Buying a House
TL;DR As a founder or startup employee, you don't have a lot of liquidity so banks struggle to underwrite you. The good news is that you may still qualify for a mortgage. Shopping around with different banks will help you get the best rate. More “tech-friendly” banks may also accept your startup equity as leverage in order to win your startup’s banking business. You might also consider waiting until you have the liquidity to buy your house in cash upfront and taking out what's known as a "cash-out mortgage" to save on taxes.
Every month you pay thousands of dollars to your landlord in order to live in your home. Ever wonder if you should be putting that money towards a mortgage instead, building wealth in the process? Maybe you’ve even found your dream home but between everything you have to worry about and enjoying your precious free time, you haven’t had time to dive into how getting a mortgage would actually work.
As a founder, you might have a high net worth, but because that money isn't liquid, banks struggle to underwrite you. The good news is that you may still qualify for a mortgage.
How does a mortgage actually work?
When you buy a house, you provide a down payment that’s typically 20-30% of the home’s total purchase price. (You can get a lower downpayment depending on the loan type and your credit score.) A mortgage is a loan that a bank provides for the remainder of the purchase price. The bank will charge interest on this loan over a set period of time. (Most mortgages are 15 or 30 years, though some last for 5, 7, or 10 years.)
Ex: You buy a $1M home, you put $300k down, and you get a mortgage from a bank for the remaining $700k + 3% interest paid over 30 years.
Mortgages can have either a fixed or adjustable interest rate. With a fixed-rate mortgage, your monthly payment is the same for the entire life of the loan. (Your parents probably had a 30-year, fixed-rate mortgage.) With adjustable-rate (ARMs) AKA variable-rate mortgages, the interest you pay is fixed for a period of time, then starts “floating” based on current market rates. Most people refinance (this is when you get a new mortgage with new terms) before the interest rate starts floating. The shorter the fixed period of the loan, the lower the rate because the bank is getting their principal back sooner. This structure can be to your benefit if you don’t have long-term plans to stay in your home.
Ex: You buy a home and you only plan to be in it for 6 years. You could select a 7-year ARM mortgage. Since the period of the loan is shorter, you’ll receive a lower interest rate than if you went with a 10-year or 30-year, fixed mortgage.
Mortgages are typically amortizing, meaning you are required to pay down the balance of the loan (principal + interest) every month. But some borrowers prefer interest-only mortgages which allow the borrower to only pay the interest for a set period of time (resulting in a lower monthly payment), before jumping up to a larger amortized amount once that period ends. This type of mortgage may be attractive if you want to keep more money in your pocket on a monthly basis now (e.g. while your company is getting off the ground and you’re not taking a salary or if you’re expecting a windfall later on). While this does mean higher costs later on, most people do not hold their interest-only mortgages into the amortization period. They refinance prior to that, move/sell their house, or pay it off.
What different types of mortgages can I get?
Here are some common types of mortgages you might encounter:
Qualified or Non-Qualified
The government divides mortgages into qualified (AKA QM loans) and non-QM mortgages. QM loans are safe products that protect the lender from lawsuits and buybacks if the borrower fails to repay. QM loans comply with the requirements set forth by the Consumer Financial Protection Bureau (CFPB) and standards set by the federal government. These requirements include restrictions on risky loan features like balloon payments, excess fees, and loan terms greater than 30 years. QM loans have lower rates because they have higher standards and thus lower risk of default.
If a loan doesn’t meet the above criteria, it is known as a non-qualified mortgage (AKA non-QM loan) and may have higher interest rates. Foreign nationals, investors, and those who are self-employed, as well as borrowers with low credit scores or prior bankruptcies or foreclosures, may find it difficult to qualify for a qualified mortgage and may want to explore this option. Non-QM loans are riskier for lenders, so their rates and costs are usually higher. Non-qualifying mortgages can be useful for buying quirkier properties including non-warrantable condos or condotels.
Conforming or Non-Conforming
Mortgages are further classified by being conforming or non-conforming. A conforming mortgage meets the dollar limits set by the Federal Housing Finance Agency (FHFA) and the funding criteria of Freddie Mac and Fannie Mae. In 2021, the limit is $548,250 for most parts of the U.S. but is higher in some more expensive areas. These limits change from year to year. For borrowers with good credit, conforming loans are advantageous due to their low interest rates.
If the loan amount exceeds the conforming loan limits, it’s classified as non-conforming and is known as a jumbo mortgage. For borrowers interested in purchasing more expensive properties, jumbo loans are a valuable alternative. An added benefit of this mortgage option is that you’re not required to buy mortgage insurance (costs ~0.5-2% of total loan amount). However, because this loan may come at a higher risk to the lender, it typically has stricter qualification requirements than typical conforming loans that possess lower limits. If the loan amount exceeds $1M, it is known as a super jumbo mortgage.
Note: If you served in the US military, you may be eligible for a VA loan, a mortgage available to veterans, service members, and select military spouses. VA loans are guaranteed by the U.S. Department of Veterans Affairs (VA) and allow you to buy a house with $0 down and great rates.
How much can I afford to spend on a house?
