Living in an affluent city where tech companies thrive has its perks. For one thing, there are plenty of career options.
But it also has its downsides.
Like paying through the nose for a place to live: whether you rent or buy. ???? ????
When an “average” house costs $1 million, the dream of buying a house seems totally unattainable, and like you’ll be stuck renting forever. But, since owning a house can be a huge asset in your long-term financial plan, finding creative ways to pay for it (like with your stock options), can be a great idea.
Otherwise, getting together a downpayment might mean saving $200,000 out of your salary, which would take forever. Especially with sky-high rent rates and a cost of living that’s way, way higher than your cousins in the midwest have to deal with.
The good thing is, as an employee in a pre-IPO company, you’re at an advantage. You have this incredible wealth potential in your IPO stock options that can turn into the cash you need for a down payment when the IPO hits.
In this article, we’ll walk you through how to do it.
The Finances of Home Buying: A Disclaimer
As city real estate costs skyrocket, it’s getting harder and harder to answer the question of whether buying a house is a good decision or not.
It’s never a definite yes or no. It always depends on the market where you live, your annual income, and your overall financial standing.
If you’re still unsure if buying a house is the right move for you, check out our article on the pros and cons of homeownership.
If you’re pretty sure you do want to buy a house, or to use your stock options to buy a house, read on.
First Things First: How Much Should You Spend On a House?
Anyone who’s ever shopped for a home knows this familiar trap:
There is always a slightly nicer house in a better neighborhood that’s just a little more expensive. ????➡️????
The realtor helps you rationalize the higher expense, and before you know it, you’re buying a house above the maximum price you set for yourself.
So before you start shopping (or selling your stock options for the down payment), here’s the rules I use to advise my clients on home price, in terms of their annual income:
- In large, expensive cities like New York and San Francisco, spend no more than 4x your annual income.
- In mid-size, less expensive cities like Nashville and Austin, spend no more than 3x your annual income.
For example: let’s say your salary is $195,000 with a $35,000 annual bonus. That’s $230,000 per year.
If you live in San Francisco, don’t spend more than $920,000 on a home.
If you live in Nashville, don’t go over $690,000.
And yes, I know it’s hard to buy a home in San Francisco at that price. We’re not trying to limit you here… just trying to keep you from having an empty house because you can’t afford to put furniture in it.
To get over this challenge in San Francisco, though, you could pay a larger down payment, or count your RSU as a part of your income.
So, if you had the same $195,000 salary with a $35,000 annual bonus as above, but you also get approximately $100,000 worth of RSU, that increases your annual income to $330,000. Multiply that by four, and you get a $1,320,000 house. It’s still not a lot for a house in San Francisco, but it’s more doable.
The Down Payment: How Much? (Using Stock Options to Buy a House)
We’re fans of the 30-year, fixed-rate mortgage. With these loans, you can usually borrow at a lower interest rate than the expected ROI on your home, increasing your equity in the property. For these loans, a 20% down payment is pretty standard.
Some of you may be tempted to put down more than 20%, especially if you’re liquidating your stock options to buy a house. But before you pay a massive down payment, think through the numbers.
Which IPO Stock Options to Sell for Your Down Payment
When your company goes through an IPO, you could have up to SIX different types of equity to sell:
- Shares that are Qualified Small Business Stock
- Shares that are considered long-term capital gains
- Shares you’ve had for less than a year
- Restricted Stock Units
- Incentive Stock Options
- Nonqualified Stock Options
Every person’s situation is different, of course, so we’ve written about what stock options to sell and when, as well as five ways to sell your stock after an IPO.
But to sum it up for you:
- Sell all your RSU first.
- These are taxed as ordinary income as soon as they vest. You’ve already paid taxes on them as income, so you may as well turn them into cash.
- Sell your Qualified Small Business Stock (QSBS) shares, if you have them.
