I’ll admit I have houses on my mind these days — a trade-up house, more specifically.
I have a third kid on the way, and my existing two kids are the proverbial bulls in a China shop. They’ve pretty well trashed our existing place, so even if I don’t buy a new house, I’m probably looking at tens of thousands of dollars in repairs and remodeling. A little extra square footage in a trade-up house wouldn’t be a bad thing.
We’ll see. If the right house comes along at the right price, I’ll likely join the millions of my predecessors that got suckered in the housing trade-up game. Or, I might resist the urge and continue on in my broken-down hovel for another couple years.
This brings up some questions on when and how to trade up. The first and most important thing to keep in mind is that your house is not an asset. I might concede that, at best, it’s a long-term inflation hedge. But more than anything, it’s an expense and should be viewed as such.
That’s OK. We get out there and work precisely because spending money is fun. You only live once, after all, and you can’t take it with you when you’re dead.
But like any expense, you have to be smart about it.
Rules for Buying a Trade-Up House
Rule No. 1: Retire with a Paid-Off House
I consider this the single most important rule for your financial well-being. You do not want to start your retirement with the responsibility of a mortgage.
Once you’re retired, your income stops. You no longer have the ability to work overtime or earn that year-end bonus that helps you wipe the credit card balance clean. You have to live off of Social Security and whatever dividends and income your portfolio throws off.
I’ve never understood the financial planning maxim that your expenses fall in retirement.
Why? Do you suddenly eat less once you’re retired?
Your expenses in retirement will be higher than you planned. It’s inevitable.
And if you let your expenses get out of control early in retirement, you risk depleting your assets and then being forced to move in with your kids later. So, do whatever you need to do to ensure your mortgage is paid off before you retire. That potentially frees up several thousand dollars per month and gives you more flexibility.
So, if you’re thinking of upgrading, do the math. If you’re 45 and planning to retire at 65, will you be able to pay off your trade-up home in 20 years?
If that’s not realistic, then don’t upgrade or do so with a cheaper house. That beautiful home with the perfectly manicured lawn might be a trophy at 45, but at 65 it will be an albatross around your neck.
Rule No. 2: The Three-Year Rule
This rule is a bit more extreme, but I like it. I have a colleague in Houston that runs a large wealth management practice, and his rule for a trade-up house is simple: If you can’t pay it off in three years, don’t buy it.
The “Three-Year Rule” is obviously unrealistic for the young couple struggling to save for a down payment on a starter house. But that’s just it. We’re not talking about your starter house. We’re talking about an optional upgrade that you might want but that you certainly don’t need.
It’s important to note that you don’t necessarily have to pay off the house in three years. You just need to be able to pay it off in three. If you choose to keep the mortgage and invest your cash somewhere more profitable or stash it in a 401(k) or IRA, that’s perfectly fine. The Three-Year Rule is more about setting a practical spending limit than on keeping a specific timeline.
Rule No. 3: Watch Out For Taxes and Expenses
Let’s say you’re disciplined and get your mortgage paid off. Good for you! That’s a major financial milestone.
But your homeowner expenses don’t stop with the mortgage. You also have to pay property taxes, insurance, maintenance and possibly more frivolous things like HOA dues and landscaping.
So, consider your neighborhood closely. If your kids are already out of high school, paying the property-tax premium for a house in a good school district might not be necessary.
Likewise, some houses are far more expensive to insure than others due to their proximity to flood zones. And some neighborhoods have outrageously high HOA dues that are used to pay for services you might not want or need.
You might be able to skimp a little on maintenance, cleaning and landscaping. But once you’re moved in, you’re stuck paying taxes, insurance and HOA dues for as long as you own the property. So, be sure to take those numbers into consideration before you buy.
There’s nothing wrong with splurging on your dream trade-up house. It’s your money, and you only live once. But if you bite off more than you can chew, that dream home is going to end up being a financial nightmare for you.
• Money & Markets contributor Charles Sizemore specializes in income and retirement topics, and is a frequent guest on CNBC, Bloomberg and Fox Business.
Follow Charles on Twitter @CharlesSizemore
