Should I buy a Starter Home or save up longer for my Dream Home?

Ross Atefi, AAMS®, CRPC®, CCPS | May 07, 2018

Should I buy a Starter Home or save up longer for my Dream Home?

One of the most common and important financial decisions people face is determining whether it is more financially advantageous to buy a starter home now, or wait to purchase their dream home. This is particularly important in Los Angeles and Orange County where many of our clients reside, as home prices are among the highest in the country. This article attempts to evaluate and compare the two options, and provide readers with some insight which may aid them in their decision.

Define ‘Starter Home’:

A home that you can afford now or in the near future, and be ok living in for the next 3-10 years
This may be a ‘bridge’ between your current housing situation (renting, living with family, etc.) and your dream home

Define ‘Dream Home’:

A home you can see yourself living in for 20 years or more.
Big enough to accommodate a growing family
Envision making improvements to over time to enjoy

General Pros and Cons of Buying Starter Home vs. Waiting to Purchase Dream Home:

Consider the following pros and cons of purchasing a starter home (rather than waiting to purchase a dream home):

Pros:

If realistically it will be many years (10+) until you will be able to purchase your dream home, buying a starter home is often the preferred approach because:

You are able to purchase a home much sooner.
Financially this enables you to begin building equity in the new home, receive a tax deduction on the mortgage interest, and avoid spending money on rent
The starter home can be a solid investment if you plan on holding it for at least 5-years. If you plan on holding it for closer to 10-years, it will almost certainly be an excellent investment (barring a significant real-estate crash in which the market takes many years to recover, such as the impact 2008 had on real-estate values in the Inland Empire of California.)

*Continue reading below to find an analysis on the break-even point and investment value of purchasing a home

If the real-estate market is on a tear (increasing in value rapidly), buying a starter-home sooner allows you to participate in this growth. This is important as remember that your dream home is increasing in value as well (and therefore the cost for buying it is increasing rapidly).

For example, if your starter home is worth $500k today, and the real-estate market is growing at 5%/yr, in 10-years it will be worth $814k.
If your $1million dream home is also increasing at 5%/yr, in 10-years it will be worth $1.629million
Now if you sell the starter home in year 10, there is $314k of equity just from leveraged growth. This is almost enough to make the 20% down payment on the dream home. If you add-in the amount of principal you would have paid-down on the starter home over those 10-years, this should be more than enough equity to now buy the dream home with 20% down after selling the starter home.
If you had not purchased the starter home, you would have been able to invest the down payment on the starter home of $100k, but over 10-years growing at 7%/yr this would have only grown to approximately $200k. Therefore you would need to have saved a significant amount more over those 10-years to accumulate enough of a down payment to purchase the dream home.

Tax-deduction upon sale of the starter home which makes it an extremely tax-efficient investment:

As a single person, you can make up to $250,000 in profit on selling your primary residence and not owe any capital gains tax.
As a married couple, you can make up to $500,000 in profit on selling your primary residence and not owe any capital gains tax.
This is a unique tax-break and one of the rare opportunities to realize tax-free profits on an investment.

Locking-in currently low interest rates

Interest-rates are still at or near all-time lows. 30-yr mortgage rates as of early October, 2017 are hovering around 4%/yr.
Compare this to the 1980’s when 30-yr mortgage rates hovered around 17%/yr!

Ability to rent this starter home out in the future (rather than selling it) if you have the financial means to be able to buy your dream home in the future and keep this one.

