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Situation: Around 1,000 month disposable between 2 of us. Current mortage outstanding balance is 95k on a 120k property, saving almost entirety of disposable income.

Now the situation has arisen where a move is required.

On one hand, it is affordable and desirable to upgrade and purchase a property with up to 300k value. This would mean lowering disposable income to 400 per month and would extend the term from 15 years to 25.

On the other, we could purchase a similar property value and pay off the mortgage in 5 – 7 years. but, that would mean we benefit less from house price inflation (obviously 10% on 120k is much less than the same inflation on 300k.)

  • LTV is 90%
  • Age is 30 yrs
  • Planning to live in property for 7 - 8 years

What is the best financial decision here? Higher debt, higher asset value, but less disposable, or the inverse?

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    With a 90% LTV, will you have to pay PMI? That's wasted money. What's the impact of one of you losing a job, staying home with the children, etc? What's the mortgage:income ratio? Above 3.0 is risky. The lesson of the 2008 Crisis was never over-buy. – RonJohn Feb 9 '18 at 14:01
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    Without knowing a lot more details, answers can't be more than generalities. I keep going back to risk management. Are you currently a two-income household? If so, then what's the mortgage:income ratio if you lose your job? If your partner loses his/her job? If you're currently a single-income family, then since the m:i ratio is less than 3.0, the $300K house is probably a good deal. – RonJohn Feb 9 '18 at 15:18
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    The curmudgeon in me is asking how onerous the $120K house really is. There are more than a few billion people who would consider "a 100 year old stone building in a busy area" to be a palace. Are there any houses in the $200K range? – RonJohn Feb 9 '18 at 15:19
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    "without drastically increasing lifestyle" you're right that this, then is a poor choice. Remembering the 2008 recession, and how many people lost their houses from over-buying, I just don't want that to happen to you. – RonJohn Feb 9 '18 at 15:35
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    @Cloud I have exclusively purchased houses along the path of future public transportation rail routes, but I haven't let the projected growth influence my buying decisions. I would be substantially better off if I had gone to the max of what lenders would throw at me, but it can just as easily go the other way. I am more comfortable missing out on some gains than fretting over where the money will come from if things go south. Let the projected growth influence where you buy maybe, but not how much you spend. – Hart CO Feb 9 '18 at 17:35
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Your comment about quality of living is the answer to your own question.

In general, it's best to live in as small a house as one can be comfortable.

You offer no other real details beyond $1,000/mo disposable income. Is that after depositing 15% to your retirement accounts, and having a fully funded emergency fund? Is it truly extra, or does it get spent, and trying to send such a large chunk ($600) to a mortgage will result in a shortfall, and credit card debt?

In my opinion, the best solution would be to get a moderate house, in between the current two choices, but get a 30 year loan. Once you settle in, see how much of that $1000 you can send to the mortgage to pay it faster.

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    Almost exactly my thoughts on the topic. – Hart CO Feb 9 '18 at 15:47
  • @JoeTaxpayer Thanks, really appreciate the info. The 1000 is truly disposable and after retirement savings and expenses. Now, if I could afford payments on a 15 year loan, would a 30 year one not just end in less equity and more interest paid (even if I paid it off in 15 years)? As well as a higher interest rate? – Cloud Feb 9 '18 at 16:45
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    @Cloud Well they'd both end in the same amount of equity, but you're correct that you'll get a lower interest rate on a 15-year mortgage and therefore pay less than a 30-year even if you pay the 30-year off in 15 years. It's just a question of whether you're comfortable with having a fixed higher monthly cost to save some interest or if the extra interest is worth the increased flexibility you'd get with a 30 year. – Hart CO Feb 9 '18 at 17:22
  • The closed question links to a good one regarding 30 vs 15. Ultimately, that’s a decision between a bit more cost vs a lot of flexibility. With today’s low rates the 15 payment is about 50% higher even with a .25% lower rate. – JoeTaxpayer Feb 11 '18 at 21:46
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Other things to consider:

  • Bigger house generally leads to higher costs besides the purchase price. Utilities will be higher, general repairs will be higher, Taxes (I assume you figured them in, but still worth mentioning) will also be higher.
  • Does the commute change between the properties ? Cost/time increase in commute (or ideally decrease) can significantly improve overall satisfaction
  • How are you investing your current savings ? Are they making you money. If they are not, investing them in a better property would likely be beneficial.

If we're leaving out all other factors (including the ones above) I would opt for a smaller house (that I'm happy with) and investing the disposable income elsewhere (401(k), index funds, etc.).

5

As a basis:

  • Twenty-five year mortgage schedules are rarely, if ever, the solution. Because the term is so long, the interest in the early years is almost the entire payment. Basically, if you move in seven years again the equity uncovered is pretty low.

  • Residential homes gains aren't good investment vehicles. After adjusting for inflation, home prices tend to be flat. Put another way, don't think you'll come ahead by getting an expensive home loan at 4% on a property that will gain 2% *. (Exceptions of course exist.)

You could upgrade to a 200K home on a 15-year or have a 120K home and do the 5-7 year payoff as you suggest. I think 300K over 25 is silly.


