Retirees are outliving their savings. When they do… then what? This article is for homeowners who have considerable equity but can’t afford, or don’t want to maintain, their current house. Then the question becomes: is it better to sell and rent, or downsize and buy?
In the 80s, the mantra was location, location, location. Today, the question is less about the location of the house and more about the location of wealth and how to make the most of it. Finding the right answer to the ‘location of wealth’ question can be the difference between not having enough income in retirement versus being comfortable and able to provide an inheritance to loved ones. At a critical point people are unknowingly making a mistake that can cost them hundreds of thousands of dollars.
Demographics Are Destiny
The Government Accountability Office released a report last June on the current financial status of households between 55 and 64. The median household approaching retirement has a nest egg of between $10,000 and $20,000. Forty-one percent of these households have no retirement savings. Fifty-six percent of households are homeowners though only 22% have their house paid off.(a)
There will soon be so many people who need to understand this research and the right strategy so they can avoid the wrong choice. Today there are more than 48 million people who are over 65. By 2030 that number will grow to 73 million.
There are currently around 75,000 people age 100 or over, by 2050 there will be over one million.(b) This income-gap issue is going to apply to a lot of people. Just because we can’t solve a problem (in this case, people outliving their money) doesn’t mean all choices have equal outcomes.
“Would you rather run out of money in the next decade or three decades from now?”
HECM for Purchase
Most people, including financial advisors, are not aware that you can now use a reverse mortgage (HECM) to buy a home and have no mortgage payment. Property expenses (taxes, insurance, HOA dues) must still be paid but eliminating the mortgage payment is key to having enough income in retirement.
What follows is a hypothetical scenario that looks a lot like situations we encounter every day. A homeowner has a house that is no longer an ideal fit. Maybe the neighborhood’s not right, the house is too big, or the existing mortgage is too much.
The homeowners explains that they hoped to get the house paid off but there were a couple of cash-out refinances to pay for home improvements, college, wedding, and navigating the great recession. Bottom line, it’s time to sell. Sometimes the best way to illustrate a point is by way of an example.
The Big Question
A hypothetical 67-year old homeowner asks, “If I can’t afford my current place, should I: a) sell and rent; or b) use a reverse mortgage to downsize and buy?”
The truth is most people don’t know when they're deciding if they want to rent or own in retirement that they can afford more house than they thought if they use a reverse mortgage when they buy the next home. They assumed they had to pay cash because they know they can't qualify for a conventional loan. People are always excited when we explain this. Their future lifestyle options become much brighter.
- Home purchased in 1987 for $250,000
- Now worth $800,000
- Mortgage balance is $320,000
- Mortgage payment (principal and interest) is $1,623
- If sold; $400,000 net proceeds after commissions, capital gains, etc.
To answer the rent versus own question, one needs to calculate the difference in net worth between: 1) selling and using those sale proceeds to pay rent; or 2) selling and buying a smaller home using a reverse to cover half or more of the purchase price.
Because the buyer is downsizing, they’re not going to use all their sales proceeds. The amount they don’t use is invested in a side account that provides liquidity (for the unexpected) and is available to cover property expenses.
The reverse mortgage is the key to this strategy because it allows for repositioning a portion of the wealth; making it more accessible for emergencies and other uses. It’s the ‘location’ of wealth issue.
In our example, our 67-year old client has a bunch of equity but little cash. That situation often leads to not sleeping well – there is an awareness that they’re one big expense away from a crisis.
Actually, this rent versus own choice is not an easy question to answer. We had to build a tool to answer this question and to generate the graphs you see below.
For our example, we assumed the renter paid $2,500 per month and the downsize purchase option was for a $500,000 home. The charts below tell the story.
Net Worth - Using Sales Proceeds to Pay Rent
Net Worth - Buying Smaller House and Investing the Rest
Difference in Net Worth - Owner vs. Renter
- The renter's investment account runs out in year 14
- The home owner has a net worth of $305,764 in year 14
- The renter's investment account in year 20 is -$349,529
- There is a $569,708 advantage for the home owner 20 years out
Obviously, there is no such thing as a negative $349k investment account - it's just illustrating they ran out of money but still had expenses. The rent payment had to have been paid by someone; either our renter, from other funds, or someone else (children).
