Sweet In Law Suite Decision ⋆ XRAYVSN

Johanna’s Take:

Do you love your in-laws – as long as they are on the opposite coast?

Or does devotion and love in your family mean you feel an obligation to sharing your home with the parents who raised you?

Neither answer is right or wrong.

As I’ve learned in working with couples of very diverse heritages, choosing to bring your parents into your home is expected in certain cultures and is not considered a privacy invasion as it is by most Americans of European descent.

This week’s applicant is on track for FIRE (mainly FI) at age 50 and would like to know if adding an in-law suite to their house would push back those plans.

We’ll call her Dr. FF, for Family First.

The positives:

* High income

* Good at saving (close to $2.25M net worth at age 35)

* Estimate addition will increase value dollar for dollar (as opposed to a vacation or expensive car, for example)

* Only 1 child

* Career(s) allowing for flexible work arrangements after reaching FI

The negatives:

* Living in HCOL area

* Trying to reach early FI [I used 15 yrs rather than 12]

* Uncertainty of declining healthcare reimbursements

* Not sure about child #2 – would double college expenses and daycare

Assumptions (I will use conservative estimates wherever there is an uncertainty.)

* 6% average long-term returns on savings (assuming no emotional mistakes in upcoming bear markets and corrections)

* Average inflation 3%

* You retire in 15 yrs

* 1 child

* Including $350k in future dollars for college (see below)

* You have plenty of appropriate life and LTDI in place.

* No divorce

* No other significant financial assistance for other family members

* Reasonably good health

In our emails, I learned Dr. FF’s actual current income allocation is:

Living Expenses 24%

Savings 39%

Taxes 37%

To save the $105k for the downpayment (ignoring the current $110k on hand), we would need to reduce saving for the next two year to 30%.

After that, planning on a 15-yr 3% family mortgage, I estimate annual payments including real estate taxes and insurance at $32,400/yr.

At $600k/yr gross, that leaves 31% for savings.

In addition, I deducted the present value of the future $350k college estimate from their current investment portfolio.

This does not include any 529 savings already set aside.

Using the above assumptions, I arrive at an FI portfolio of between $6.5M and $7M @6% (in 15 yrs).

Is this enough to allow the FF’s to walk away from work if they wanted?

Let’s take a look:

* At 4%, the FFs could withdraw $269k/yr from their portfolios with a relatively high degree of comfort they would not run out of money in retirement.

* Dr. FF assumes living expenses in retirement would be $120k. She stated this would include the mortgage, but she would have only 2 yrs left on the addition at that time by my calculations. I’m going to assume that healthcare costs (pre-Medicare) will replace the mortgage.

* $120k inflated @3% 15 years in the future is $186,956.09, well below $269k/yr assumed available.

If the FF’s continue with the part-time/consulting work schedule for 10 years beyond age 50 and save 10%/yr, their portfolio would grow to ~$12M. This assumes they would not draw down on the portfolio during these 10 years. If they supplemented living expenses with 1% of their portfolio annually, the portfolio could potentially grow to ~$11M by age 60.

Suggestions:

* Stop the passive income investing until you have a solid plan in place, have arranged funding and have saved the 25% down. RE investing can be lucrative, but it has added risks that I do not believe you should be taking on right now. Financing the addition is your short-term priority.

* Plan for the part-time/consulting work beyond age 50 if you have a second baby.

* Part-time work with access to health benefits between 50 and 60 would be ideal. I would give higher weight to this benefit than to retirement benefits.

* Roth and taxable account space are especially valuable when one retires before age 59.5. Plan on Roth conversions in down markets and when you cut back work in 15 years.

Therefore my decision is….

Xrayvsn’s Take:

As Johanna pointed above, being a physician multimillionaire at the age of 35, with no student loans to speak of, is quite impressive and way ahead of the game compared to where I was at that stage.

However, like a lot of people in high cost of living areas, there is quite a heavy concentration of wealth in the primary residence ($1.9M home equity is almost 85% of the $2.25M net worth Johanna mentioned above).

This leads to the phenomena of being “house rich but cash poor.”

