Buying a home is typically the biggest financial decision in a person's life. To help you navigate this complex process, we've focused on answering three essential questions on the home-buying journey:

Should I rent or buy right now?
How much house can I afford?
How do I save for my down payment?

By addressing these key issues, we aim to empower you with the knowledge to make a confident, informed decision that aligns with your long-term financial goals and lifestyle preferences. Whether you're a first-time buyer or looking to upgrade, understanding these crucial aspects will set you on the path to successful homeownership.

Should I continue to rent or buy?

The decision between renting or buying a home is a fundamental question in financial planning. Housing expenses account for approximately 30% of the average American household's monthly budget, making it the largest expense category[1].

Purchasing a home offers several financial advantages:

Build equity:
- Contribute towards your own net worth versus that of a landlord
- Benefit from potential property appreciation
Tax benefits:
- Potential deductions for property taxes and mortgage interest
Financial stability:
- Fixed-rate mortgages offer predictable housing costs
- Protection against rising rental prices

However, it's important to consider the following factors before deciding to buy:

Upfront and ongoing payments: Purchasing a home requires significant upfront payments including a down payment, closing costs, and potential renovations. Additionally, homeowners are responsible for all ongoing maintenance and repair costs
Market fluctuations: Real estate values can decrease, potentially leading to negative equity
Reduced flexibility: Owning a home can make relocating more difficult for job opportunities or lifestyle changes

Don’t wait too long to purchase your first home. When you take out a mortgage, you begin the process of paying down your loan's principal balance. It's important to note that with a traditional mortgage:

Initial payments are primarily interest
The proportion of payment going towards the principal increases over time

This payment structure, known as amortization, means that your equity builds slowly at first but accelerates over time. Therefore, starting the clock on as soon as it is feasible from a financial and lifestyle standpoint can help you build wealth more quickly.

Overall, buying is typically the preferred option if:

You plan to live in the area for at least 5 years, and you don’t require living arrangement flexibility
You can afford mortgage payments for the foreseeable future, or if monthly rental income (assuming you’re OK being a landlord) can mostly cover mortgage payments should you need to relocate
Buying is more cost-effective than renting over your chosen time frame (see below)

Quantifying the rent vs. buy decision:

To quantify whether buying is more cost-effective than renting, potential homeowners can forecast two parallel scenarios over a specific time frame:

Continuously renting over ‘x’ years
Purchasing a primary home and selling it at the end of ‘x’ years

First, rental expenses should take into account future inflation- according to the U.S Bureau of Labor Statistics, annual rent prices rose between 3%-4% in the years leading up to the pandemic, though differences exist depending on the location.

In the home purchase scenario, additional factors beyond mortgage payments must be considered, including (but not limited to):

● Property taxes

● Insurance

● Repairs and maintenance

● Realtor and closing fees

● Equity ownership, including down payment and price appreciation

Ultimately, the analysis will differ by property and location, and the rent versus buy decision should incorporate both qualitative and quantitative factors.

As an illustrative analysis, we look at an example Ballaster client paying $5,500/month in rent and considering the purchase of a $1 million home. After running the calculations above, purchasing ends up with $82k of higher projected net worth after 5 years. We show an abbreviated summary in the table below:

*Note: Homeownership equity includes home value minus outstanding mortgages after 5% broker fees. Home value in 5 years assumes price appreciation of 3%/year. Homeownership costs include closing costs, property taxes, insurance, maintenance/utilities, and closing costs.

How much house can I afford?

To estimate a suitable house purchase price based on your financial situation, consider your income, debt, and the down payment needed to purchase a home.

The 28% rule states that your mortgage payments should be no more than 28% of your gross income. For example, a household earning $400k pre-tax income/year x 28% = $112k, or $9.3k/month as the maximum monthly cost to consider towards housing. You can then use a mortgage calculator (I use the Zillow one) and include mortgage, insurance, taxes, and maintenance costs to back into a purchase price representing a home costing $9.3k a month.

*Source: Zillow. Sample illustration assumes $18k/year property tax, $3k/year insurance, $6k/year maintenance/HOA*

A similar derivation of this calculation is to sum all of your monthly debt (mortgage, car, student loans, etc.) and ensure it’s no more than 35% of your gross income[2].

Important Considerations:

Upper limit: The calculated purchase price should be viewed as the maximum, not a target
Budget analysis: Ensure the housing costs don't impede other financial goals, such as retirement savings
Down payment: Aim for at least a 20% down payment to:
- Avoid private mortgage insurance (PMI)
- Reduce lifetime interest costs
- Start homeownership on solid financial footing
Market factors: In high-appreciation markets or low-interest-rate environments, a lower down payment might be justifiable

How should I save for a down payment?

To strategize how to save up for a down payment, consider your time horizon and risk tolerance when deciding how to invest your down payment assets. These assets should be carved out separately from a longer-term investment portfolio.

