Welcome to Taking Stock, a space where we can take a deep breath and try to figure out what the COVID-19 economy really means for our finances. Every month, personal finance expert Paco de Leon will answer your most difficult, emotionally charged questions about money. These last two years have forced many of us to reprioritize our finances, and there’s no clear road map for getting through the pandemic yet — but Taking Stock is here to help us figure it out together.
This month, we’re talking what to do when you’re ready to invest beyond the usual 401k and Roth IRA, but aren’t ready to buy a home just yet. What are your options for high-yield savings to maximize returns, with the ultimate goal of investing in real estate?
If you’d like to share your own experience (good or bad) with using high-yield savings options to invest your money wisely before you pull the trigger on purchasing a home, we’d love to hear from you.
Dear Paco,
I’m 25 and trying to think ahead on what I can be doing in addition to the “typical” investments that most people get out of college (401k, Roth IRA, etc.). I have pretty solid savings in the five-figure range and contribute 10% of my income to my 401k every month, along with $250 to my Roth. I want to invest in real estate, but with the state of the housing market that’s a little too far out of reach at the moment. My partner and I live in Boston and we’re worried we won’t realistically be able to buy here or if we’d eventually be priced out and have to move somewhere cheaper just to own. We pay more in rent every month than my parents pay for their mortgage, yet see no return because we don’t own the apartment. We’re super fortunate that we can afford to live here right now but down the road, if we want to buy, it probably won’t be here due to the upfront costs and rising housing prices.
I feel a little stuck at the moment with not knowing what else I can be doing with my savings other than having it sit in an account not generating any interest. I’ve heard high-yield savings accounts are a good option, but I don’t know enough about them to pull the trigger. I’d love to know more about how I can best use my savings to stretch the interest in the short and long term, with the goal of buying a home in the next few years.
Dear stuck at the moment,
Before we discuss financially preparing for a home, let’s first address the fact that you’re only 25, you have five figures in savings, you’re saving for retirement, and you’re laying the groundwork for buying a home. This is an excellent start. I hope you appreciate your progress thus far.
While comparing your rent to your parent’s mortgage is tempting, try not to. My parents’ mortgage is also cheaper than my rent in high-cost Los Angeles. But there is so much we aren’t seeing with these two data points. They were fortunate to be born when homeownership was plainly much more accessible. The economic circumstances are different.
Next, you mentioned that paying rent is not offering a return. While you’re correct, I want to note that renting isn’t wasting money. I know you didn’t say this, but for anyone reading that might subscribe to this belief, I want to address that rent is an expense that affords you something useful and valuable. In the same way that buying food isn’t a waste of money, neither is paying rent. Paying for rent gives an incredibly valuable thing: a place to live.
Now let’s talk about what renting affords you. In many ways, living in Boston is probably affording you opportunities that wouldn’t be available elsewhere. Although folks can work remotely, being physically present in a major city means you’re surrounded by more people and you have the chance to encounter valuable and enriching experiences that are unique to city living.
Renting also affords flexibility. By renting, you aren’t on the hook for costly property taxes and the inevitable maintenance expenses that come with home ownership. Instead of shelling out $10,000 for a new roof, you can invest that money.
Renting allows you the ability to build equity outside of homeownership. In addition to the example above, you can also take the difference between what you pay to rent your place and what it would cost to buy it (the mortgage plus insurance and property taxes) and invest it. For example, a mortgage for your current place would be $6,000, and a rent payment of $3,500 is a difference of $2,500.
The key to building equity in this way is to actually invest as much of the difference as you can afford. Returns on stock market investments are comparable and, at some points, have been even greater than returns on real estate. While we are comparing them right now, remember that the stock and real estate markets are two very different things. Real estate has inherent, tangible value, whereas investments don’t. The stock market is much more volatile, but real estate is less liquid, which means if you wanted to sell your home for cash, it would take much longer than liquidating your investments.
Of course, there is a trade-off with all this flexibility. You may feel insecure because you don’t feel entirely in control of your housing costs. At any moment, your housing situation might change. But, as your net worth grows, this might give way to feelings of security and stability.
Ultimately, the decision to buy a home, while largely dictated by circumstances, is also very personal. I’m not trying to discourage you from buying a home, but I want you to understand the benefits and not just the drawbacks of the position you’re in. This moment is also a good inflection point to examine the stories, beliefs, and cognitive biases you may have internalized about home ownership in America, like the idea that you haven’t “made it” until you own a home.
While purchasing a home can be a milestone in one’s life, it doesn’t have to be the main marker of financial success. There are quite a few high-profile, high-income personal financial experts that choose not to own a home and are sharing their stories to give us a different perspective. Jannese Torres talks about how buying a home left her financially worse off. Stefanie O’Connell Rodriguez, Tori Dunlap, and Ramit Sethi are all personal finance experts and high earners choosing to rent.
The last belief I want to address is that investing in real estate only happens through buying a primary residence or actual physical property. This isn’t the case. One way to invest in real estate without buying a house is through an investment vehicle called a Real Estate Investment Trust (REIT). A quick note: This isn’t investment advice. REITs are great because you can have the benefits of investing in real estate without the cons of actually owning real estate. Granted, owning shares of a REIT is not as sexy as owning property. With a house, you can invite your friends over for dinner and show off your purchase. (I guess you could always show them your account statement!) This brings up an essential point for you to reflect on: Do you want to invest in real estate, or do you want to own a home? Of course, there can be an overlap, but it’s also good to take a moment to recognize the distinction.
