Will purchasing a home help or hurt financial independence?
A few approaches to a complicated question.
A few approaches to a complicated question.
When I first discovered financial independence (FI or Effai), life was simple. I could plug in a few numbers into an online calculator and get a rough idea of when I could “retire”. After all, the principal is very simple. Mark your expenses on a graph. It should be a horizontal line with a slight upward slope to account for inflation. Plot your expected passive income each year. It should be a line with a steeper upward slope. Once those two lines intersect, congratulations, you are financially independent.
Figuring out your expenses is simple. Take your income. Subtract your savings. Whatever is left is your expenses.
How about your passive income? That’s easy as well. Take your net worth — all money you have invested. Apply the 4% rule (I have yet to write about it. You can Google it for now. In short, you can consider 4% of your net worth as passive income for the year). Done.
That’s all fine and dandy while you are living in your mom’s basement like I did. At some point though, you are likely to get your own place that comes with a mortgage and its own set of responsibilities. That’s when things get tricky. The fundamental idea doesn’t change. You still need to wait for the expenses curve to intersect with the passive income curve. The complexity is identifying those expenses.
While building Effai.me I had to think long and hard about it because I just bought my own house. I was trying to see what kind of an effect it would have on my Effai date. After combing through the interwebs and researching through the available literature, the answer was… it depends. It depends on what you want to do. Turns out, you have three choices.
Sell your house. Assuming the price of the house increases over time, you may find yourself at a point where selling your house could net you a big pile of money. That could significantly shorten your time to Effai. Once you sell it, the passive income you could generate would skyrocket.
How would you know if this is a good option for you? It’s a little more involved. You have to know several things.
Your mortgage payments
Your home maintenance cost
Your property tax
The sum of the three above is your housing cost. In addition, you’d need to know your new rental costs. That’s just one more number.
The cost to rent something equivalent.
When you sell, you bring your housing cost down to zero but introduce a new expense — rental costs. The two expenses are likely in the same ballpark and mostly cancel each other out. Selling your house and renting is usually your fastest way to Effai.
Of course, most people wouldn’t dream of ever going back to renting. After all, they’ve “left college years ago”. In that case, you are left with two other options.
Pay off your mortgage. In a way, this is a mirror image of selling your house. Instead of putting money to work for you, you decide to reduce your expenses. This strategy will eliminate your monthly mortgage payment (Yay!!). However, you are still left with the maintenance bill and the always increasing property tax (Boo).
This could be a great strategy if you don’t have much debt left on your mortgage. A simple rule of thumb is this:
If the mortgage payoff amount cannot generate more passive income than your monthly mortgage payments, go ahead and pay off your mortgage.
Don’t (or never) pay off your mortgage. You probably saw this one coming. If the rule above does not hold, this is for you. You are likely to find yourself in this situation if you bought the house recently and you still have a large amount of debt left. In that case, it may be cheaper for you to just keep your expenses as they are — mortgage payments included — and have your money passively pay for those expenses. This is a temporary solution since at some point you’ll have so little debt left you may want to pay it off. However, in the interest of retiring as early as possible this is definitely a possibility.
You’ll be glad to know that Effai.me runs all three of these scenarios for you. It is very biased towards retiring early. I hope the above made sense. Don’t hesitate to reach out if you need some clarifications.