Clients who have stopped working but want to purchase a different (or an additional) home will have a couple of questions for you.
The first will hopefully be, “What can we afford?” and the answer will be determined by them, you and perhaps their lender if they choose to get a mortgage. The second will likely be, “How can we pay for it?” Here are the options you can present to them.
The easiest, optimal way for clients to purchase a new place is to just write a check, perhaps with the proceeds from the sale of their previous home. But if the property is a second home, there wasn’t a lot of net equity generated by the sale of the previous house or the clients don’t have a huge stash of cash held outside of their retirement accounts, they may be tempted to tap their IRAs to raise the funds in a lump sum. That could be a big, expensive mistake, as it would mean the IRA withdrawals would be taxed at a higher rate than they would if they were instead taken out over a longer period of time.
For instance, if the clients needed $400,000 for the new house and the IRA withdrawal would be taxed at a 33 percent overall rate, they have to take out about $600,000. Worse yet, that chunk pulled from the portfolio could substantially reduce the clients’ liquid assets, making them house-rich and cash poor.
Therefore, the clients should only pay cash for the property if they have enough funds to cover the cost without tapping tax-deferred accounts and if they will still have readily accessible funds to meet other future emergencies and expenditures.
Even if the clients decide to pay cash for the home, they should still establish a home equity line of credit for as much as the lender will allow. This will allow the homeowners to tap the equity in an emergency without having to go through the typical mortgage application process.
Going to the bank
Clients who possess neither the liquid assets nor inclination to write a check for the new property can of course apply for a traditional mortgage at a bank, credit union or other real estate lender. But even if the clients are financially comfortable and have solid credit scores, they are probably missing another component that may be required by the lender: a traditional, reliable paycheck.
You and the client may be able to placate the lender by initiating a regular monthly withdrawal in a suitable amount from the clients’ investment accounts to their personal checking or money market account. The lender may also require you to prepare a letter documenting that these transactions have begun.
Another method that the lender may use to approve your clients’ loan application is the “asset depletion” calculation. The lender begins by adding up the clients’ total liquid investable assets. Then subtracts 30 percent of the home’s purchase price (the amount of the required down payment), plus any closing costs. She then takes the remaining amount and divides it by the length of the mortgage, in months. That figure is then added to the monthly income figure, usually along with any Social Security or pension payments.
Not all lenders require the income component to approve a mortgage for retirees, or allow the asset-based strategies to qualify as income. So make sure your clients shop around until they find a lender who offers a solution that fits their needs and situation. Assuming the clients are eventually approved for a mortgage, they should consider a 30-year fixed-rate loan. The monthly payments will be lower, making the purchase more affordable and more likely that the loan will get approved.
That lower payment also means that the clients will have to pull less out of their tax-deferred accounts to make the monthly payment, which may then lower their annual tax bill. Then they can always pay it off early if they wish, usually with no penalty.
Reverse the process
There is a third intriguing option many retirees have to “borrow” money to purchase a new home, and it has a less-stringent application process and no future monthly payments: using a reverse mortgage.
It’s technically called a Home Equity Conversion Mortgage for Purchase. To qualify, the buyer, or one spouse, who must be at least 62 years old. The HECM must be used on the buyer’s primary residence, but can include 2-to-4 unit complexes, condos that are approved by HUD, and FHA-approved manufactured homes. The amount that can be financed via an HECM usually ranges from about 40 percent to 70 percent of the purchase price, and is dependent in part upon the youngest borrower’s age, the price of the property and the current prevailing interest rates. The buyers have to cover the unfinanced amount of the purchase from their own savings. But once the purchase is made via a combination of buyers’ savings and the HECM, no future payments are required from the buyers. Instead, the balance of the HECM will grow at a fixed or variable interest rate.
Once the homeowners leave the home, the home is usually sold. The sale proceeds first go to pay off the balance of the HECM, and any remaining funds are then transferred to the owners (or in the case of death, to the estate). But if the balance of the HECM exceeds the sales price, the owners (or their families) owe nothing. That deficit also means that some combination of the interest on the HECM and a lack of appreciation on the property have eroded all of the original down payment the buyers made.
For more information on reverse mortgages, send your clients to tinyurl.com/revmortg, or have them call 800-569-4287 to find a HUD-approved counseling agency in their area.