When Bob and Sally came into the office, their finances were a mess. They had recently retired and were withdrawing nearly 10% annually from their retirement savings. At their current withdrawal rate, they would be out of money by the time they hit 75. To make things even worse, they weren’t able to enjoy any of the luxuries they had when they both were working. No traveling, no going out to nice restaurants, and barely able to get by even after a high retirement account withdrawal rate. The problem? They had finally bought their dream home right before retirement, and after going over budget, the mortgage payment was killing them.
This article will help guide you in determining how much your home payment should be for a comfortable retirement.
The 20% rule of thumb while working
When someone is working, my general rule of thumb is that a person should not spend more than 20% of their income on a home. For example, if your family income is $100,000, your total mortgage payments, including taxes and insurance, should not be over $20,000 per year, or $1,667 per month. The last thing you want to have happen is that so much is going out between mortgage payments, taxes, and other debts, that you don’t have any money left over for some of the fun stuff. Now, this is just a rule-of-thumb, and 20% can be tweaked based on your situation. For example, maybe you are younger and expecting your income to go up, so you can spend a little more. Or, maybe you have high student loan payments or other debts, and you would prefer to spend less on the mortgage or rent. I have heard other people use a 28% rule-of-thumb before, but I think that is too high, and feel like erring on the conservative side makes sense as I have seen high mortgage payments wreck people financially. So, what changes in retirement?
Can you actually afford more home in retirement?
Not necessarily, but there are some benefits that you have in retirement that you don’t have while you are working
- Typically a lower tax bracket
- No FICA tax on your income
- Not saving for retirement any longer
While you are working, you may only see 50% or less, of your actual income. For example, let’s say that your income while working is $100,000. Your effective federal tax bracket would be around 10%, plus 4.25% on state taxes, 7.65% on social security and medicare taxes (FICA), and another 10% to 20% going to the 401(k). With taxes and retirement savings, 30% to 40% of each paycheck is gone before you ever see it. This is the reason that I would like to see people keep their home payments to no more than 20% of gross income. Things are more attractive though for a retiree with the same income.
The truth is that you keep more of your money in retirement. For example, part of your social security benefit is federal tax-free, and all of it is exempt from Michigan state taxes. You don’t have the 7.65% FICA tax and you are no longer making 401(k) contributions. While working, you may see 30-40% of each paycheck eaten by taxes and savings. In retirement, you will probably see less than 15% of this same amount of income go to taxes, and of course, no savings. Therefore, you can spend more of your income in retirement on a home, but of course, there is a large catch. Your income in retirement is typically lower than when you are working.
Determine your retirement income
First, to calculate how much you can afford, you need to have an idea how much you will earn in retirement. While working this is typically pretty easy, but not as easy when you are retired. There are usually three sources of retirement income:
- Social Security
- Savings Withdrawal (5% of total retirement assets)
Calculating your social security and pension is fairly easy, but trying to figure out how your savings is converted into income, is a little tricker. I have written before how I believe a 5% savings withdrawal rate should be considered a fairly safe withdrawal rate. Therefore, multiplying your retirement savings by 5% should give you a rough estimate of how much income you can generate from your savings.
Here is an example of a couple entering retirement and their anticipated income.
Social Security: $36,000
Savings Withdrawal ($1,000,000 of assets): $50,000
This couple should expect $110,000 in income in retirement. Once you determine your retirement income, you can figure out how much home you can afford.
The 25% rule of thumb while retired
My suggestion is to limit your mortgage, or rent, payment to less than 25% of your total retirement income. 25% still is low enough, that for many of us, after a mortgage and income tax payments, less than 40% of your income is going away to taxes and mortgage payments. Hopefully, that will still leave you with plenty for traveling and other hobbies. Yes, you are spending more of your pay on a home then what I would recommend while working, but you have fewer taxes and savings on the same amount of income.
Depending on your situation you could potentially push it to 30%, but I would get pretty nervous with anything higher. You may even want to error on the more conservative side if you have fairly high, over 10%, of your retirement is spent on healthcare costs.
Let’s look at the couple above who has $110,000 in retirement income. Given the 25% rule of thumb, they can afford $27,500 per year on mortgage/rent or $2,291 per month.
The 25% rule of thumb is not for everyone
Living in Michigan, we are fortunate to have lower home prices than most parts of the country. This has allowed my family to have a very low mortgage payment compared to our income. My wife has family all around the country, and they laughed at how much our home cost until they saw it. Now, I think they are just jealous. This doesn’t mean that we save all of this extra money. Instead, it has given us the freedom to spend money on things that we love doing. I love to ski and she loves the ocean, and we can take that extra vacation. She loves to cook, and enjoys nicer restaurants, and having more disposable income allows us that extra night out each month. You may prefer to have a smaller mortgage payment so that you can take that extra vacation, buy a Corvette, or do what you love to do.
Or, maybe for your family, your home is your oasis. You want to buy a place on the lake, and that is where you spend all of your vacation and time. It is the place where all of the kids and grandkids consider to be the home away from home. In that case, maybe you do want to push it a little and spend a little more on your home. Retirement is about choices. You will have a fairly fixed income, and how you spend that income is up to you. For most of us though, having too high of a mortgage payment so that you can’t enjoy the other things in life is also not a great choice. That’s why I recommend not spending more than 25% of your retirement income on your home.
Need more help?
Bryan Haggard CFP®, CFA is a Michigan based fee-only financial planner. He specializes in working with families to help them live a stress-free retirement. Interested in putting together a plan to help you meet your retirement goals? Schedule a time to meet below.