Downsizing vs reverse mortgage: Which option is right for you?

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For many Canadians approaching retirement, their home is by far their largest asset. With detached homes in major cities selling for well above $1 million, it’s not surprising that owners expect to tap into that equity to help fund their golden years, prompting the common refrain: “My home is my retirement fund.”

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To make this strategy work, homeowners have a couple of options:

sell your home, buy one that’s cheaper and pocket the difference (also known as downsizing);
or, if homeowners are 55 years and older, take out a reverse mortgage, which provides up to 55% of the market value of a primary residence, tax-free.

Although a reverse mortgage charges monthly interest on the amount borrowed, you don’t have to make any payments—neither interest nor principal—until you sell the house, move out of your house, default on the loan or the last homeowner dies. Each approach has its advantages and disadvantages. Here are some of the factors that you should consider before deciding which one is best for you.

Location and the proceeds of your home sale

Downsizing from a house to a condo in your city might not leave you as far ahead as you expect—especially after real estate fees, land transfer taxes, HST (if you’re buying a new build), moving costs and the added monthly expense of condo maintenance fees. (We’ve crunched the numbers for you below, in “Do the math.”) In other words, downsizing often means moving to a location where properties are significantly cheaper to maximize the proceeds of the sale. For some, this could be ideal—for example, those who want to leave the rush of the big city behind and whose adult kids have already moved in search of more affordable housing themselves. For others, leaving town could mean being a less-involved parent or grandparent, or losing access to specialized healthcare or other services found in a larger centre. In that case, a reverse mortgage might be a better option, as you can receive either a lump sum or regular cash payments from the equity in your home, while you stay put close to the family, friends and services you know and love. (See “Do the math,” below, for a more detailed breakdown of the costs of downsizing vs taking on a reverse mortgage.)

Are you ready to live without a backyard?

If you love hosting backyard barbecues in summer or often have overnight guests, downsizing to a one- or two-bedroom condo might feel a bit restrictive. Indeed, with social distancing being a concern for the foreseeable future, losing your outdoor entertaining space or second bathroom might make it nearly impossible to socialize at home (when COVID-19 recommendations allow), unless you go the virtual route. Similarly, if you or your spouse plans to keep working from home, are you really ready to live in smaller quarters? These are important questions to think about before deciding to downsize.

Leaving an inheritance for your kids

If you have kids and it’s important to you to leave them a sizeable inheritance, downsizing is likely the way to go. After you sell your current home, you’ll own a property that will (hopefully) continue to appreciate and it will be passed along to your heirs with the rest of your estate. Now, the same is true for a reverse mortgage—as long as you remain in the home, you will continue to own the property, which will also (hopefully) continue to appreciate. And the home will be left to your heirs as part of your estate. The difference, however, is that interest accumulates on your reverse mortgage loan. Depending on the amount borrowed, your interest rate and the number of years you live, there may not be much equity left on the home for your heirs to receive. (Note that the estate must repay the reverse mortgage loan and interest when the last borrower dies. Depending upon the size and liquidity of your estate—how much of it is easily accessed as cash—that may require your heirs to sell the property in order to obtain the necessary funds.) Rest assured, however, that they will never owe more than the home is worth, as long as reverse mortgage obligations are met.

Consider your age and future plans

Homeowners as young as age 55 are eligible for a reverse mortgage of up to 55% of the appraised value of your home. However, the amount you can borrow increases with age. So younger retirees should make sure to get an accurate quote on a reverse mortgage before making a decision. It’s also important to note that a reverse mortgage may be suited to those who plan to stay in their home for life, as selling requires the homeowners to pay the outstanding mortgage balance, and may incur a prepayment charge as well. Especially if you are still several years away from full retirement, it may be harder to commit to staying put, since nobody knows what the future holds (as 2020 has taught us all).

Income issues

Some homeowners who downsize to help fund their retirement invest the proceeds and draw on the investment earnings to cover living expenses. But, unless you invest in an annuity that provides a steady income for life, it’s hard to know how long that money will last. Plus, investment income—even from an annuity—is taxable, which could affect income-tested government benefits such as Old Age Security (OAS) or the Guaranteed Income Supplement (GIS). A reverse mortgage, on the other hand, can provide regular tax-free income, which will not trigger OAS or GIS clawbacks.

Do the math

The amount of cash freed up by downsizing from a detached three-bedroom home to a two-bedroom condo might not take you very far, as the following example illustrates. (We’ve used the most current market rates in Toronto as of date of publication.)

Downsizing costs	Amount
Sale price of home	$1.2 million
Real estate commission	$60,000
Outstanding mortgage/HELOC	$240,000
Proceeds of sale	$900,000
New condo purchase	$700,000, plus $91,000 HST
Land transfer taxes	$21,000
Moving costs	$3,000
Total cash remaining	$85,000
Condo maintenance fees	$750/month ($9,000/year)

(Sale price based on Toronto Regional Real Estate Board average for a detached home in the GTA as of November 2020. Real estate commission based on standard 5% fee. Land transfer tax estimate assumes both provincial and municipal taxes are levied (i.e. condo purchased in Toronto). Condo fees estimated using Ratehub.ca calculator.)

In this example, the homeowners would exhaust their cash proceeds within 10 years, just by making the condo maintenance fee payments! In other words, downsizing in this situation will not help fund their retirement. If the couple were in their early 70s, they would qualify for a reverse mortgage of about $510,000, based on their age, the home’s location and its value. After paying off their outstanding mortgage and HELOC (a requirement with a reverse mortgage) they could borrow up to $270,000, tax-free. And they wouldn’t have to worry about condo fees. Keep in mind when you are comparing costs that reverse mortgages also involve specific expenses, such as the cost to have the value of your home appraised, and setup and legal fees that you’ll need to decide whether to pay upfront or add to your reverse mortgage loan principal. As well, reverse mortgages do carry higher interest rates compared with conventional mortgages, and that will affect the amount that ultimately needs to be paid back to the lender.

Bottom line

If the numbers work in your favour, downsizing to a smaller home or community can be a great financial move—giving you cash to fund your retirement while retaining equity that you can pass on to your heirs. But it’s also a lifestyle decision. You have to be prepared to leave your home—and possibly your family and friends—to put down roots elsewhere. For many, it’s these non-financial factors that sway their decision. A reverse mortgage offers the ability to maintain close ties to loved ones, stay in a beloved home that holds memories, and enjoy the luxury of space, while also providing tax-free funds to support your retirement.

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