The Worst Way To Budget For a House

Try to budget for a house like this without cutting your 401(k)

I recently read an article about a person who was wanting to purchase a home. In order to help mentally prepare himself, he practiced “having” a mortgage by actually saving the extra amount. While some of the article was actually not horrible advice, there was one specific piece that stuck with me as absolutely terrible.

His Situation

The individual in question, who I’ll refer to as Hopeful Homeowner (or HH), was living with a roommate in an apartment costing him $600 each month. The house he was anticipating on purchasing would come with a mortgage payment of about $1500 he estimated; definitely a sizable increase, but based on his current situation he figured it may be possible. So, HH followed through with a plan to test the waters and make sure he wouldn’t be in over his head.

In order to make sure he was comfortable with a potential future purchase, HH decided to budget as if he already had the mortgage – that is, set aside the full $1500 anticipated cost each month toward housing. His strategy was to essentially set up an additional automatic savings plan that withdrew $900 extra into a separate bank account. Over time, this would grow to become his down payment.

Okay, So What?

This in and of itself is an excellent strategy. It’s a great way to feel what the spending would be like in other areas of your life should you choose to purchase a more expensive home or even live in a more expensive apartment compared to your current living situation. It’s got the added advantage of getting yourself into the habit of saving money; even if that particular segment of your income would be allocated to housing in the future, for most people saving is a mental game, not a numbers game. So far, so good.

But then, Hopeful Homeowner got into specifics on how he was able to make the rest of that $900 work by adjusting his budget.

His Specifics

He went through the usual things; things Kristin and I are doing, like cutting out nights out on the town, reducing the amount of social spending we do, eliminating frivolous shopping, etc. These are all logical things to cut and honestly aren’t really that big of a deal. As long as we can get the occasional Boba tea, Kristin’s happy and as they say: happy wife happy life. I personally could spend nothing on anything discretionary, but I’ll allow the occasional Boba to keep peace in our household.

Before this Hopeful Homeowner cut those expenses, though? He made a big mistake with his plan of attack. He started by contacting HR and dropping his 401(k) contribution percentage so that he would have more income coming in each pay period. This is one of the most foolish things he could have done for a few reasons.

Your Future Self Won’t Thank You

The idea behind cutting his 401(k) percentage was pretty straight forward: if you’re putting less money into one place, you have more money to put somewhere else. It’s simple math, right? Well, it’s not exactly that clear-cut. HH must have overlooked the fact that 401(k)’s are tax advantaged, meaning he was either getting a tax break now, or a tax break later – depending on what kind he was set up with. Additionally, compound interest is a hugely powerful thing that gets more and more powerful the longer your money has to grow. By limiting his contributions now, he’s missing out on some pretty big potential. How much?

Well let’s assume that HH cut his 401(k) by $100 a month, and his 401(k) is yielding 6%. If HH is 30 years old and works till 65, and continues to miss out on that $100 a month, he’d bring in an extra $42k take-home over those 35 years, and miss out on about $137,000 of growth; a net loss of nearly $100k; not exactly chump change.

I’m going to give HH the benefit of the doubt and assume that he didn’t lower his contributions to below the Employer Match (if applicable) and is still contributing something to his 401(k) plan, but who’s to say if that is actually the case? If he did lower it more, this is basically skipping out on free money – employer contributions are huge because they aren’t coming out of your paycheck. If you do nothing else, contributing the bare minimum to your 401(k) to get the full employer match is essentially a ‘must’.

I know some of you might be thinking “he cut it now so he could save!” but that’s not really the case based on the numbers he outlined. Hopeful Homeowner cut his 401(k) contributions because he simply couldn’t afford the house he wanted on the income he had. This is lifestyle inflation without the income to support it – and, over time, is a surefire way to get yourself in over your head. When he gets that house (and he did) it’s not like he’ll magically be able to increase his contributions simply because he’s done saving for the down payment – what he was saving for the down payment is basically exactly what the mortgage payment will be. Add on to the this the other costs of home ownership – repairs/maintenance, increased utility costs compared to renting in most cases, home owners insurance – that he’s overlooking and he’ll be spending more than just his mortgage payment to live in her house. This will stretch his budget even further than he’d anticipated.

You Don’t Know Your Future Situation

Maybe HH assumed that in the future he’d be in a better position to earn more money. The fact of the matter is, while that may be the case, who’s to say? What’s going to happen if he loses his income, and has to find another job which pays less? It was already a stretch for him at $1500 – if his income drops to 80% of what it currently is, how painful will that be for him?

There are countless studies that show that people assume their future will be better than their present: it’s called optimism bias. It’s in our nature to be optimistic about our own personal situation, generally speaking. Tons of people fall into a trap of spending money now based on the assumption that they’ll be able to pay that amount later – it’s the reason the average balance-carrying American household is over $16k credit card debt!

Regardless of what you think your future will look like, making spending decisions based off of (rosy) assumptions of that future is always a bad idea.

So What Should HH Have Done Instead? How To Really Budget for a House.