Like you, I plan to eventually buy a home even though it might not be the best return on my investment. That being said, here’s what you can do to fortify your finances and prepare for your big purchase.
Understand the economics of homeownership.
For most folks, buying a home is the biggest purchase they’ll ever make. Given those stakes, it’s important to spend time truly understanding the costs. While many of us know that affordability is a function of our income, many folks overlook other details.
Note that there are two categories of home costs: upfront costs and ongoing costs.
Upfront costs can include, but are not limited to:
• Your down payment
• Closing costs
• Inspection fees
• Appraisal fees
• Attorney fees
• Additional cash reserves
Ongoing costs may include:
• Mortgage payments
• Property taxes
• HOA fees
• Homeowners and mortgage insurance
• Home maintenance, repairs, and utilities
Start understanding what you can afford.
Knowing what you can afford is a good place to start. Although it can also be a harsh wake-up call, running preliminary calculations can give you a clearer timeline and a goal to aim towards. While models aren’t always 100% accurate, getting a broad view will help you understand housing economics beyond just what you need for a down payment.
There are lots of spreadsheets available for this. Here’s one (please make a copy and don’t request edit access!) I’ve had sitting in my Google Drive for years. I don’t even remember how I got it; maybe a coworker emailed it to me (perks of working in finance). Use models like this to help you understand the economics of homeownership. To ensure you have the full financial picture, make sure the calculator you use includes as many of the costs mentioned above as possible.
If the model shows you that you’re closer to buying a home than you realized, it might be a good time to find a lender to get pre-approved. A lender can also help you understand what incentives or government programs you might be eligible for as a first-time home buyer, like an FHA loan, a program meant to help first-time home buyers or folks with a less-than-stellar credit score. But beware of the hidden cost in the promise of reward: While a program like this allows you to put down less, you’ll likely pay more monthly interest.
Now that we know what direction we’re heading, it’s time to start stacking savings.
Think about your money being in separate buckets for separate goals.
You clearly understand that you need more money to afford a house. You mentioned having savings in the five-figure range. The first step is to figure out how much of that savings should be set aside as an emergency fund. The textbook definition of an emergency fund is at least three and up to 12 months of your expenses. If you have any cash left over after this calculation, it can be used to start a house fund (more on that shortly).
Keep your emergency fund in a high-yield money market savings account. Open up a high-yield money market savings account. Pro tip: Typically, the best yields are at online banks. The interest rate from a money market won’t be anything to brag about, but that’s OK. The goal with this money is for it to be available when you have an unexpected expense resulting from an emergency.
Your Roth IRA and 401k are in the retirement bucket. This money is earmarked for your cute, adorable, wrinkly, retired self. While some people can borrow from their retirement account for first-time home purchases, if it can be avoided, that would be best because the longer your money is invested, the more it will compound and grow.
Since you’ve started around/before your early twenties, you’ll want to keep it compounding for as long as possible. Time is an essential factor in the compounding equation, so you should try not to interrupt that process.
Start your housing fund. Save and invest more. Now that you have your emergency fund and your retirement fund buckets figured out, you need to start a house fund.
After you’ve run housing calculations, you’ll have a better idea of how much cash you need and in what timeline. You’re probably going to need a lot more money. You can grow your funds using high-yield money market savings, but the interest rate will be some of the lowest (and least risky) returns available. Again, this type of account is perfect for preserving cash for the short term.
If you want a down payment sooner, the best strategy is to increase your investment and savings rate by a lot. The pinnacle of ridiculous excellence to aim towards is saving and investing 30% of your income. Yeah, I know that’s three times your current rate. But you can increase your rate over time; it doesn’t have to happen overnight.
OK, I’m sure many readers are now screaming at the screen. Something along the lines of “THIRTY PERCENT?! WTF?! What kind of a monster recommends this, and in what world?!” I know exactly what I sound like: a person living in a different reality than other, real human people. And I am sorry about this. I’m sorry about the state of inflation, the state of student loans, the rising cost of health care, rising rates, and especially the state of the housing market.
Another option you have is to invest your housing fund using a brokerage account. A brokerage account is like a retirement account but with more flexibility about when you can use the money. You’ll need to consider your timeline and the amount of risk you’re taking if you invest your housing fund. Remember, investing is all about a risk/reward relationship. Oh yeah, don’t forget, this is not investment advice. A platform like Betterment can give you advice and help you determine how to invest your money. They also have tools to help you project when you may reach your goal and make a recommendation about how much to invest. In a perfect world, you’d give yourself both more time and increase your rate of saving and investing. However, I know we don’t live in a perfect world.
The last thing I did not mention here, and you also didn’t mention, is your credit score. Spend some time understanding how this number impacts how much you’ll be able to borrow and at what cost.
All of this might feel overwhelming and frustrating. The best advice I have for you is to always, in every moment, try to find your agency. Focus on what you can control. Take the time to unpack your values and beliefs about homeownership. Make sure you’re going down this path for the right reasons and understand the implications with your eyes wide open. And lastly, sometimes, the best way to reach our financial goals is to let go of the outcome and learn how to fall in love with the process. Best of luck to you.
Your finance friend,
Paco
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