Why It Is Better to Sell and Buy Smart
These results are because the person who purchased the smaller house retains ownership of an appreciating asset. Even though the reverse mortgage loan balance is growing, so too is the value of the home. The renter's house appreciates too; it just benefits their landlord.
These results would be different if home prices fell over the long run, which has never happened. What is really supporting home prices at present is a lack of inventory, a problem that for many reasons is not likely to turn around anytime soon.
Below are four interesting charts that support at least 3.6% long-term house price appreciation. The first one is from the St. Louis Federal Reserve. It shows house prices since 1975.
This second chart is interactive (click it). It shows Los Angeles, San Diego, and U.S. home prices since 1980. Dark green is LA, orange is San Diego, light green at the bottom is the whole U.S.
This third chart shows house appreciation rates during different phases of the real estate cycle. (c) National Association of Realtors data from 1968 to 2004 shows an average yearly increase in median home prices of 6.4%. Our analysis used a house price appreciation rate of 3.6%, which we consider conservative.
This fourth chart looks at the most recent year-over-year price changes, by state.
You can see from the chart below, over a twenty-year look, the home’s value exceeds the loan balance. That difference is where the homeowners net worth advantage comes from.
Advantage of Owning
In this example, owning a home with a reverse mortgage is better than renting by:
- $100,000 in year 6
- $200,000 in year 10
- $500,000 in year 18
Our fictitious 67-yr old person might live to be 87, so a 20-year planning horizon is reasonable. Of course, the renter and/or homeowner may use other income such as Social Security, savings, annuities, pension, etc. to extend the time when their investment accounts hit zero but the conclusion is the same: owning appreciating assets increases and/or preserves wealth.
Eventually, the home owner will likely sell and perhaps move into an assisted living facility. Far better to still have some wealth than have been a burden on one’s kids for many years leading up to that. Even 20 years out, the home owner has net worth that can be used for late-life expenses.
This analysis and these results were recently published in a national magazine. We had to build a powerful analysis tool to run these numbers. If you’d like us to run numbers for you, click the Complimentary Consultation button below. Implementing this strategy could make a big difference for your heirs.
This rent versus buy analysis sought to keep comparisons like-for-like as much as possible. In the rent scenario, proceeds from selling the house were then used to pay the monthly rent and renter’s insurance. Both were adjusted for inflation.
In the buy scenario, investment account proceeds were used to pay property taxes, insurance, and HOA dues.
A 3.6% house appreciation rate was used, which is the average annual pre-bubble appreciation rate.(c) Rent and insurance rate of inflation of 3.22%, which is the average long-term inflation rate between 1913 - 2013 .
In both cases, the investment account earned 3.94%, which is the ten-year average of a low-load, tax-free bond fund (symbol VCAIX).
The owner has another option besides a cash or bond side account. The side account was used to make the two scenarios as similar as possible. The buyer can leverage a reverse mortgage line of credit, in lieu of the side account, but that is a complex issue we'll have to tackle another day.
Two factors that would have enhanced the outcome of the reverse purchase strategy but they were purposely excluded from this comparison to try to keep thing simple: 1) a possible future utilization of the deferred mortgage interest deduction, and 2) in CA, transferring a lower tax basis from a previous residence via Props 60/90.
(a) The Motley Fool, Average American household approaching retirement has this much saved up, Austin Smith, 8/19/16
(b) Investment News, The Longevity Paradox, Elizabeth MacBride, 8/22/16
Also, see image hyperlinks and facebook.com/theReverseAdvisor
About the Author
Kent Kopen earned his Reverse Mortgage Specialist credential in March 2007. Last year Kent earned the CRMP (Certified Reverse Mortgage Professional) designation. Note, there are less than 150 CRMP designees in the United States. Mr. Kopen also provides education, tools, and strategies to professionals who offer financial and legal advice to others. "Our resources help financial advisors, CPAs, and estate planning attorneys help seniors optimize their home equity to provide greater security and peace of mind."