Last week, a long-time reader e-mailed a superb question: If you must choose, should you save first for retirement or save for a down payment on your first home?
Obviously, both are important. The younger you are when you start contributing to a 401(k) or IRA, the longer compounding interest will work its magic. At the same time, many of us want to own a home before we turn a certain age, get married, or have kids. And if we’re able, the money-savvy among us would like to buy our home with a substantial down payment (ideally 20 percent).
That’s no small goal.
But can you save for both retirement and a down payment at the same time? And, if you must choose, which should be your priority? The answer is, of course, complicated, and depends on some individual financial factors. But, in general, save for retirement first.
Emotionally, most us of will want to save for a home first. Even if we’re being pragmatic and saving a down payment, a home is tangible, a Roth IRA is not. Financially, however, saving for retirement before a home is the right move.
Historically, over 20-25 years or more, stock market gains far outpace real estate. (And, as an aside, I don’t believe anybody should buy their primary residence as an investment. Yes, professional real estate investors have made fortunes, but it doesn’t mean you will—especially on your own home. Buy your house to live in. Period.)
Let’s say Jane Investor saves $6,000 a year for five years before turning 25. For the simplicity of this example, Jane tucked the money under her mattress and didn’t earn any interest during that time. Jane has $30,000 to use as a 20 percent down payment on a $150,000 home or invest in a retirement account that will earn an average of seven percent annual returns over the next several decades.
If Jane Makes a Down Payment
Jane’s first home turns out to be ample for her needs, and she stays in her home for 25 years. According to the Forbes report linked above, the average increase in real estate prices between 1980 and 2004 was 274%. Using this figure, Jane’s home would be worth $370,500 and the $30,000 she “invested” as her down payment would now be worth $74,100. (Obviously, she would have been making mortgage payments, building equity, and would make more of a profit on her home, but I omit those gains here to focus only on the initial $30,000 down payment).
If Jane Saves for Retirement
Jane decides to pull the $30,000 out from under her mattress and invest. She works with an investment advisor to build a well-diversified portfolio and, together, they adjust it at least every year. (Although Jane continues to put money into her 401(k), she put this money into its own account and makes no more contributions). Her conservative but intelligent investing yields an average seven percent annual return over 25 years meaning her $30,000 is now worth $162,823. (Note that over the same 24-year period in the Forbes article, the S&P 500 gained more than 1,000%. That would make Jane’s investment worth over $300,000). What would that same $30k be worth when Jane turns 65? A cool $449,234.
The Bottom Line
Unless you are very lucky or very skilled, real estate can’t beat the stock market as an investment. Add the tax advantages of retirement accounts, and I think the answer becomes even more clear: save for retirement first.
There’s No Need to Rent Forever
If you’re concerned about renting for longer than you had planned, don’t be. Rent is not wasted money any more than your electric bill is wasted money. You need electricity, you pay the power company; you need shelter, you pay rent.
But all of this doesn’t mean you need to rent forever and put all of your money into the stock market. But you should probably put money towards retirement—especially in tax advantaged accounts—before you start putting away for a down payment. What does that mean? Follow this simple algorithm to determine what you should save for retirement:
- If your employer offers a 401(k) or 403(b) and matches employee contributions: Contribute the maximum percentage of your salary your employer will match (usually six percent). Then contribute up to $5,000 (if eligible) to a Roth IRA. If you have money left over, save as you wish.
- If your employer offers a 401(k) or 403(b) and does not match employee contributions: Contribute up to $5,000 into a Roth IRA (if eligible) and any extra either to your 401(k) or for other savings goals. (If you earn too much for a Roth, contribute as much as you can to your employer’s plan).
- If your employer does not offer a 401(k) or 403(b): Contribute up to $5,000 a year to either a traditional or Roth IRA and save additional funds as you want.
Once you are saving a reasonable amount for retirement (the greater of the $5,000 IRA cap or 10-15 percent or your salary), feel free to put additional funds towards saving for a down payment. To accelerate your down payment saving, especially when rates at savings accounts are so low, you might consider opening a regular brokerage account and investing some of your savings in the market.
Using an IRA for Your Down Payment
Finally, the IRS allows you to withdraw up to $10,000 from an IRA for a home purchase without paying the standard 10 percent early-withdrawal penalty. There are some rules: the IRS treats a withdrawal from a traditional IRA as income and you must pay taxes. Withdrawals from a Roth IRA for a home purchase are both tax- and penalty-free as long as the Roth is at least five years old.
Although this loophole provides cash-strapped home buyers with an additional source of funds for a down payment, I wouldn’t recommend using it; any money you withdraw now is money that won’t be earning returns, tax-free, for 30 or 40 years.
Do You Need Twenty Percent?
If you follow my recommendation to save for retirement before saving for a down payment, you may be watching your dream of home ownership fade several years into the future. This can be especially true if you live in areas with pricier-than-average real estate markets. (In some parts of the country, $150,000 can buy a very adequate first home; in others, a buyer might have to spend $350,000 or more for a comparable property). Although regional salary differences can make up some of this difference, in these areas cost of living typically jumps faster and higher than pay, according to the Salary.com Cost-of-Living Wizard.
In this situation, you could consider putting less than 20 percent down. (I would still recommend at least 10 percent). If you have been saving for retirement for a few years, have few other debts, and have a responsible notion of how much home you can afford, putting less than 20 percent down on your home shouldn’t be too much of a problem. You’ll need to pay private mortgage insurance (PMI) for as long as you have less than 20 percent equity in your home, but over the long-run the gains your retirement account is making will make up for the money spent on PMI.
What do you think? Do you agree or disagree that saving for retirement should take precedence over putting away for a down payment? What did you do? Are you happy with your decision? Please weigh in with a comment.