Elsewhere it was suggested to start a separate thread on an off-topic tangent about whether it was better for a young person to prioritize saving in 401k vs saving for a primary home downpayment. I found this topic interesting, so I did a more detailed review.
If you don’t want to read the long post, the basic summary is 401k came out ahead with current mortgage rates However, with 0% fed rate type <4% mortgages as was common in the past, the results may differ. The results were also highly dependent on what type of rental you choose in place of a home.
My opinion is that 401k investment is generally financially advantageous to purchasing a home. There are also less direct financial advantages, such as being more open to opportunities for taking a high paying job out of area or working fully from home in lower cost of living area. Instead the primary benefits to buying a home are often not financial, improved quality of life benefits.
When comparing different investment types, I think it is important consider the relative risk/variance. There are different average return expectations for different risk levels. Using Case-Shiller stats since 1987 as a proxy for home value, I get the following stats for home value:
Home Value – Average Annualized Return = 4.5%, Standard Deviation = 6%
This standard deviation is much lower than a full market index type investment. With the lower variance, it’s more appropriate to compare with a 2/3 bonds, 1/3 market Index type portfolio. Using the same 1987+ period, this portfolio, I get the following for this portfolio:
2/3 Bond Portfolio – Average Annualized Return = 7.1%, Standard Deviation = 6%
As an initial comparison, I’ll start with the more simple case, without a mortgage. I realize this is not typical, particularly for younger persons. However, many do purchase homes without a mortgage in my area.
For the home purchase case, one needs to subtract home expenses from the home gain such as property tax, home maintenance, home repairs, home insurance, HOA, etc. The size of these expenses are going to be highly variable depending on both the specific home and specific location. Dividing average surveyed expenses by average home price in the US, I get a ~2.5% of home value annual expense. I’ll use that figure for now.
With the bond portfolio, one needs to subtract 401k related expenses, as well as rent expenses that would not occur with the home. I’ll assume 0.6% for 401k + fund expenses. Rent are expenses are highly variable, depending onw what you are renting in place of the home. You could live with your parents and pay no rent, rent a small apartment, or rent a large home. The results will vary dramatically depending on which option you choose. The average rent / average home value = 3.6%. I’ll assume 4% for now. This results in the following rough year to year estimate prior to home sale expenses. The 401k comes out ahead, but not by much per year. With different assumptions, buying a home could come out ahead.
Home (purchase in cash): 4.5% - 2.5% = 2.0%
401k (2/3 /bonds): 7.1% - 0.6% - 4% = 2.5%
Next I’ll compare to a US market index portfolio and mortgage leverage for similar variance level to a full US market index portfolio. The full market portfolio averaged a 10.5% annualized return in the reference period. If I consider the variance in return as a function of the initial investment and principal, I get a similar level of variance to US market index with a 35% downpayment on home. I’ll assume the buyer keeps their home for 10 years (most young people sell before 10 years) and has 6% of home value selling fees when home is sold. The average 30 year mortgage rate is currently 7%. The average throughout the period since 1987 is closer to 6%. I’ll use 6% for now. I will assume the relative difference in annual expenses between the 2 options is invested in 401k each year, and the 401k is never maxed out. 401k investments that are the same in both cases are not included. With these assumptions, the results are summarized and pictured below for a $500k home with 35% * $500k = $175k down.
Home (35% down, 6% mortgage): $330k equity - Expenses = $54k on year 15
401k (100% market index): $733k 401k - Rent = $476k on year 15
The bulk of the 401k advantage in the example above comes from rent being a lesser expense than mortgage + home expenses, so more gets saved in the 401k during each year if you rent instead of buyng home.
Obviously few young persons put 35% down on a home. According to Rocket Mortgage, the average first time home buyer only puts 6% down on a home. 6% down corresponds to an extraordinarily high risk level, a far higher risk than a 100% US market index 401k. I’ll ignore this higher gain expectation given the increased risk level for now. 6% down also usually results in PMI and worse mortgage terms, which I’ll also ignore. Instead I’ll use the following more generous assumptions towards home buying this time – 6% down, 5% mortgage, 5% rent (if not buying home), 8% return after fees on 401k. With these assumptions, I get:
Home (6% down, 5% mortgage): $364k equity - Expenses = Negative $126k on year 15
401k (8% return): $289k 401k - Rent = Negative $32k on year 15
While 401k still came out ahead. This time the results were much closer. If one could go back to past years when the fed rate was often ~0% and <4% mortgages were common, buying a home would have come out ahead in this example.