Friday, June 26, 2015

Should a Former Student Buy His First Home in the S.F. Bay Area

Welcome to another segment of CCM blog!

In today's episode, I have a former HS student asking me for help.  In fact, he represents one of the first students I ever taught, having him in my science class as a first year teacher in 2001.  He emailed me the other day:


Thanks for sending me your email address.

As I said on my message, I want to be more involved in investing and saving. I have a good job, and my fiance will be a teacher soon. Both of us are financially responsible, but we have no clue how to even get started on investments and saving more. 

Our goal is to get a house, eventually, and have a future that is financially stable. 

I remember speaking to (name) once and him saying that you live a bit far from the Bay Area and that you are a busy individual. However, I was wondering if perhaps we can chat or sit down and talk about how you did it--being financially stable, that is.

Let me know what you think. I am all ears and willing to try what you suggest.


So as to keep his identity private I will only share minor details about him.  He's 28-years-old, i.e., a Millennial, and is an engineer renting near Palo Alto where he works.  As you can read from his email, his soon to be wife will be working as a teacher.  I also know that his company offers a 401(k) but they do not match.  Bummer.

Before getting to this young couple's shared dream of purchasing their first home, I'm gonna advise my former student (let's call him, Jose) to get to know his employer's pension plan.  Is he being placed in a high-cost group annuity plan, or given investment options with high expense ratios?  He's gonna have to do some reading and find out, because if that is the case, then I suggest he stop making contributions to his 401(k).  For most other people, I would tell them to continue to contribute to a high cost 401(k) plan with their employer IF they do not have the discipline to save on their own AND they rely on their company's payroll deduction to keep them saving toward retirement.  Jose was one of my most disciplined students so I know once he sets his mind to something, he'll have no problem executing.  Thus, Jose, only stay with your employer's pension if you discover that the plan options are, low-to-average cost, and well diversified.  Since he has "no clue..." I will most likely be reviewing and explaining his pension plan options at some point for him.  That's what teachers are for.  On to housing in the, Yay Area!

Heck to the No!  Don't Buy, Don't Buy!  That's really what I would tell everyone thinking of buying a home in top markets, just to get it out of my system and be able to later tell them: "I told ya so!"  Just take a look at this chart:


Jose is a happy worker bee as an engineer, and I've asked him take my money personality quiz just for fun even though I know he will score Spartan.  Meaning, Jose wants to be rich.  And besides, just read his email, it is the talk of a Spartan..."investing and saving."  Nothing wrong with this of course.  I just have to, as the responsible party giving him advice, make sure it is geared to the Spartan mindset and not the Roman one so as to ensure it hits home, so to speak.  If you are a Financial Advisor somewhere and are working with Millennials who do not know the difference between becoming wealthy and rich, by all means use my free money personality quiz.  Subscribe and I'll send you a link.

Even though Jose is a Spartan, I must educate him about assets and liabilities.  A rental property is an asset.  A personal residence, however, is a liability because every month it swallows your capital, and the monthly return in combined equity and appreciation is never on pace with the total monthly expenses (taxes, mortgages, insurance, incidentals, etc).  There are exceptions of course.  Remember the RE bubble that led to the crash of 2008?  In the Bay Area in particular, homes were appreciating so fast, people were in and out of them (getting subprime leveraging) in less than six months with positive cash gains!  That's not happening today in the U.S.  Go to Canada for that.  My friends, Andrew and Matt, over at have a great article for Jose, and others to read: Will Your Home Be A Good Investment?

Many renters make the mistake of simply comparing the rent they are shelling out each month to what they could be paying on a home mortgage.  For example, say Jose and his fiance will move in together and pay the average 2014 rent for an apartment in Santa Clara County, $2,197.  Seems like a lot.  It'd make many puff out their chest and say to their partner, "Look at all this money we're just throwing away by apartment!"  Sure, the rent is covering the landlords bills on the home, but don't expect to get a similar set-up unless you leave that RE market and go far East!  Like the desert.  In Santa Clara, County you'll have that (if you're lucky) be your first mortgage, followed by a second of say, $350-$600 on a 3 bedroom, 2 bath in East Side San Jose AFTER putting 20% down on a $600K fixer-upper.  That price tag may not cover your impounds!  Taxes and Insurance.  Then there are maintenance costs as undoubtedly something will break or need repair like every stinkin month!  In sum, being a homeowner is for the Rich, not the Wealthy.

