Don't ignore the equity in your home when retirement planning
There’s a piece of advice that I keep reading in personal finance blogs and articles: “Your home shouldn’t be your retirement plan.” One reason people say this is because you always need a place to live, and if you sell your home, you will need to buy another one, or rent. They say not to count on the cost of the new place being much less than the cost of your existing home.
Absolutely true and homeowners have to save using RRSPs and TFSAs to fund their retirements. You should not rely on the home as the only source of retirement income.
However, for some people the value of their home could well be higher (much higher) than what it will cost them to house themselves in retirement. Realistically, if you live in Toronto (or other cities where house prices are high), selling your family home and moving into a smaller place or somewhere outside of the city is likely to leave you with extra money.
When putting together a retirement plan, you shouldn’t ignore this money. It can make a real difference in how much you need to save now and to the decision of when you can retire.
When I am preparing a retirement plan for clients, I like to create several scenarios regarding the person’s home, especially if they are unsure of what they plan on doing with it. Some people want to stay in their family home for as long as possible, while others expect to downside into a condo or move to a less expensive area. Others, understandably, haven’t decided yet.
One approach I like to take is to calculate how much of the equity in the existing home will be needed to pay for a new place to live once it is sold. How long can the proceeds from the sale pay for their rent? I do the analysis assuming the house is sold at various ages: 65, 75 and 90 for example. Then, I figure out how many years’ worth of rent the proceeds of the house could pay for. When doing this, I assume a monthly rent in today’s dollars and apply a rental inflation rate. For ages 90 to 95, I assume that long-term care is needed. Here is what the analysis looks like:
Want to be more conservative? Let’s assume 0% house price increase:
Still looking pretty good.
Knowing that the equity in your home will allow you to pay rent for the rest of your life is very freeing. And if there is more money than needed, the excess can then be incorporated into the retirement plan, helping to defray the need to withdraw from RRSPs and TFSAs in later year.
Note that this analysis doesn’t consider the fact that the funds from the home will be invested, which will provide even more money. For example, if you took the $847,568 at age 75 (and put the $1.06M aside for rent) and invested it earning a conservative 4% per year, you would be able to withdraw about $40,000 a year starting at age 75 until age 95 (adjusting the amount higher by 2% each year for inflation). This makes a real difference to the amount you need to save for your retirement.
Another approach is to assume the house is sold at a certain age and the owner moves to a smaller place, like a condo, or a less expensive town. In this case, I do the same analysis, replacing the rent cost with the cost to buy a new home.
Ignoring the fact that you might have extra money from the sale of your home isn’t doing you any favours. If you live in a high-priced housing market like Toronto, it is probably overly conservative. Why deny yourself the wiggle room just because you don’t want to assume the housing market will continue to rise, or that you will be able to downside your living space? There’s a pretty good chance that both of these things will happen. Of course, you might not want to downsize in price if, for example, you’d like a home on a lake in Muskoka. And as with any kind of forward-looking planning, nothing is guaranteed. The risks in this analysis are house prices falling over the next 10, 20 or 30 years and that the cost of renting skyrockets. You decide what you want to bake into your analysis.
There is another option for home owners: staying in your home and accessing the equity you have built up to fund your retirement while you are still living there. In this case, a reverse mortgage or a home equity line of credit (HELOC) are two options. I will write about this in a later blog post.