Some people’s guilty pleasure is thumbing through the celebrity gossip magazines at the supermarket checkout. Others is a binge watching Netflix. Mine is reading the personal finance stories on CNN Money. The advice they offer is so broad and generic that it’s basically useless, but every so often I come across a gem that warrants a second look. This article, was one of them.
It was basically extolling the virtues of a millennial who bought a condo in a hot housing market, but then was able to flip it and trade-up for a house. The article describes the whole thing as a “financial windfall” but I’m not so sure.
Meet Sam Saslow
The article tells the story of Sam Saslow, a 33-year old in Denver who bought a condo 4 years ago. It doesn’t say anything about the rest of his finances that would give you some insight into his ability to afford the place. Here is what it does say about his condo purchase:
- $164,000 purchase price
- 3% down payment ($4,920)
- $7,000 total out of pocket costs (so closing costs, etc. were $2,080)
With those numbers he had a starting mortgage balance of $159,080. If we assume a 5% interest rate and 30-year fixed term, his monthly payment for principal and interest would work out to $853.98 before property taxes, etc.
It goes onto say that he sold the condo for $285,000 four years later, an impressive 74% unlevered return. Since he only put 3% down his cash-on-cash returns were an insane 1500%. To get that number I’m assuming he paid down about $10k on the mortgage in the 4 years he owned it and paid 8% of the sales price in realtor fees, transfer taxes, proration, etc.
Sam then used the net proceeds from the condo sale, which I estimate to be about $113,000, to buy a house and pay for a few renovations and furnishings. Here are the details in the article from the home purchase:
- $402,500 purchase price (145% more expensive than the condo!)
- $20% down payment ($80,500)
- It doesn’t say anything about what his total out of pocket, but the proceeds from the sale would still allow him $33,000 of cushion for the rest of the costs mentioned
The starting mortgage balance on the house based on the numbers given would be $322,000, or slightly more than double the mortgage balance on the condo. Using the same mortgage assumptions as above, his monthly mortgage payment for principal and interest would be $1,728.57, also slightly more than double what he was paying on the condo.
Let’s Start Poking Some Holes
All of the numbers I’ve referenced so far were facts from the article or could logically be inferred from them. That said, I think there are two big things the article glosses over, both of which could have disastrous financial implications the next time around.
- Leverage. Sam’s first condo purchase was highly levered to say the least. A 3% down payment mathematically means he had a 97% loan-to-value (LTV) ratio, well in excess of the 80% LTV with standard financing. He must have purchased using a first-time homeowner program, but the risk he’s taking is that a very small decline in prices will wipe out all his equity. While paying down the mortgage over time helps, he still has to contend with the fees to sell. Bottom line, without the rise in value, he’s break even at best and at substantial risk of decline if there are any hiccups.
- Doubling Down. While he made a lot of money on the sale of the condo, he effectively rolled it all into the purchase of a new, bigger house. We know nothing about the rest of his finances, but his mortgage payment doubled as a result of the move. It’s a safe assumption that his property taxes and other housing costs (utilities, maintenance, etc.) all went up similarly as well. Did his finances improve enough in the last 4 years to absorb all of these costs? What’s his new debt-to-income ratio? Unless his income magically doubled in the same time, he’s losing ground.
There’s no doubt he did well on the condo, but instead of banking the gains, he still has some major financial risk if anything goes wrong. He can absorb a much larger decline in housing prices since he’s less levered, but what about if he loses his job or struggles to meet the new payment obligations? Are those fixed expenses crowding out other savings?
All of these points are curiously absent, but ignore that: housing prices are going up!
Everybody’s Making a Fortune, You Should Jump In Too
Hmmm. Where have we heard that sentiment before? It’s like we’re in Groundhog’s Day again and hearing all these stories about how everyday, average people just like you and me are making tons of money in the housing market. And if you’re not in it, you’re missing out on untold riches.
That’s what grinds my gears about articles like this. They’re nothing but hype and I doubt your average CNN Money reader can see through it. Even if they attempt to balance out the risks, it still doesn’t reflect that this poor guy is effectively going all in on his home. He mentions seeing the carnage in Florida when it all went wrong, but he’s happily willing to trod the same path in Colorado.
Okay, I’ll get off my soapbox now. Now let’s talk about how you can use this as a case study for your own finances:
- Treat your house like a place to live, not an investment. It’s value is putting a roof over your head, not as another investment vehicle. If you end up making some money at the end of the day, treat it like gravy.
- Understand the affordability metrics that go into mortgage underwriting. Banks don’t do it for their health, they do it to see how financially stable you are. The guidelines exist for a reason.
- Don’t miss other costs of home ownership. If you already own your home, you’re likely familiar with these already, but there’s always something that you’ll miss.
- Know how bad it can get. How will you keep your mortgage current if things turn south again? How far would home prices have to fall for you to go underwater on your mortgage? Where are their blind spots in your finances?
Readers, what do you think about my take on Sam’s situation? Would you have done anything differently?
John started Present Value Finance in 2017 to share his experiences and insights on personal finance to help people make better decisions and take control of their financial lives.
He achieved financial independence in 2016 by walking away from the high stress world of corporate finance to focus on his family. He’s a husband, father, family CFO, and all around finance geek.