Wouldn’t it be great if we had enough money to create a lifetime income stream, and could live forever in the home we own? Sure! But all too often we need to use our home to help generate that income stream. This post explains four ways to do so.
Every December my generation of my family watches “It’s a Wonderful Life.” Among the heartwarming scenes is one where the townsfolk show their gratitude to the hero, who has been operating the mortgage company that enabled them to buy their homes. It’s a lovely way of showing how important it is psychologically to most of us to own a home. In Post #23 (http://donezra.com/23-two-other-considerations-buying-a-home-and-life-insurance/) we noted the feeling that we’re born short a home, meaning that we don’t feel complete and secure until we own one. There are studies showing that homeowners behave better in society than renters. Governments often encourage home ownership. And so on.
We also noted that a home is not only a roof over our head, it’s also an investment. Typically we need to borrow money in order to buy it, at a time when we’re asset poor but cash-flow rich. Then we pay off the mortgage debt gradually from our income. Meanwhile the home tends to appreciate in value over the long term, and though we have to pay for repairs and property taxes, it saves us from having to pay rent.
I’m not saying that home ownership is always a good investment. Sometimes it’s cheaper to own, at other times it’s cheaper to rent. I’m simply mentioning the emotional connection.
For many homeowners, their home is often the single largest asset they possess. And so it plays a large role in the finances of their retirement.
The fortunate ones have enough other sources of retirement income that they don’t need to monetize their homes. They can then consider leaving it to their children, or whoever. But for most, at this stage of their lives they are now asset rich and cash-flow poor, and so they need to convert their home into a source of retirement income. (When we look at the forthcoming calculator for your personal funded ratio, I’ll incorporate a distinction between liquid and total assets in your pension pot.) They have essentially four options.
The first is to sell it, and rent an apartment or a house. This is often a psychologically wrenching decision. It’s not just that change is unsettling. It’s also that the home is a huge source of loving and happy memories. In principle the memories remain after a move, but in practice it’s tougher to remember them when in different surroundings. That’s why so many people, even in the final stages of life, hate to move (or worse, be moved).
From an investment perspective, though, a sale generates liquid capital, which can then be added to other liquid assets and invested to become a source of drawdown income. Of course, rent now has to be paid, but the former owner can now afford to do so – for some period of time, at any rate. And from a strictly financial perspective, the former owner now has the typical retirement issues of uncertain longevity and determining what is a sustainable drawdown, and so on, uncomplicated by home ownership.
The second option is just a variation on the theme of selling. It’s to downsize. In other words, sell, but buy another home, smaller and less expensive than the previous one. It matches the middle of three stages of retirement that studies categorise: an early stage characterised by throwing off the shackles of work and a release of suppressed urges and energy, often involving travel; a middle stage in which the lifestyle is downsized, and for which a downsizing of the home may be an appropriate accompaniment; and a potential final stage of impaired health. (These are sometimes called go-go, slow-go and no-go.)
The third and fourth options are for those who don’t want to sell at all – they want to stay put – but they also want to find a way to use the home as an asset to generate cash flow. The obvious way is to rent out some space to a tenant, thus generating cash flow. A friend suggested that I include the notion that if you’re going to rent out a room in your home, making it a B&B could add purpose and joy to your retirement.
But if you don’t want to share your space, you need a fourth way.
The finance industry has come up with a way, typically called a reverse mortgage. The homeowner borrows a lump sum, or takes out a line of credit, or even borrows a cash flow stream (for example, every month or every year) against the security of the home. Aha, you say, but what about paying interest on the loans – doesn’t that reduce the available cash flow? And how does the aggregate loan get paid off, if the home isn’t sold?
In fact, those are exactly the questions you need to ask before considering a reverse mortgage.
The interest is never paid. In effect, each unpaid amount of interest is added to the loan. So, as you can imagine, the aggregate loan grows pretty fast. That’s why the amounts that lenders are willing to advance are relatively small. (For example, in most countries advances stop when the aggregate reaches perhaps 50% to 60% of the home’s value.) And those advances are made only to borrowers who initially are at or near what the community considers normal retirement age. Critics point to fees that may be added to the loan value, possible penalties, high interest rates and other potentially negative features, so a reverse mortgage is something that needs to be studied carefully and not entered into lightly.
The homeowner retains title to the home and therefore remains responsible for its upkeep and property taxes. The lender gets repaid when the owner sells the home, moves out of it or dies. In some places the repayment is limited to the actual value of the home at the time of repayment.
(Dr Wade Pfau has written a book called, appropriately, Reverse Mortgages, published by Retirement Researcher Media. While it focuses on US considerations, it is also an excellent explanation of the many uses to which these instruments can be put. The usual disclaimer: I know Dr Pfau but have no connection to him.)
So there they are – four options if your home needs to be called upon to assist your retirement finances, none of them entirely happy.
There are four ways to use your home to generate income after you retire: sell, downsize, rent it out or take out a reverse mortgage.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.