What is worse is that this desired item tilts the scales in the wrong direction even more.

I will disagree with Johanna and Dr. FF on the assumption that the addition will automatically carry with it a dollar for dollar increase in home value.

In real estate a home is worth what a buyer is willing to pay for it.

Many an individual has poured money into renovating a home to only find out that they lost money in the process.

I would go as far as to say that losing money on renovations happens the majority of the time (notice how none of these renovations recoups 100% of cost).

I am very conservative in my DIY financial planning philosophy so I will put these biases into my analysis:

The primary home value is taken off the table when calculating “usable net worth.”
- I am assuming Dr. FF does not want to downsize or do a reverse mortgage to tap into this equity at the age of 50.
I am going to analyze the scenario for a complete retirement scenario where the FF family will solely live on the accumulated investment assets.

Using Johanna’s $32k/yr estimate for the expenses this addition will bring (loan servicing, etc), will therefore increase the current yearly expense of the family to $187k/yr.

I also subtracted this $32k additional expense from the current yearly savings which would give $228k saving/yr for the first 2 years and $178k/yr for the next 13 years (based on the presumed drop of income of $50k due to declining reimbursements).

This results in approximately $2.77M of possible savings over 15 years.

To simplify the math I made the assumption that this was equivalent to adding $15.38k/mo into investments and gave a somewhat conservative 5% rate of return (compounded annually).

Plugging this data into an online calculator the final total I achieved was $4.075M.

As for the current $110k liquid savings I subtracted $70k for the downpayment of the desired rental property purchase, leaving $40k.

At the projected annual burn rate, this would be less than 3 months in emergency funds.

Being underfunded for emergency, I therefore removed the current savings amount completely from my analysis/calculations.

I also subtracted the $105k downpayment of the addition from the current $300k taxable account leaving $195k.

Using the same online calculator, this $195k investment adds another $405k to the “usable nest egg,” bringing the combined value of usable assets at the age of 50 to $4.48M.

I also am conservative in the safe withdrawal rate (SWR) percentage I feel comfortable with and typically use 3.5% SWR for my own financial decisions.

Applying this to Dr. FF’s usable nest egg at age 50 would mean that this portfolio can support a $156.8k/yr withdrawal.

In my opinion this would be too slim a margin for Dr. FF to support current annual expenses of $155k/yr (which is assumed to return back to current levels after repayment of the family loan)

However, Dr. FF did state that when she pulls the trigger at age 50 she expects retirement expenses to drop to $120k/yr.

This is another assumption I am not entirely onboard with, especially if she has to come up with health care coverage until medicare kicks in.

There is a possibility the portfolio value could rapidly erode before the age of 59.5 when the retirement accounts can come online to help with income, especially if there is a bad sequence of risk event occurring early on.

There are some things I did not factor in such as potential real estate returns from the planned investment property purchase but I do not think this will significantly push the needle either way.

What can significantly push the needle financially in a negative way is if there happens to be a surprise addition or additions to the family.

Some things that might make the addition a survivable financial move would be:

Use the in-laws to take care of the child(ren) and completely eliminate childcare costs.
Plan to tap in the equity of the primary residence via downsizing or reverse mortgage
Do not fully retire and work part-time to the point where healthcare would be subsidized by employer.

This analysis does not even address the elephant in the room which could be a potential change in family dynamics when lending/borrowing/paying back money is involved.

There are numerous instances where family discord erupts when money comes into the picture and a quick search of the internet gives ample evidence of reasons to not lend or borrow from family.

If the only reason the addition of an in-law suite can even be financially feasible is with a below market loan rate from a family member, than that in itself should be the biggest warning sign.

Therefore my decision is….

But first…

A Request:

This series, which I hope you have been enjoying, relies on submissions from the public to make it work.

Our supply of cases has been continuing to dwindle so I am putting out a cattle call for any additional submissions.

So if you have a major purchase you have been contemplating (home, vacation, car, jewelry, etc. please complete the form and Johanna and I can hopefully create an analysis for it).

Thank you- XRV

The Decision:

Johanna: Thumbs Up

Xrayvsn: Thumbs Down