Prioritizing financial goals is one of the hardest things to do. And it comes into play in so many different ways. How much would you save for an emergency fund while you’re paying off all your debt? Which debt should you pay off first? Should you pay off all your debt before saving for retirement?
The list of competing financial goals goes on and on and on. What makes these decisions particularly difficult is that we must make some assumptions about the future. What will the stock market do? Will interest rates go up or down? How stable is your job?
Many of these questions came to mind as a read the following e-mail from a reader named Christy:
My husband and I just moved to Texas and assuming we continue to like the area and our jobs we are looking to potentially buy a house in about 2 years. My question is this- is it wise to slow down retirement contributions so we can save a solid 20% for a down payment? I feel like we should make minimal contributions to retirement while throwing the bulk into a house fund, but I read and hear so much about maxing out retirement accounts it makes me nervous to save for a house before maxing out those accounts. Our income is pretty limited right now (about 50K/year) but my husband is in IT and we expect his income to go up significantly over the next two years as he obtains certifications in his field. I am just starting a part-time position this week (I work in a hospital laboratory) and have the flexibility to pick up extra shifts but am really trying to focus on being at home with our infant daughter right now. Should we max out an IRA for each of us and only after that consider saving for a house (we don’t have access to 401K plans at work)? Or is it okay to do minimal investing for retirement while we save like crazy for a down payment? I am 26 and my husband is 28. We currently have 20K saved in old workplace 401Ks and have no debt.
Any advice would be appreciated!
Christy’s question is the kind of financial decision many of us will face multiple times. It forces us to decide what is most important to us, and what our financial priorities should be. Often those two things conflict.
In my opinion, there is no one right answer to Christy’s questions. There are, however, a number of factors that one should consider when making these types of decisions. Before we cover them, let’s look at what others have said in response to similar questions.
What others have to say
Mitch Tuchman: I previously interviewed Rebalance IRA founder Mitch Tuchman on Dough Roller podcast episode 78. In an article published on Forbes, he leaned very much in favor of saving for retirement. He noted that “housing only puts on about half a percent over inflation over the very long term, measuring from 1890 through 2008. Leaving aside for a moment the housing bubble and bust, consider what that means: Housing is a protector of value, perhaps, but not a powerful grower of value.
Mitch was looking at this question from the perspective of "what's the better investment?" He felt that investing for retirement, say an index fund, is a better investment than investing in a home; hence, he leaned in favor of maxing out your retirement accounts.
Bogleheads Forum: Another response that I found was from the Bogleheads Forum, where a reader outlined his plan. He stopped making the retirement contributions, but in his case, his employer contributed 10% without requiring an employee contribution. He then kept money aside in a savings account and continued to max out two Roth IRAs. They were leaving the rest in a savings account until they reached a 10% down payment. Once they reached 10%, they then contributed partly to the 403b plan and partly to the down payment until they reached 20%.
What I liked about this approach was that they were tackling multiple financial goals at the same time. For this person, it wasn't all or nothing.
Walter Updegrave: Walter Updegrave from CNN wrote an article a few years ago, where he very much sided with saving for retirement ASAP.
I think that you should definitely start saving for retirement ASAP. Saving for retirement isn’t something to do with leftover money. It should be considered a core living expense. It is paying for housing and food that you’ll need after you leave the workforce.
Assuming your company has a 401(k) plan, sign up for it as soon as you're eligible and contribute at least enough to get the full employer match. If you can possibly max out, do so.
If you decide you really do want to be a homeowner this early on, you can then direct extra savings toward your down payment. It may take you a few years to accumulate enough cash to buy.
Emily Brandon: Finally, Emily Brandon from the U.S. News wrote an article where she stressed the importance of not foregoing a contribution if your company matches your 401k or 403b contributions. You wouldn't want to leave that free money on the table to save for a home.
Now to my thoughts on Christy's question.
Are You Asking the Right Question?
As a starting point, it's important to make sure you're asking the right question. Is the choice really between saving for retirement or a down payment, or can accomplish both by cutting back in other areas?
There are three potential answers to this question:
- We can't cut back anymore in other areas;
- We can cut back in other areas and will do so to save for both retirement and a home; and
- We can cut back in other areas, but we don't want to.
Whatever choice you make is your judgment call. Before you even make a decision, however, be sure that you’ve considered your entire financial picture.
Do the math
Don’t be afraid of numbers. In all of the answers to this question that I’ve found on the internet, not one of them suggested doing the math. What I mean is this. How will putting retirement savings on hold affect your retirement goals? These answers will depend on a number of factors, including (1) how much you’ve already saved, (2) when you want to retire, (3) future returns, and (4) future inflation rates.
Let’s make some assumptions in Christy’s case. Let’s assume a 27-year-old will suspend IRA contributions for 2 years to save for a home. We’ll also assume she plans to retire at age 65. What impact will this have on retirement savings?
Given a retirement age of 65, Christy will save for retirement for either 38 more years (if she doesn't stop saving) or 36 years (if she stops saving for 2 years). Since she and her husband are maxing out IRAs, we'll assume annual contributions of $11,000 ($5,500 per IRA). We'll also assume their investments earn 5% (taking inflation out of the picture).
So what difference do two years make?
36 years: $1,054,199
38 years: $1,184,805
That’s a $130,000 difference. Does this surprise you? Well, that’s the power of compounding. The point you have to factor in is that what may seem like relatively small differences in percentages, when multiplied over almost 4 decades of investing, can make huge differences.
So what do you do with these numbers?
Two ways to look at these numbers:
1. Wow! Delaying savings for just 2 years results in a loss of $130,000 30+ years from now. Suspending retirement savings for two years would be a mistake.
2. Delaying savings for two years still enables you to meet your retirement goals. Therefore, you'll focus on saving for a down payment so that you can meet that financial goal, too.
Obviously, there are a number of key assumptions used in calculating these numbers. You may wish to change those assumptions in your own calculations. Further, the numbers might not provide a complete answer to this question for you. There are other things to consider (see below). But it will help place your decision into perspective.
Finally, here's the excel formula I used to calculate the above numbers:
fv = future value
5% = rate of return
38 = number of years to save and invest
-11000 = annual contribution (using a negative number produces a positive result in excel
Homes have value
There's a lot said about a home not being a great investment. In some ways, it's not a great investment. It generally doesn't generate any income (unless you rent out a room). It requires significant capital for maintenance and upkeep. And home values typically do not rise much more than the rate of inflation.
A home, however, is a reasonable investment. While values won't go up over the long term as much as stocks, they still go up. The use of reasonable leverage can increase returns. There are significant tax advantages to homeownership. And it insulates the owner from rising rents.
This may seem like a silly observation, but it’s worth underscoring given the never-ending drumbeat of skepticism when it comes to a home as an investment. Yes, returns will unlikely match the stock market. But it’s a totally different investment. It involves extreme leverage and tax breaks, not to mention a place to call home. If you want to see specific numbers, check out my article and podcast on the returns my wife and I received from owning our first home.
The point is this. The above math focuses just on retirement savings. Buying a home has its own advantages, which will partially offset the loss in retirement savings.
Take a holistic approach
Finally, take a holistic approach to your finances when considering this question. Retirement and buying a home are just two financial goals. You likely have many more, such as getting out of debt, saving for a child’s education, and perhaps starting a business. Consider these other goals before making a decision.
There is no one right approach here. Most likely, this all comes down to how much you value owning a home versus how much you value saving for retirement?