But I must give Jose a best case scenario for one day owning a home in the Bay Area.  Even though he's a Millennial, it looks like he plans on staying in one place, as opposed to moving around every three or four years like the rest of his cohort does.  He's getting married soon, and will want to have a place to call home by the time his wife is pregnant.  Let's say this will be sometime around 2020.  This gives him 5 years time to save for his starter home and the baby...he'll name it, Carlos, of course, if it's a boy.  If it's a girl, Carla?  Sure, why not?

Okay, so the way to do this is:

1) Stop making 401(k) contributions now!  There is no employer match anyway, and building this fund with pre-tax dollars will mean a surefire tax penalty if he were to use the funds later for a home purchase.  This action will increase his current take home pay.
2) Whatever he was contributing monthly to his 401(k), do it now, but in a Roth IRA.  Now check this strategy out:

With a Roth you can take out $10K tax and penalty free for a home purchase if the account has been open at least 5 years.  So, Jose would create a simple spreadsheet keeping track of all of his monthly contribution amounts.  Say each month he put in $500.  After 1 year he'd have $6000.  After 1.5 years, he'd have $9000.  I'd want him to stop right there.  No more contributions.  Why stop?  Because now he could invest that $9,000 within his Roth IRA and have 3.5 years to make $1000, a very conservative and do-able endeavor for a rookie investor.  A sample suggestion for him would be to buy shares of Vanguard's Dividend Appreciation ETF (VIG).  VIG has a 0.10% expense ratio and invests in companies with a record of growing their dividend year-over-year.  This will dampen losses brought on by a major market correction.   

His wife would follow suit.  Adding everything together: $9K + $9K of actual saved money + $1K +$1K of investment returns within two individual Roth IRAs = $20K for a down payment in 5 years.  Not enough?  No...unfortunately, this would still not be nearly enough.  As first time homebuyers, with great credit, Jose and his wife could qualify for loan parameters of 10% down versus 20%.  Private Mortgage Insurance?  Yes, that may be part of the 10% deal.  So say his dream home in East San Jose costs $550K.  He'd need $55K plus be able to show he's got emergency cash in the bank.  Add another $10K to this.  Now we're looking at $65K.

$20K from the Roth IRAs.  Still needs $45K.

3) Open up a Brokerage account with a discount broker like Scottrade.  

I have Jose and his wife currently saving $500 a month for 1.5 years.  Now Jose saves $500 a month for 3.5 years in his Scottrade account, amounting to $21K.  His wife does the same, equaling another $21K for a total of $42K.  But, they're not just going to deposit cash every month.  They'll also be investing, buying quality businesses (stocks) that are potential turnarounds, meaning the stock is beat up, and the company is a couple of years from being back where it was.  Names like McDermott (MDR) and Actuant (ATU).  I'd ask him to start building positions in these two sample companies (and other's I'd recommend) from the get-go and look to sell them as they eventually appreciate in value over the next several years.  He could, this way, make another $5K easily over 3.5 years.  His wife would be up similarly.  Putting it together, they're at $52K + $20K from the Roth IRAs for a total of $72K.

Again, this is just a scenario using $500 cash savings per month for each individual.  As an engineer, he may be able to save more than this each month.  His wife, as a teacher, may not.  However, anything over $1000 a month combined would place him well above his target of $65K.  

Home Buying Strategy

I advise Jose that he find an excellent realtor that will get him the crappiest house in the best neighborhood for his budget, whatever it may be.  The neighborhood matters more than the turnkey-ness, so to speak, of the house.  If he buys a fixer upper anywhere outside of East San Jose, it would be an improvement over a decent ready home in that area.  I know, I'm from there.  And I love all my friends (and family) who live in East San Jo, but y'all got to get up out of there.  Why do you insist in livin' in the most expensive hood in the nation?

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