With the stock market setting new records in 2020 and interest rates at all-time lows, some people are wondering if it’s time to pull the trigger on that dream second home.
For example, one of our clients found the perfect cottage for a second home and was wondering if she should sell some of her investments to buy it. Assuming she lives until age 95, her financial projections showed she would have around $4 million when she passed away. Rather than pass along every dime to the next generation, she wanted to use some funds for her own enjoyment.
Even though the financial stars seem to be lining up for such a purchase, there isn’t a simple answer. Before moving ahead, here are five issues to consider.
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What is Your Objective?
Before tackling the financial issues, determine the personal reasons behind buying a new property. For many, it’s the sheer enjoyment of waking up every day on the beach or in the mountains. It could also be an investment decision, or a combination of personal and investment reasons.
Examine the dream closely and have a realistic understanding of the non-financial commitment of owning a second home. For example, many retirees believe it will become a family vacation spot where your children and grandchildren will visit regularly. But will this really happen?
In reality, your children and grandchildren have busy lives and may not be able to visit more than once or twice annually – especially if the second home is several hours away. If that’s the case, will you enjoy a new environment without your network of family and friends nearby?
If the underlying purpose to buy a second property doesn’t meet this personal need, you may have your answer.
Understand the Costs Associated with the New Property.
Determine the true cost of owning a second home. It’s more than the face value and mortgage payments; it also includes property taxes, home insurance premiums, utilities, maintenance, furnishings and even homeowner association fees. These costs could easily run $25,000 annually or more, drastically increasing the true cost of ownership. And this will ultimately increase the amount of investments needing to be liquidated annually.
On the other hand, most people won’t purchase homes with cash and will require financing. Fortunately, with mortgage rates being at historically low levels, there has been no better time to look a potentially financing a second home.
Does It Make Sense from a Cash Flow Perspective?
Making sure you have enough cash flow is important for covering the expenses associated with owning a property as mentioned above. Without it, there could be a huge negative impact on your investments and potentially your financial plan.
For instance, we had a client make a down payment on a $1 million home, leaving $1 million left in his account to cover mortgage payments. Six months later, the stock market had a downturn, and this account had lost 20% of its value. Now valued at $800,000, his account balance continued to diminish due to ongoing mortgage payments and other new housing costs during the bear market. He then had to consider dialing back the risk on his account to protect his investments against further losses. However, as his portfolio became more conservative, so did his returns. This ultimately resulted in him having to work longer than he wanted to maintain his lifestyle.
Are You Prepared for the Tax Bill from Liquidating Assets to Fund the Purchase?
If you plan on selling appreciated investments in a non-retirement account, there will be taxes. For example, the cottage our client wanted to purchase was valued at $800,000. However, the investments she planned on selling to purchase the property were in a taxable account and had grown by more than 50% since purchasing them. Due to this appreciation, she would be subject to capital gains tax and would actually need to sell more than $800,000 of her investments to account for the additional tax levied on the sale.
The exact amount of capital gain tax varies based on the investment’s tax basis and holding period. Consult with your tax professional to determine the tax impacts from selling your appreciated investments.
What is the Opportunity Cost of Not Staying Invested?
It is always important to analyze the opportunity costs of any major financial decision, such as purchasing a second home. On one hand, you can choose to sell your investments to buy a $1 million home, turning your dream into a reality.
And on the other hand, depending on your life expectancy, this move could also potentially cost $1 million or more in future investment growth. For some people, this “cost” won’t have a major impact on achieving their financial goals, but for others it could harm their financial plan.
While you may be able to buy a second home with your investments, can you really afford to over the long haul? Using your investments to cover the costs of owning a property prevents them from appreciating over time. This could serve as a potential setback, causing other areas in your financial plan to suffer. To catch back up, you may have to make changes in your plan, such as delaying retirement or reducing your spending.
Another opportunity cost is forgoing the opportunity to travel to other places since you’re maintaining a property. Oftentimes when people purchase a second home, they feel obligated to use it as much as possible since they are paying for it. This sense of obligation may prevent you from traveling to other destinations you wanted to visit.
From early retirement to purchasing your dream home, we all have different financial goals and aspirations that we want to achieve in life. While emotionally it may make sense, consider the financial aspects of your decision to ensure it aligns with your other financial goals.
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