For those whose financial situation improves over time, keeping their starter and renting it out, even after purchasing their dream home, may be an option. The value of this is as follows:

Relatively stable leveraged asset:

Even if you have negative cash-flow initially, the growth on the property in comparison with your initial investment (down payment) and even current equity may be significant
For example, if you own a starter home worth $500,000 and have total costs / expenses (including the mortgage, property taxes, insurance, maintenance, etc.) of $3,500/mo. but you are only able to rent it out for $3,000/mo, you’ll have a negative cash-flow of $500/mo ($6,000/yr).
HOWEVER, if the property increases in value by just 3%/yr, that would be an annual increase of $15,000/yr!
Even after the negative cash-flow of $6,000/yr, you would be net positive approximately $9,000/yr.
Better yet, about 30% of your mortgage payment will be going back to you in the form of increasing your equity in the home by paying down the mortgage balance. Assuming your mortgage payment was $1,909/mo for a $400,000 mortgage at 4%/yr interest, 30% would be $572/mo ($6,872/yr).
So the total benefit on this rental property would be approximately $9,000 + $6,872 = $15,872/yr.
Compared with the equity in the home (assuming it was $100,000 at this point), a $15,872/yr net increase would be a 15.8%/yr net return.
Rental real-estate is one of the only types of investments in which leverage (debt) can be appropriate to increase returns due to the relative stability of real-estate values and income from the properties (in comparison to publicly traded equities for example). Also, the debt on rental real-estate has a long amortization (typically 30-yrs) and a fixed interest rate.

Ability to raise the rent over time; therefore eventually you should see positive cash-flow which can be a valuable and stable source of income in retirement
Diversification of your investment portfolio
Could rent out the starter home for up-to 3-years after moving to dream home and still receive the capital gains tax deduction upon sale of the starter home

Learn more about capital gains tax deduction on primary residences here: https://www.kitces.com/blog/limits-to-converting-rental-property-into-a-primary-residence-to-plan-for-irc-section-121-capital-gains-exclusion/

Rental properties are relatively tax-efficient investments due to depreciation

Learn more about the value of depreciation here: https://www.zillow.com/blog/tax-savings-rental-property-depreciation-explained-112255/

Cons:

Buying a starter home is likely more expensive on a monthly basis than renting

On average in California it costs 62% more to own than to rent.
https://www.nerdwallet.com/blog/mortgages/cost-homeownership-vs-renting/

Note however that the costs of owning stay relatively the same over time as the two major costs of owning stay relatively consistent over time (mortgage payments don’t increase unless you refinance, property taxes increase slowly due to prop 13).
In contrast, rent payments will typically increase with local inflation rates.

Loss of use and liquidity of down-payment

Purchasing any home requires a sizeable down-payment; particularly if you want to avoid the additional cost of mortgage insurance (PMI) which can be an additional cost of 0.3%/yr to 1.5%/yr of the original loan amount. When you purchase this home, the money you put towards the down payment is essentially ‘locked-up’ in the house.

As an example of the impact of PMI, imagine a $500,000 home in which you put only 3.5% as a down-payment. Your mortgage cost will include the following:

Mortgage balance: $482,500
Typical 30-yr Mortgage Cost @ 4%/yr: $2,303/mo ($27,636/yr)
Additional 1%/yr for PMI: $402/mo ($4,825/yr)
Total Cost: $2,705/mo ($32,460/yr)

In comparison, the mortgage cost with the traditional 20% down payment would be $1,909/mo ($22,908/yr)
This is an additional costof $9,552/yr!

You can no longer access the money you used as a down payment until you sell the home (or refinance in the future). This means you lose the ability to invest this money in other ways (for example in the stock and bond markets), as well as the ability to spend it on other things.

The starter home could drop in value, potentially causing you to have to wait longer to buy the dream home than if you just waited and saved-up for it.

This is best illustrated in an example:

Couple 1 – Buy Starter Home:

2017:

Current Savings Allocated for Home Purchase: $100,000
Starter home cost: $500,000
Dream home cost: $1million
Saving $20,000/yr towards dream home purchase
Use their current $100,000 savings allocated for a home purchase to purchase a starter home valued at $500,000

2022:

5-years after purchasing the $500,000 starter home, it has dropped in value by $100,000 and is now worth only $400,000 (think 2008)
They have saved an additional $20,000/yr towards the purchase of their dream home, so now have an additional $100,000 saved-up.
They have paid-down the $400,000 loan on the starter home to approximately $360,000.
However, because the starter home has dropped in value by $100,000, they only have $40,000 of equity in the starter home at this point (current value: $400,000 – current loan balance: $360,000 = $40,000).
Total money available for dream home purchase: $100,000 savings + $40,000 equity = $140,000
*NOT enough to purchase $1million dream home! (with 20% down). They would have to wait potentially years longer and continue to save to be able to buy their dream home.