How much you can afford to spend on a house is likely going to be a big part of your decision-making process. There are a few ways to approach that question. You can:
- Evaluate the monthly all-in payment. You can look at the all-in mortgage payment, property taxes, homeowners association (HOA) fees if you’re considering a condo, insurance, upkeep, utilities, etc. These elements help you get a sense of the total monthly cost and what you’re comfortable spending given your cash flow. A common metric is:
Max monthly mortgage with taxes and insurance rolled in = Total Gross Income x 45% - All Debt Payments / 12
- Go to a bank (or multiple banks) to get pre-approved for a mortgage. When you submit your financial statements, tax returns, and pay stubs to a bank, they’ll share the mortgage amount and interest rate they are willing to provide based on a given purchase price. Banks update these rates on a weekly basis based on the overall interest rate. Certain banks will give you discounts for having assets with them. You can shop around and find out who will give you the best rate and have them bid against each other. This process can take hours. Many banks won’t even publish their rates; they make you speak on the phone with them. At Compound, our team will guide you through the whole process. Reach out to your Compound Financial Advisor or email firstname.lastname@example.org for more information.
What questions should I ask banks to get the best rate?
- “Are there any points?” Some banks make you pay 1% of the loan amount as a fee. Some banks will quote you rates in “points”. You want no points.
- “Are there origination fees or bank fees?” These are fees the bank would charge you to use their product. A good lender will not charge any.
- “Do you provide a credit for closing costs?” At the end of the home-buying process, some banks require you to pay an appraisal fee (an appraiser goes out to the property and confirms the house is worth $X), title fee (you taking ownership of the home on paper), and title insurance (insurance that you’re buying the home you think you’re buying). These costs can add up to $5-20k. Always ask a bank to cover or give you a credit for closing costs.
- “Will you match a competitor’s rate?” You can almost always ask a bank to match or beat a rate offered by another bank.
Can I leverage my equity to get a mortgage?
Traditional mortgages are based on liquid income, which can make things difficult for a founder, who usually has a high total net worth but lower salary/liquidity. Most banks do not count private stock as an asset to qualify you for a mortgage. However, certain banks will sometimes approve mortgages for founders as a way to win their company’s banking business. As a general rule of thumb, retail banks like RocketMortgage won’t accept equity as leverage while more “tech-friendly” banks like Silicon Valley Bank, JP Morgan, and First Republic Bank have been known to accept equity as leverage but rarely do.
What are some tax strategies I might consider?
Say you did a secondary or tender offer so you have the ability to pay in cash for the home. Having cash is an advantage because it a) allows you to make an all-cash offer which sellers want in competitive markets like San Francisco, New York City, etc., and b) provides additional tax benefits vs. buying a home with a mortgage to pay the purchase price.
The current IRS mortgage deduction allows you to take a tax deduction for interest payments on the first $750k of debt (i.e. If you have a $1M mortgage, you can only deduct 75% of your interest payments). However, if you use what’s called a “technical refinancing” AKA “delayed financing” and invest the loan proceeds, you can potentially deduct a higher amount by classifying the loan as an investment interest expense.
Ex: You buy a $5M house with cash, then take out a $3M mortgage against the house. A couple of things happen. First off, you can make a more competitive all-cash offer. Second, if you invest that $3M*, you can also take a tax deduction for the interest on the entire $3M mortgage because that interest is now classified as an “investment interest expense.” This allows you to deduct more interest against any investments that create taxable income. (In certain cases, your CPA may elect to deduct against capital gains and qualified dividends.)
*Must be into a taxable investment (i.e. single stock or ETF/index fund)
If you buy the house with cash, you also have 90 days to take secured debt against the home to claim it as a mortgage expense. So using the example above, if you take out a $3M loan, $750K can go back into your pocket (counted as a mortgage interest expense) and the remaining $2.25M should go into taxable investments.
Note: If your portfolio is made up of 2% or more tax-exempt securities, the government may take the position that the interest is partially non-deductible because you have the ability to sell tax-exempt securities to generate cash for taxable securities.
There's also something called a "cash-out refinancing" which replaces your current home loan with a bigger mortgage, allowing you to take advantage of the equity you’ve built up in your home and access the difference between the two mortgages (your current one and the new one) in cash. You can then use the cash for home remodeling, consolidating high-interest debt, or any other financial goals.
Code Section 121 Home Sale Exclusion
Buying a house now may create current deductions (home mortgage, investment interest expense, etc.), but you can also exclude up to $250K ($500K if married filing jointly) of gain from selling the house in the future. To qualify for the Section 121 exclusion, you must have owned and lived in the house for at least two years out of the five years prior to its date of sale.
Buying a house is a big financial decision — especially for founders with limited liquidity. Fortunately, in today’s low-interest environment, it’s easier than ever. The type of mortgage that’s right for you depends on your overall financial picture, including your liquidity constraints and expected future cash flow. Some more “tech-friendly” banks will lend to you as a founder to try and win your startup’s banking business. Regardless, asking banks the right questions, shopping around for the best rate, and having a proactive tax plan can help you save money.