Home Truths: Unlocking The Retirement Potential Of Your Mortgage

Retirement doesn't have to stop you from buying a new home. In fact, many standard loan programs allow seniors receiving Social Security and retirement income to qualify for a mortgage without proof of employment. This is because lenders are much more concerned about your ability to pay back your loan than how much money you earn.

However, qualifying for a home loan can be difficult for those on a fixed income. It's possible for creditworthy homebuyers to purchase a new home by relying on income from retirement accounts and other investments.

Qualifying for a retirement mortgage without proof of employment

Retirement mortgages are home loans for retired borrowers that don't require standard income documents like pay stubs and W-2s. Mortgage companies follow special guidelines related to retirement income set by Fannie Mae, Freddie Mac, and government-backed loan programs.

Evaluate your credit score

Lenders prefer mortgage applicants to have a credit score of 620 or higher to qualify, and borrowers with higher scores qualify for the most competitive rates. Check your credit score in advance to make improvements before talking to a lender. You can do this by visiting the three major credit bureaus, using a free credit scoring website, via your credit card provider's credit tracking tools, or with the help of a nonprofit credit counsellor.

Determine your income after retirement

Lenders typically require income documentation going back two years when evaluating a mortgage application. If you retired more than two years ago, you'll need to show evidence of Social Security, pension income, dividends, and interest payments. You can also rely on your retirement or other assets to establish a monthly income using the "drawdown on retirement" or "asset depletion" methods.

Calculate total housing expenses

To qualify for a mortgage after retirement, ensure your PITI (principal, interest, taxes, and insurance) is less than 28% of your total income. Include other housing expenses such as HOA fees, utilities, and lawn maintenance to get a more accurate picture of your total monthly housing costs.

Check your debt-to-income ratio

Your debt-to-income (DTI) ratio is a critical factor in qualifying for a mortgage. A DTI of 43% or less is necessary for a Qualified Mortgage (QM) within safe harbour regulatory requirements, but lenders prefer applicants to have a DTI of 36% or lower. You can calculate your DTI by dividing your monthly debts by your gross monthly income.

Consider the type of property

It's generally easier to qualify for a mortgage on a primary residence than a secondary home. Financing a second home may require a larger down payment and meeting more stringent income and credit requirements.

Apply for a mortgage

Streamline the mortgage process by working with your current lender or a financial institution familiar with your finances. Shop around for competitive rates, and inquire about additional expenses like mortgage insurance and discount points. Take advantage of the pre-approval process to right-size your expectations and show sellers you're serious.

Explore down payment options

Down payment options for retirees are more diverse than for traditional mortgages. Depending on your income calculation, you may only need to put down 5% of the purchase price using the drawdown from the retirement method. However, this number is typically higher for asset depletion-based incomes and could be closer to 30%.

Seek alternative finance options

If you struggle to qualify for a traditional mortgage, consider taking out a loan against your non-retirement brokerage account. This approach can make your offer more attractive to sellers as it's a cash offer not contingent on financing.

Remember, while it's possible to qualify for a retirement mortgage without proof of employment, the decision to enter retirement with a mortgage depends on your unique circumstances. Consult a financial advisor before committing to any significant financial decisions.

Retirement income streams that can be used to qualify

Social Security

If you have worked and paid into the system during your younger years, you will likely receive regular income from Social Security. Lenders view these payments as your primary source of income during retirement and do not put an expiration date on these funds as long as you are drawing them from your own personal work record.

Pension

Income from government or corporate pensions is also considered regular and consistent by lenders. You don't need to prove that your pension income will continue if you include it in your mortgage application.

Spousal or survivor's benefits

Mortgage lenders consider spousal support or survivor's benefits as limited sources of income because these payments will eventually run out. To include them in your application, you must prove that you will receive these payments for at least three years.

Retirement accounts

If you draw money from a 401(k), Roth IRA, traditional IRA, or another retirement account, you can use this income to qualify for a loan. You must prove that your payments will continue for at least three years beyond the date of your mortgage. Most lenders will only consider 70% of the value of these accounts because they contain volatile assets that can suddenly drop in price.

Income from investments

Any income you receive from rental properties or dividend- or interest-producing assets can be used to qualify for a loan. Lenders don't require you to prove that this income will continue because you own the asset indefinitely, unless you draw income from an asset that diminishes over time.

Annuity income

You can use annuity income in your calculations as long as the annuity is set to continue. You must prove that your annuity payments will continue for at least three years after you take out your mortgage loan.

Asset depletion loans

Retired borrowers with a high net worth may opt for retirement mortgages that let them convert their assets to income. For example, a lender might offer a 15-year mortgage based on your asset balance, calculated as a monthly income over a set number of months.

Bank statement loans

Some lenders offer bank statement programs if you can’t document income on your tax returns but receive regular large deposits. Qualifying income is based on your deposits for the last 12 to 24 months.