* It sounds like the home loan will be 200K on a 300K property. In year one, the interest with those numbers will be 8K while the appreciation will be 6K. Second year it will be ~8K vs 6.12K. Third year ~8K vs 6.24K. Eventually you'll come out a head but if you move within a few years, you've paid more in interest than appreciation. (That extra money spent on interest, compared to a 90K mortgage, could have been invested elsewhere.)

  • Hello, sorry no my LTV is 90% so mortgage would be 270k – Cloud Feb 9 '18 at 13:32
  • Also, I understand the sensibilities of your answer, but the quality of living in a 120 vs 300k home where I live is a world apart. You are talking a 100 year old stone building in a busy area vs a newly built executive suite out in the country. – Cloud Feb 9 '18 at 14:53
  • @Cloud is the "Out in the country" home an upgrade? If the commute is an additional 30 miles away compared to a 120K property, that is 60 miles a day, times .51$ per mile, times 5 days per week, times 4.3 weeks in a month, times 172 for ten-year opportunity cost, is 113,158.8 per car. – Lan Feb 9 '18 at 15:18
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    @Cloud Is the middle ground feasible, 200K at 15yr or with a 5/1 arm? – Lan Feb 9 '18 at 15:19
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    Upvoted for the second point. A primary residence should never be treated as an investment. Unlike true investments, the carrying costs are substantial, not just due to the mortgage, but also taxes, insurance, maintenance, utilities. The main purpose of a primary residence is to put a roof over your head. – njuffa Feb 10 '18 at 4:12
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It actually depends on other factors. For example, below should be considered:

  1. Your age, will the 25 year mortgage last into your retirement. If it does, then certainly it is not desirable
  2. Your retirement plan. Lowering of disposable income means less funds available for retirement investment in other asset classes. If your retirement planning suggests you have to invest more than 400 monthly, then 300K property becomes non-workable
  3. The final use of the property. Will you sell it or will you stay in it. If you stay and settle in the property, then the actual value of the property is less meaningful as you probably will never monetize it.
  4. The actual capital appreciation rate, which is very dependent on the situation and other factors (it may not be 10%)

In general any mortgage or debt should be carried only for a reasonable time. Probably (given above), 5-7 years could be a better option.

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Interest payments on mortgages are roughly the same as rent. If you buy a more expensive place, you'll basically be paying rent to you mortgage company through your interest payments. So this comes down to whether living in the more expensive place will provide you with value greater than the greater rent/interest, plus all the other costs of a larger place.

In an efficient market, price increases will be priced into the interest rates. So the only reason that a higher asset price would be a plus, rather than a minus, would be if you think that you can predict price increases better than financial experts. And even then, your higher interest payments would be "wasted"; it would be more profitable to buy a small place for yourself and a medium place as an investment property, and then you could offset the interest with rent.

  • So you're saying real estate generally doesn't grow in value beyond that of interest rate plus inflation? I didn't know that before if so. – Cloud Feb 12 '18 at 11:35
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Creating an answer as requested...

While this is somewhat ancillary to the question asked, I suggest looking into the merits of keeping the current home and turning it into a rental property. If your market would support renting it out at a rate that covers the costs of keeping it, doing so could put you way ahead in the long run.

I recommend doing a bit of research on your local rental rates and property management fees. Essentially you are looking for projected rent to cover, or slightly exceed, the current mortgage, taxes, insurance, management fees, and other expected expenses. A slight deficit might be acceptable to you too, but be realistic about how much you are willing to put into the old home as opposed to the new, and when you will be able to recover those expenses.

Don't fall into the trap of trying to manage the property yourself. You are moving away and will not have time to deal with the day to day issues of keeping the place maintained and occupied. A good property management firm is well worth the cost.

The plus side of going into this arrangement, if things work out, is that you continue to build equity in the current home, without significant negative impact to your personal finances. Then once the mortgage is paid off, that portion of the rent payment converts to income for you.

Some of the major risks of this arrangement are:

  • The place could sit vacant, causing you to have to cover its mortgage and expenses out of pocket.
  • Significant repairs could be needed earlier than expected (they will come, but hopefully not until the place has generated enough income to offset the cost), causing you to have to come out of pocket to keep the place habitable.
  • Someone could get injured and try to sue you as the property owner.

Again, a good property manager and properly crafted insurance goes a long way to mitigating these risks, but they never go to zero.

If you decide to go this route, I strongly advise setting up a separate set of accounts, and keeping books on the place as if it were a business. This helps keep the income and expenses of the property separate from that of your family, and forces you to make a conscious decision any time you move money from one to the other. I would also suggest talking to an accountant and/or attorney about the advantages/disadvantages of establishing a LLC or corporate entity, and turning the property over to it.

IF this seems like something you want to do after looking into everything, it doesn't necessarily have any great impact on your decisions with regards to the size/expense of your new home. Although, that you are still carrying the existing mortgage could impact your financing options for the new purchase, potentially forcing you into the smaller home. In the absence of that however, going with the smaller new home leaves you with more disposable income to help offset the risks noted above.

protected by Chris W. Rea Feb 14 '18 at 13:20

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