By Keith Whitcomb
Housing will likely be the largest expense you face in retirement. According to the Bureau of Labor Statistics, average spending on housing in retirement is two to three times greater than healthcare. Plus, housing is more than just an expense. For many, a home will be their biggest asset when they retire.
So, the housing decision touches on shelter, controlling expenses, and long-term investing. Bottom line: You not only need to look at healthcare costs, but also housing when developing your financial plans for retirement.
Your Home Strategy
Given that shelter is a lifelong need, your housing plans for retirement start to take shape as soon as you begin working and living on your own. Determining when it makes sense for you to rent space or to own a home is likely the most significant issue regarding housing. Breaking down the rent/own decision into the following three life-phases will help guide you to the right financial and functional choice.
Phase 1: Working Full-time; Focus on Accumulation
Renting: According to ATTOM Data Solutions, 71% of average wage earners in the United States can't afford to buy a home, so renting may be your only option. However, this is not necessarily a bad thing. Renting is often viewed as cheaper and more flexible than owning a home.
For example, if you expect to move frequently, high closing costs can make home ownership more expensive than renting. However, while renting may currently be your best option, you should still financially position yourself to be ready to buy a home if/when it makes sense for you to do so in the future. That's because studies that conclude renting is better than buying often assume that any savings from renting will be invested and grow at a "market" rate of return. Actually, it's debatable whether people will invest or just spend the savings.
The point here is that a generalized analysis which considers a home to be a good or bad investment may completely miss the mark if the assumptions don't fit your profile. So, even though the concept of home ownership as an investment has been questioned by financial experts, the correct choice for you is driven by your individual motivations, where you live, and your financial circumstances.
Buying: The evaluation of purchasing a home as a retirement asset versus traditional market investments is difficult because it is like comparing apples to oranges, e.g., you can't live inside a mutual fund. A typical investment analysis considers risk, return, and taxation. Purchasing a home includes that and much more. Attributes of home ownership to consider include the following:
- Asset -- Whether the experts like it or not, technically your house is viewed as an asset on the balance sheet just like stocks and bonds. And like stocks and bonds, the value of a home fluctuates. The good news is that it may counteract the volatility of your 401(k) and IRA investments based on how real estate is valued (supply/demand, location, mortgage rates, and potentially taxes). The bad news is that you are probably overweighting your portfolio in a single asset, so avoid buying an overpriced house in a marginal neighborhood. In addition, buying and selling a house triggers high transaction expenses, i.e., closing costs, when compared to discount brokerage fees on market-based investment transactions.
- Debt -- There are few investment opportunities that allow you to own an asset by putting down as little as 3.5% of the purchase price (or maybe 0%), and financing that purchase with very low interest rate loans. However, it doesn't take a lot of research to see how an over-extended mortgage can lead to financial difficulties, so be extremely cautious and don't borrow beyond a reasonable limit. Additionally, don't assume your reasonable limit is the maximum amount you are allowed to borrow from the bank.
- Liquidity -- Almost by definition, a house is not a liquid investment. You can't carve off a piece of your home and sell it, although a Home Equity Line of Credit, or HELOC, allows you to borrow money and in effect monetize the equity in your home. However, it will also come with interest payments and the dangers of increased debt.
- Expenses -- Insurance, utilities, taxes, and maintenance also need to be accounted for in the "investment" evaluation. However, these expenses are offset by the rent that would have been paid if you lived in an apartment. Mortgage interest and real estate taxes are tax deductible on your Federal Income Tax return, but the now increased standard deduction and limits on mortgage and real property tax deductions may mean it no longer makes sense for you to itemize your return to receive this tax benefit.
- Emotional -- There is a whole layer of non-financial decisions involved with buying a house that muddies the investment analysis. Where do you want to live? How does your job influence the choice? How long will you be there? What about safety? And the school district? Is the house close to relatives (or too close)? Sidewalks? Streetlights? Is it a multi-generational homestead? These functional issues, and others like them, will likely override any financial analysis so sort them out first.
- Behavioral -- Another aspect of home ownership is that it is a form of forced savings that seems to work. You have to make that monthly payment and a portion of it goes toward building equity in your home.
Key objectives for Phase 1: Build equity on a long-term basis. Pay off the mortgage before Phase 2. Limit churning that produces excess transaction costs, i.e., don't move. Limit using home equity for liquidity by using an emergency fund or perhaps a 401(k) loan before a HELOC. Consider refinancing or accelerating principal payments to reduce your interest expense and/or shorten the maturity of the loan.
Phase 2: Retirement; Focus on Utilization
When you reach the end of your full-time working career, if you own a home you have some choices to make. They include:
- Sell -- By selling, you can use the proceeds to augment other assets to generate retirement income, and then rent or downsize to a smaller house. The sale can provide a lump sum to help finance "Go-Go" spending. It may also avoid capital gains tax that can help lower overall taxes paid during those higher spending, early retirement years.
- Reverse mortgage -- An alternative to selling your home is to keep it, set up a home equity conversion mortgage (HECM), and use the HECM as a diversifying source of retirement income that can shield you from market downturns and provide tax free funding when needed. Unlike traditional mortgage based financing, a HECM has no interest or principal payments, and offers protection against your loan exceeding the equity value of the home.
Key objectives for Phase 2: No mortgage or debt when entering retirement. Fully evaluate getting a HECM at age 62. Explore retirement living alternatives that range from continued home ownership to traveling in a recreational vehicle.
Phase 3: Retirement; Focus on Transition
Housing alternatives at this stage of life include aging in place, assisted living, and more comprehensive long-term care. At this point, there tends to be a convergence of health and shelter requirements. From a financial standpoint, the issue is how to pay for changes in living arrangements as you trend into higher cost facilities, e.g., outright sale of the home. Additionally, can home equity be sheltered from Medicaid spend down rules? From a behavioral standpoint, the challenge is to be emotionally prepared to make the moves that aging dictates.
Key objectives for Phase 3: Establishing or enhancing financial, geographic, and emotional transition flexibility. Protection of the home asset from Medicaid spend down rules. Legacy planning.
Your Best Strategy
Your best retirement income strategy may include storing value in a home along with other financial products with different tax, payout, and market exposure profiles. Home ownership opens up a number of options to help you financially navigate through your retirement years. By taking a proactive planning approach early in life that is integrated into your asset accumulation and utilization plans, you can better position yourself to fund a number of housing arrangements as you age. If handled correctly, your home can provide not only shelter, but also bolster your financial security in retirement.
About the author: Keith Whitcomb MBA, RMA, is the director of analytics at Perspective Partners and has more than 20 years of institutional investment experience.