- Capital gains are excluded on the sell of QSBS shares, which offers the greatest benefit when you’re in a high tax bracket. (And when the IPO happens and all your double-trigger RSU are released, you’ll be in a higher tax bracket.)
- Sell your long-term capital gain shares.
- Because you’ve had these stock options for more than a year, they’re taxed at a lower rate.
- Sell Nonqualified Stock Options (NQSO) next.
- These are always taxed as ordinary income, but are only taxed when you exercise.
- Sell Incentive Stock Options (ISO)
- If possible, it’s better to hold onto these for a year or more so they’ll qualify as long-term capital gains. However, if you need to, you can exercise these and do a same-day sale if that’s the only way you’ll be able to pool together enough cash for a down payment.
Prepare for the Mortgage Pre-Approval Process
First off: Get mentally prepared.
This stage of the process is brutal. And I’m not over-exaggerating.
It’s not fun, but it has to be done.
First, choose the account you’ll use to wire the funds for your down payment and move the cash from the sale of your stock options here. Ideally, you’ll move this money into your account three months before you meet with a lender for pre-approval.
Having this money sitting in your bank account for that long will reduce the amount of documentation they’ll want from you. We realize it may not be possible with the time constraints around an expiring lockup period, selling your shares, and buying the house. But if you can manage this time frame, do it. It’ll make your paperwork a lot easier.
After that, prepare the paperwork to show your lender. They’ll want to see your tax returns from the last two years, and your last two W2s. (And possibly your end-of-year pay stub from the last two years.)
They’ll also want to see your bank statements from the last two months showing direct deposits from your pay stub. Just keep in mind that if there are any deposits that are more than 50% of your monthly income, it’ll trigger requests for more documentation. (This is why we want you to move the money into your bank account three months ahead of time.)
Also, don’t start shuffling money around when you know you want to get pre-approved. The less money you move, and the fewer accounts you have, the easier the approval process will be.
You May Have to Create a Paper Trail
Any paperwork can be a pain in the bum, but creating a paper trail to track your money can be especially boring. And it’s a lot of work when you’re using stock options to buy a house.
For example, in a recent IPO one of my clients went through, they sold different shares that went to different organizations.
The shares he sold went to Shareworks, and the stock options and RSU he sold went to Etrade. He didn’t choose this complicated setup, his company did.
But, because he wanted to buy a house with this money, he had to show the lender exactly where it came from. He had to chase down documentation to show where the shares came from, where the cash for the shares came from, and where the options and the RSU came from. It was a headache.
Adjust to Your New Mortgage Payment
With the price of real estate in tech-heavy cities, your mortgage payment will more than likely be higher than your rent payment. This adjustment can be tough at first, and stresses a lot of people out.
To ease the anxiety, though, you can use your stock options to do things like paying more than 20% down, so you can get a monthly mortgage payment that gives you more breathing room in your paycheck.
Or, you can choose to refinance in a year. After a year, you’ll probably have more cash from your RSU you can put towards your mortgage to lower your payment.
Just don’t let the anxiety to take over. If you give yourself time to adjust to the higher payment as your new normal, it’ll be okay. Plus, you can create an emergency fund (or cash out some IPO stock options to create it) to have 20% of your mortgage balance there, just in case anything happens.
It’s a good idea when you’re in the adjustment period to use a tool like YNAB to track your money, identify your spending shifts, and make sure you don’t find yourself in the hole at the end of the month.
As a rule of thumb: give yourself a year to adjust.
- Put 20% down.
- Put 20% in an emergency fund.
- Use YNAB.
- See where you are one year from now and if refinancing with RSU sales is possible.
Work With Someone Who’s Been Through The Process of Using Stock Options to Buy a House Before
It’s an understatement to say using stock options to buy a house is complicated.
But it’s 100% possible, and it’s an incredible alternative to using your salary as your only means of saving up for a down payment. But with all the funding requirements, financial paperwork, and paper trails required, working with an experienced financial planner can really help make this process A LOT easier.
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