Seniors looking to downsize to a smaller but more luxurious home can do so without digging into their retirement savings.
Rachel’s husband was a very handy man. He could fix anything, and one often found him up on a ladder or with a tool belt strapped around his waist. But ever since he passed away, the house had grown difficult for her to manage on her own. While the house served them well and was the perfect place in which to raise their family, the four levels and 50-year-old construction was more than she could maintain.
What Rachel really wanted more than anything was to buy one of those low-maintenance patio homes that her friend bought. It was new construction and had all the luxury features she wanted–security system, new appliances, lots of light, and just enough room on the back deck to have the right size container garden.
Here was the problem: The home she would sell had some deferred maintenance and was not in the best condition. She was only going to net around $500,000 from the sale. The new construction replacement home was going to cost $700,000. On the surface, it sounds like the only way to make this work is to either draw $200,000 from her retirement investments or take on a mortgage of $200,000. And who wants to sign up for mortgage payments at age 75?
Rachel’s situation is based on a number of cases I’ve seen over the years.
Put Yourself in the Position of Her Financial Advisor
You want Rachel to have the lower-maintenance lifestyle that she deserves, but now that her husband has passed (and she no longer has his pension income), taking on a mortgage payment of $1,330 at this stage of her life does not sound like the wisest advice. (This is $200,000 financed on a 30-year fixed rate of 7.0 percent/7.248 percent APR.)
And taking $200,000 out of the $500,000 nest egg that remains also does not seem very wise. You’ve run the projections—if she can leave all $500,000 invested, you can be reasonably certain that this sum will provide the supplemental cash flow she will need for the rest of her life.
You’ve done a great job as her financial advisor, she has the right amount of insurance, and she has some fixed-income sources from Social Security. But that $500,000 is going to be needed in its entirety if she lives as long as her own mother did—into her 90s. If she withdraws $200,000 now, the probability of her portfolio’s success goes down below 50 percent. Your software (eMoney Advisor, MoneyGuidePro, MoneyTrax, etc.) doesn’t lie.
An Often-missed Option
So, do you have to advise Rachel to stay the course and remain in her current home? There is another option—HECM for Purchase, also known as H4P. HECM is short for home equity conversion mortgage.
This FHA-insured program was designed just for her. It allows her to finance a portion of the purchase price on a loan that requires no monthly principal and interest payments for the rest of her life. In Rachel’s case, she sells her current home and nets $500,000 from the sale. She uses $440,000 from the sale proceeds to make the down payment and finances the remainder of the $700,000 purchase price using the H4P (more in a minute on how it works).
This leaves Rachel with $60,000 left over, and now she finally has the reserve fund that you’ve been wanting her to set aside for a rainy day.
The new buyers accept the home in as-is condition because they are a young couple with all the energy needed to bring this home back to life. Additionally, they know that after investing a little sweat equity, this home will likely be worth close to $600,000.
Does this not sound like the perfect win/win solution? This young couple purchases a home that they can afford and have the energy to make the needed repairs. And the next generation makes great use of the home in which Rachel raised her own family.
Does this sound too good to be true? It is the same FHA HECM that has been around for decades. But new consumer safety provisions have enhanced the program, especially over the past several years.
How the FHA HECM Works
Rachel makes a down payment of $440,000 on the $700,000 purchase price. The U.S. Department of Housing and Urban Development calculates the required down payment by factoring in 1) the age of the youngest borrower or non-borrowing spouse, 2) the purchase price of appraised value of the home, whichever is lower, and, 3) the current expected interest rate. This is also how HUD determine the portion of the homes equity available for withdrawal (https://www.hud.gov/program_offices/housing/sfh/hecm/hecmhome) to use for home maintenance, repairs or general living expenses.
After financing all the closing costs, Rachel begins with a loan balance of $287,000. She is not required to make a principal and interest payment for as long as she lives there as long as she 1) lives in the home as her primary residence, 2) pays all property charges including taxes, insurance and HOA dues, and, 3) does not violate any of the terms of the loan agreement. Terms include not allowing the home to fall into disrepair.
Rachel is allowed to let the finance charges accrue on the loan balance throughout the entire time she lives in the new home. While she would be allowed to make payments, that would not be required.
Next Steps
If she lives there for another 20 years and either she or her estate sells it, the home value may have grown to approximately $1.53 million, and her loan balance may have grown to about $1.23 million. This example presumes an average growth rate of four percent per year on the value of the real estate and it presumes that the finance charges accrue at an average rate of 7.3 percent.
When Rachel sells the home 20 years later, she can take to her next living situation the more than $300,000 in equity she has in this home. Or, if she remains in the home until her death, this $300,000 would be inherited by her estate.
If Property Values Fall
But what if things don’t go as anticipated and either Rachel or her estate sell at a time when property values have declined? At that point it is possible that the HECM balance could be higher than the value of the house. That is where FHA steps in. There is a no-recourse provision built into the HECM that ensures that neither Rachel nor her estate are responsible for the difference. The FHA mortgage insurance provides the protection to ensure that there is no personal responsibility for payment of any deficiency balance. That is the peace of mind that Rachel needs to be certain that she is not leaving a debt to anyone.
The next time one of your clients asks your recommendation on whether they should remain in a home that no longer suits their needs, make sure you take a closer look at HECM for Purchase. Maybe she can have her cake and eat it too. Plus, you retain more assets under management and your client keeps a larger nest egg. And your client realizes you care about her, which strengthens your relationship.