Consider keeping your down payment in low-risk, highly liquid vehicles if:

You plan to purchase a home within the next year
You have a low tolerance for investment market volatility
You have limited access to alternative funds in case of a shortfall

High-Yield Savings Accounts (HYSA’s) offer a good starting point versus keeping cash in a checking account given HYSA’s typically earn higher interest. However, savings account rates are sensitive to the Federal Funds Rate, which is expected to decline from ~5% to ~3% by 2026:

Fed Funds Rate Projections — Source: FOMC, St. Louis Fed, as of August 19, 2024

Higher Return / Higher Risk Investment Options

For those with higher risk tolerance and longer time horizon towards a home purchase, consider allocating your down payment towards:

A diversified mix of fixed-income investments
A modest allocation to stocks

As mentioned in a prior blog that discusses ways to earn more interest versus cash, fixed income is an asset class representing debt issued by corporations and governments, with steady interest payments paid to the investor as long as the issuer doesn’t default.

*Source: Vanguard, State Street, Invesco. Yield to maturity (YTM) as of 8/19/24 for VFISX, VCSH, SJNK, VWEHX. BKLN shows 30 day SEC yields.*

A core component of this portfolio may be comprised of Treasury Bills (T-Bills), which is an investment in short-term government debt. T-bills offer several advantages over HYSA’s:

Tax benefits: The interest earned on T-Bills is exempt from state and local taxes, whereas interest from HYSAs is subject to taxation at both the federal and state levels. This can result in a more favorable after-tax return for T-Bill investors
Locked-In returns: When held to maturity, T-Bills provide guaranteed returns, barring an unlikely default by the U.S. government
Liquidity: T-bills function similarly to bank certificates of deposit (CDs) but offer greater flexibility as they can be sold in the secondary market before maturity

Note that based on prevailing interest rates, modest price fluctuations may occur if sold before maturity.

To enhance returns, a portion of this portfolio can be allocated to stocks and high-yield/senior loans. High-yield/senior loans involve investments in lower-rated debt, which inherently carry a higher risk of default and potential loss. However, these investments typically offer elevated yields to compensate for the increased risk.

Stocks represent company ownership and are characterized by the highest potential for returns within this portfolio. While historical returns have been more volatile than fixed income, their ability to generate substantial growth can add to the portfolio’s performance.

It is important to note that high-yield/senior loans and stocks should comprise only a minority portion of the down payment portfolio to pursue higher returns while maintaining a balanced risk profile.

When constructing this portfolio, investors should consider a diversified mix of fixed-income investments with shorter maturities to align with a home purchase in 2-5 years. As you approach your target home purchase date, consider decreasing the proportion of riskier assets in your down payment portfolio. This strategy helps protect your savings from market volatility as you near your goal.

How do we work with clients saving up for a home purchase?

At Ballaster, we craft a customized portfolio for our clients by blending a proprietary mix of investments designed to potentially outperform cash and high-yield savings accounts. We carefully consider each client’s unique circumstances and preferences to develop a portfolio that balances return opportunities with downside risks.

For example, a client planning to allocate $200,000 toward a home purchase in 3 years may consider investing the proceeds instead of keeping it 100% in cash. As illustrated below, we create 2 alternate investment portfolio options with varying amounts of riskier assets to illustrate a risk/reward scenario.

The sample analysis shows that after 3 years, these alternate portfolios may earn between $7,000 to $10,000 more than the 100% cash portfolio[3]. We also balance these hypothetical returns with the downside risks of between 6-8% in case of a market sell-off. The client can then choose an option that fits with their return and risk objectives.

Ultimately, these alternate portfolios can help investors command a higher purchase price, or decrease the amount needed to save for a down payment. Consider your financial situation, goals, and risk tolerance, and consult a financial and tax advisor before making investment and tax decisions.

Source: Portfolio Visualizer, Morningstar. Historical data on Cash (0-3 month T-Bill), Short Term Treasury (VFISX), Short Term Investment Grade (VFSTX), High Yield Corporate (VWEHX), US Stock Market (VTSMX) between Jan 2000-July 2024

References:

[1] Motley Fool, ‘American Households' Average Monthly Expenses: $6,081’

[2] Chase, ‘What Percentage Of Your Income Should Go Towards Your Mortgage’

[3} We utilize a concept called rolling returns, which allows us to use historical data to estimate how a particular investment will perform over a 3-year holding period. We analyze how each portfolio performed over every 3-year period between 2000 to 2024 (e.g., from January 2000 to January 2003, February 2000 to February 2003, and so on, up to January 2021 to January 2024). By averaging all of these 3-year returns (there are 253 data points in total), we create a reliable proxy for how a portfolio might perform over a typical 3-year period going forward, though we note that past performance is not a guarantee of future results.

Maximum sell-off indicates the largest drawdown of these portfolios between 2000-January 2024. As per the Morningstar study ‘How Long Will It Take The Market To Recover’, most major asset classes recovered back to break even in less than 3 years on average.