There are a few things that if I were in Hopeful Homeowner’s shoes I’d have done:

  • For starters, absolutely continue to slash discretionary spending over time. This was a good move, and as you cut those things out of your life, the longer you’re without it, the easier it is to keep those expenses out.
  • I wouldn’t have cut my 401(k) contributions. In fact, I likely would have increased them to force me to save, because increasing base housing expenses by 150% will obviously mean I’m not going to be able to save and invest as much in other ways as I had previously.

With this in mind, HH had two good options in his house hunt to avoid cutting 401(k) contributions.

The first option would be to save up for a larger down payment. If you have a 30 year mortgage with a 5% interest rate, every $1000 financed is an additional $5 or so added to the cost of the mortgage; a bit more but I’ll round for the sake of simplicity. Assuming that HH would need to reduce the mortgage payment down to $1400 instead of $1500 in order to not touch his 401(k) contributions, that would mean saving an additional ~$20k.

This isn’t news people like to hear – $20k isn’t chump change by any means – but it’s the honest truth. We live in a society of instant gratification, which has the potential to cost us dearly; not only in the short-term, but also in the long term impacts of the decisions we make to satisfy the need for instant gratification.

The other option would be to find a more affordable house; either something smaller or in a less expensive area. By choosing to live in a more affordable house, obviously the down payment HH had amassed would be a larger percentage of the home’s value. This has the added benefit of potentially reducing the duration he may need to pay for Private Mortgage Insurance (with only a $10k down payment, it’s unlikely he’d have a 20% down payment depending on where in the country he is) which would help free up at least a little more money in his budget each month.

You Aren’t Robin Hood!!

Don’t steal from the (hypothetically) “rich” version of you to pay for what the actual version of you can’t afford. Making sacrifices for the things you want is okay – but when it’s at the expense of yourself and your future financial well-being, it isn’t a sacrifice: it’s simply foolish.

Instead of looking at the situation logically and with his full financial picture in mind, HH is touting his “homeowner prep budgeting” as a feat to be proud of – but in reality it’s an extremely misguided approach to trying to save for something that he clearly cannot afford.

If you’re planning on purchasing a house in the future, it’s absolutely a great idea to get in the habit of setting money aside as if you already had a mortgage payment, and then some. It helps you get into the routine of spending less than you earn. But don’t do it at the expense of your own future. It may seem like a good idea in the present, but I guarantee it’s not worth it.

Question:

Do you think Hopeful Homeowner was smart to stifle his 401(k) contributions to help him pay for a mortgage on a house he did not yet own?

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10 Comments

  1. Great response to the original article. One option not explored was to bring in roommates to offset the housing cost without sacrificing his 401k. Later, when his income can support his savings goals and his full housing cost, he can decide to live alone, having built up equity in the home on the meantime.

    1. For sure. It still probably wouldn’t have actually changed anything with the bank, but at least he’d have some more money coming in. He was already used to having a roommate, so it’s not even like it’d be that big of a lifestyle shift for him.

  2. It’s not uncommon in the UK to hear people say you should always push as far as you can on the housing ladder and get the biggest mortgage you can afford. I think it was a bad move personally, I’d opt for the more affordable housing option… coupled with a higher deposit. I’m very risk averse though, it’s not for everyone!

    1. It’s a great way to be house-poor, that’s for sure. With interest rates low and housing prices trending up overall I can see why people would argue that, but there’s a lot more expenses to take into account as well like utility costs, furniture, etc.

      IMO people should be comfortable with their housing expense, and the size of their home. No sense in getting something super expensive/gigantic if it’s more than what is ideal for you. Just because the bank says they’ll give you the money doesn’t mean you should take it!

  3. Interesting analysis. It makes me think about Mr. FAF and myself. I’ve been aggressively trying to pay off our mortgage and neglecting our retirement accounts. Mr. FAF is finishing up grad school this summer, so we’ll def need to ramp that up. Thanks for sharing!

    1. I think trying to aggressively pay off your mortgage at least is a much more admirable goal than stretching your budget to simply afford the house to begin with! Good luck in paying it down quickly 🙂

  4. Trying to save the difference between the mortgage payment and his rent was a smart move. Did he also factor in the difference in utilities (gas/electric/water/trash)? Or upkeep on the house ($25-50/month – DIY projects, lawnmowing, etc)?
    Those are things to consider as well or they will wreck your budget.

    1. He didn’t say, but I’m guessing no. A lot of times that is more expensive; particularly if you’re splitting things like cable with a roommate, but when moving into your own place you get the same cable package…suddenly your cable bill doubles!

  5. What a great post! My husband and I have been putting money away in our 401(k) (respectively), our “house” fund and a joint retirement fund. We don’t have any credit card debt but we live in Nor Cal which is really expensive. We’re also expecting a baby in November (which my hubby and I missed you and Kristin attending, but knew you were there in spirit) so it throws a wrench in our savings as we plan to open a college savings for him after he’s born.
    Will all this dispersed savings it’s making it hard to save more for our house when we do move and plan to buy, but it makes it even harder because we have NO idea where my hubby will get a job after Stanford. I just hope we’re doing the right thing.

    1. Saving up money is always a good plan, and it sounds like you guys are on a good track! November is coming up quick – congrats you two! <3

      Thanks for commenting!

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