Couple 2 – Wait and Save:

2017:

Current Savings Allocated for Home Purchase: $100,000
Dream home cost: $1million
Saving $20,000/yr towards dream home purchase

2022:

5-years later, they have saved an additional $100,000 towards their dream home purchase and now have a total of $200,000 saved.
At this point, they can purchase the $1million dream home with 20% down

Break-even on buying home is typically 3-5 years. As an example please see below.

Home Purchase Analysis:

Assumes

Real Estate Value of $1.0million growing at 3%/yr
20% Down-payment of $200k
Mortgage of $800k @ 4.0% Interest
Expenses (not including mortgage):

Property Taxes @ 1.2%- $1,000/month growing at 2%
Maintenance/Repairs - $167/month growing at 3.5%
P&C Insurance - $400/mo growing at 3%
Total: $1,567/mo ($18,804/yr)

Tax-Bracket of 30% (including State Taxes)
Current Rent Cost of $2,000/mo
Expenses of buying home @ 5% = $50,000

TheTotal Returnon your property is impacted by the following:
Positives (+): Equity, Rent Savings, Tax-Savings

Principal payment: (~$14,000/yr) because it increases your equity

Apprx. $1,167/mo of the total Mortgage payment of $3,819/mo goes to paying-down principal (30%)

Real Estate growth: of 3%/yr on $1.0million (+$30,000/yr) because it also increase your equity
Savings on Rent: You will save ($24,000/yr) in rent
Tax-Savings on Interest: ($31,824*30%) = ($9,547/yr)
Total Positives (+): ~$77,547/yr (Note this will improve slightly every year you own the house as a higher percentage of your mortgage payments go towards principal versus interest)

Negatives (-): Expenses, Interest

Interest payments on Mortgage:(-$31,824/yr) because you pay that to the bank
Expenses:(-$18,804) because you pay that out of pocket.
Down-payment Opportunity Cost: ($200k * 1.06) = $12,000/yr
Total Negatives (-): ~$62,628/yr

Based on the above assumptions, we can assume a total return for 1-year of approximately ($77,547 - $62,628) = +$14,919/yr
In this scenario, comparing the costs of buying the home @ 5% = $50,000 versus the annual financial value of owning the home of $14,919/yr, it would take approximately 3.35 years to break-even.
Other Factors / Considerations:

Risk (- or +)
Cash-flow (-)
Concentrated investment (- or +)

Owning a starter home is much more of a hassle versus renting.

As a home owner, you need to be prepared to spend time working on maintenance and upgrade projects.
Then there’s the hassle of actually finding and purchasing the starter home, and then selling it again down the road.
Many people prefer to rent relatively hassle-free until they can purchase their dream home.

CRN-1926868-101817

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Roberto J. Duran CFP®, ChFC®, CRPC® and Ross Atefi, AAMS, CRPC, CCPS are registered representatives and investment advisor representatives of Lincoln Financial Advisors Corp., a broker-dealer (member SIPC) and registered investment advisor, 18400 Von Karman Ave., Ste 550, Irvine CA 92612 offering insurance through Lincoln affiliates and other fine companies. This information should not be construed as legal or tax advice. You may want to consult a tax advisor regarding this information as it relates to your personal circumstances. The content of this material was provided to you by Lincoln Financial Advisors Corp. for its representatives and their clients. Insurance offered through Lincoln Marketing and Insurance Agency, LLC and Lincoln Associates Insurance Agency, Inc. and other fine companies.