Can Downsizing Save Your Retirement?

For many Americans, their home ends up being one of their largest if not the largest single investment asset in their portfolio, but they neglect to incorporate it into their overall financial plan. That can be a big mistake. “People lament over selling their home; they don’t make very good decisions out of desperation or when there are high emotions involved,” says Robert Stammers, director of investor education at the CFA Institute.

His family is a case in point. Does a 75-year-old widow who has moved back to her native Italy need to hang on to a large, stucco house in suburban Atlanta? Stammers is pushing for his mom to sell; she’s been holding out because she can’t get the price she wants; in the meantime, his brother is living in the house rent-free. “It can be very emotional if not thought out ahead of time; you want to make plans early to make sure you’re making them as rationally as possible,” he says.

Many people find they have to somehow monetize the equity in their home to live for 25 or 30 years in retirement. That’s because Social Security now replaces a smaller share of what you earned while working and 401(k) retirement plans typically provide less income than the employer pensions they replaced, and the income they provide is less secure, according to Using Your House for Income In Retirement, a guide put out by the Boston College’s Center for Retirement Research.

Here are some talking points for investors—yes, if you’re a homeowner, you’re a real estate investor--struggling with the decision to downsize to a less expensive house.

When should you sell? Every asset in your portfolio should have a role—even your home , Stammers says. Maybe it’s your place to live until you become an empty nester, and at that point you’ll downsize and have a source of dollars for your investment portfolio. Maybe you’ll keep it until your 70s or 80s, putting off downsizing until your health demands it. Maybe you want to plan to live there and then transfer it to your heirs. Whatever your wish, talk it through with your family and your financial advisor.

Cut your real estate exposure. If half your net worth is in your home, a quarter in stocks and a quarter in bonds, you’ve got a significant exposure to the real estate market. “Your home is an asset and it should be considered as part of your overall investment portfolio,” Stammers says. If it doesn’t make sense to have that much real estate exposure, downsize, take out the difference and reinvest it in a balanced investment portfolio.

Is downsizing cost effective? For downsizing to pay off, try a move that saves you at least 25% on your total expenses: mortgage payments and real estate taxes. Calculate all the one-time costs too: transfer taxes, real estate commissions, attorney’s fees, movers. “People overestimate the value of their home if they’re selling, and they underestimate the total cost of a new home,” Stammers says. For someone who has paid off their mortgage, it might be less expensive to keep a bigger house, even considering upkeep and property taxes. Check out this move or stay put calculator that lets you figure out how moving changes your finances courtesy of Boston College’s Center for Retirement Research.

What should you do with your profits? Say you’re left with an extra $100,000 after your move. You could invest it (consider a fixed income annuity that pays out for life). You could use it for expenses, allowing you to delay taking Social Security until you reach age 70, which increases your monthly Social Security payouts for the rest of your life. Keep in mind you’ve also freed up income by cutting your housing expenses. The Center for Retirement Research pegs that at 3.25% of your savings (say your current expenses are $8,125 on a $250,000 house, your new expenses would be $4,875, freeing up $3,250 in yearly income).

Remodel or sell as is? Stammers’ family is pricing out a new roof and considering other upgrades at their real estate agent’s recommendations. The agent feels that refurbishing will help the house compete with the alternative buyers have of building new on nearby undeveloped land. If you do remodel, new bathrooms, kitchens and decks generally help increase the value of the property while putting in a pool might be a negative. But consider that liquidating the property at a reduced “as is” price may be made up by investing in a diversified stock and bond portfolio, Stammers says.

Rent it out. Renting out your old home is one way to get income off of it, especially if you’re waiting for the local market to pick up. Watch out for tax implications. For a homeowner to take advantage of the $250,000 per person exclusion on capital gains on the sale of a personal residence, you have to have lived in the home for two of the five years before the sale.

Consider a HELOC. A HELOC is a type of loan where you only pay interest on money you actually use. It’s a great choice for people who have paid off their homes (all or mostly), don’t want to sell but want to get some money out.

Can a reverse mortgage help? Reverse mortgages are the financial vehicle of last resort, Stammers says. You’d want to consider this only if you’re in the right size home already, and you can’t get a HELOC, and you need retirement income (it can be paid in a lump sum or in monthly installments). With a reverse mortgage, you stay in your house and tap the equity, reducing the equity you own. There’s a big risk: if you can’t pay your taxes and insurance, you’ll be in default and can lose your home. See Don’t Get Stung By A Reverse Mortgage.