed for your housing expense, that leaves only $475,000 of your net worth available to fund other expenses. Applying the 4% rule to this $475,000 remaining asset base means you only have about $19,000 funds available per year for non-housing expenses.

If, in this example, you and your spouse currently earn $60,000 and $40,000 per year respectively, you would qualify for somewhere around $30,000 in total annual social security benefits (and this assumes the social security program remains unchanged; unlikely). That would mean you have a total of $49,000 annual income available to fund your non-housing living expenses. In this income range, you likely would pay little federal and state income taxes; let’s say your total tax obligation comes out to $5,000. Once on Medicare the out-of-pocket medical costs for a couple would be at least $7,000 each year (assuming the Medicare program as currently constituted remains unchanged). So after housing costs, taxes, and medical costs, you would have about $37,000 available for all other living expenses and retirement activities. Let’s analyze if this amount is realistic for this couple to live on in retirement.

Assuming that this couple believes they could live on the same amount of money in retirement as they do while working, that is, living on about $64,000 per year take home pay (after all taxes, after paying for employer-subsidized health care premiums, and paying the $13,000 housing costs), then the $37,000 available retirement funds represents quite a drop in living standards in retirement. However if, just before retirement, the couple is saving money at a $24,000 per year pace (remember the children are gone and you have no mortgage payment), then actually they have been living on about $40,000 per year for all other expenses. So, if the couple were truly saving this much, it may be feasible to live on $37,000 for all other expenses. This analysis shows why it is so important to get your retirement savings rate up as high as you can as early as you can as I discussed in my earlier Post #8. Saving early and often has a double benefit; it not only increases your retirement nest egg, it also gets you accustomed to living on less money.

On the other hand if it costs this couple $64,000 or even $54,000 per year to live comfortably, I would argue, in this situation, the couple would not retire at this point and would keep working. That’s fine if that is an option for you. But, even if the couple is willing and able to keep working, I think they should still consider whether they can afford to keep their big family home. They should think seriously about either buying a less costly home or perhaps consider renting.

Real estate investments can be a good asset to help support your retirement as I will discuss in future posts, but your personal residence can be a big drain on your retirement savings rate and your income during retirement.

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