Oftentimes, couples heading into retirement either trade up to their dream house or put a sizable amount of cash into their existing house to celebrate their retirement. Should you finance it with a mortgage or pay cash? Aside from the qualitative aspects such as the comfort knowing that a cash transaction eases the stress of required cash flow payments to fund the liability on the property, what are the quantitative aspects to consider?
At Dattilio & Ash, we use the quantitative software package MoneyGuidePro to help us answer this question. The software allows us to look at the situation holistically with a full financial profile of the situation including expected expenses and income during retirement plus all invested assets and then run an investment scenario test to calculate the “probability of success”.
Our hypothetical couple is a husband and wife, both 66, who just retired. They are both in good health and plan that they will live to an average life span of 92 years for the husband and 94 years for the wife.
They live a simple lifestyle and expect to spend about $7k per month on basic expenses plus another $10k per year on Medicare/health expenses. They also plan to spend $15k per year on travel for the next 15 years. This totals about $109k of expenses in the first year, not including the model’s 2.25% inflation rate each year. For income, they do not have a pension but do have close to a maximum social security benefit of about $35k per year each totaling about $70k income each year. This translates to a deficit each year of about $39k per year.
But, not to fear! The couple did a good job saving during their working years and have accumulated about $1.5 million in assets for retirement including a $1 million IRA between them and $500k in taxable accounts that includes $225k in cash. Invested assets are managed to a moderate risk profile including 60% equities and 40% bonds.
When we run this situation through the model with 1,000 different investment scenarios, the results are very positive with a 94% probability of success, i.e., there will be enough cash flow and investments to fund all expenses through to the “end of plan”. So, despite the negative cash flow of about $40k each year, the invested assets are invested appropriately with the right risk profile to fund all cash flow needs.
But what about the major $200k kitchen and master bath renovation they wanted to add to their house? Should they reduce their cash holdings to pay for it with cash or take out a home equity loan and fund it over 15 years? Let us simply add in a new cash expense of $200k in the first year or a 15-year mortgage of $1,500 per month to see how it shapes up!
When we add a 15-year mortgage with a 4% interest rate at $1,477 per month, the probability of success decreases from 94% to 79%; still a good result but maybe lower than a preferred answer. On the other hand, paying $200k cash for the major renovation only lowers the probability of success from 94% to a better solution of 82%; still a good answer and better than taking out a mortgage (see chart below showing the paths of all scenarios and the Average Return green-colored line). Quantitatively, this is the best solution!
But, what if the client would rather stay in the 90% range for probability of success? Downsizing the major renovation by half is one alternative, improving the probability of success for the cash purchase from 82% to 90%!
These are just some of the ways Dattilio & Ash can help you plan and manage your investments.