How to calculate your income for a retirement mortgage

Lenders will assess your income to determine whether you can afford to buy a home and pay back your loan. While there is no set dollar amount you need to have to buy a home, lenders will look at your ability to pay back your loan.

Step 1: Assess Your Income

Firstly, assess your income. As a retiree, you may have multiple streams of income that contribute to your overall household budget. These may include:

• Social Security income
• Pension income
• Spousal or survivor's benefits
• Retirement accounts (401(k), Roth IRA, traditional IRA)
• Income from investments (rental properties, dividends, interest-producing assets)
• Annuity income
• Long-term disability income

Step 2: Calculate Your Debt-to-Income Ratio

Calculate your debt-to-income (DTI) ratio by dividing your recurring minimum expenses by your total monthly income. For example, if you receive $4,000 a month from fixed-income sources and your debt and recurring payments equal $1,000, your DTI ratio is 25%.

Step 3: Determine Your Income After Retirement

You will need to show evidence of your income after retirement. This may include Social Security, pension income, dividends, and interest payments.

Step 4: Calculate Your Monthly Income

You can calculate your monthly income using one of two methods:

Drawdown on Retirement

If you are at least 59.5 years old, you can use retirement account withdrawals as proof of income. For example, if you withdraw $5,000 from an IRA each month for a minimum of two months, this will be considered $5,000 in monthly income.

Asset Depletion

Add the current value of all your financial assets and subtract any portion of the assets you plan to use for a down payment or closing costs. Then, calculate 70% of the remaining value and divide that number by 360 months to calculate income over the course of a 30-year mortgage.

Step 5: Check Your Credit Score

Check your credit score to know what to expect when you apply for a loan and to make any necessary improvements. A credit score of 620 or higher is generally preferred by lenders.

Step 6: Calculate Total Housing Expenses

Calculate your total housing expenses, including the mortgage principal and interest, taxes, and insurance (PITI). Other expenses may include maintenance, utilities, and homeowners' association (HOA) fees. Ensure your PITI is less than 28% of your total income.

Step 7: Compare Your Income to Expenses

Finally, compare your total housing expenses to your monthly income to determine if you can afford the mortgage.

The debt-to-income ratio and how it affects your eligibility

Your debt-to-income ratio, or DTI, is a key factor in getting approved for a mortgage. Lenders use it to gauge the likelihood that you'll be able to pay off a new loan, given other debt obligations, and to decide how much you can borrow.

Your DTI ratio is the percentage of your monthly gross income that goes toward paying off debt, such as credit cards, car loans, and student loans. When applying for a mortgage, lenders will also include your future monthly mortgage payment in the calculation.

Lenders typically focus on two kinds of DTI ratios:

• Front-end ratio: This shows what percentage of your income would go toward housing expenses. It includes your monthly mortgage payment (principal and interest), property taxes, homeowners insurance premiums, and homeowners association fees, if applicable.
• Back-end ratio: This shows how much of your income goes to cover all monthly debt obligations, including the mortgage (if you get it) and other housing expenses, credit card debt, auto loans, child support, and student loans.

Most lenders see DTI ratios of 36% as ideal. Approval with a ratio above 50% is tough. The lower the DTI, the better, not just for loan approval but for a better interest rate.

You can calculate your DTI ratio by adding up your monthly debt payments and dividing them by your gross monthly income. For example, if you pay $1,500 a month for your mortgage and another $100 a month for an auto loan and $400 a month for the rest of your debts, your monthly debt payments are $2,000. If your gross monthly income is $6,000, then your debt-to-income ratio is 33%.

A high DTI was the most common primary reason lenders denied mortgage applications in 2022, according to a NerdWallet analysis.

To lower your DTI ratio, you can pay off debt, refinance existing loans, pay off high-interest loans first, get a co-signer, or seek out additional income.

The pros and cons of buying a retirement home before retiring

There are several advantages to buying a retirement home before you retire. Firstly, it is easier to apply for a mortgage when you are employed and have a steady income. This means you may be able to qualify for a larger mortgage with better interest rates and lower monthly payments. Secondly, owning a vacation home provides opportunities for relaxation and leisure activities before retirement. You can also rent out the property for passive income or to build equity. Buying a retirement home early also allows you to test out the location and make sure it is the right fit for you. Additionally, you will have the financial means to fix up the place while you are still working.

However, there are also some potential drawbacks to consider. One of the main concerns is that your tastes and needs may change as you age. For example, your health may deteriorate, making it difficult to manage a large property or live far away from medical facilities. There is also a financial strain associated with owning two homes, which can ultimately push retirement farther away. It can be a lot of work to manage a rental property, and unless the property is rented enough to yield a profit, it will reduce your cash flow for saving and investing. Furthermore, your plans for the future may not be set in stone, and you may not be considering all the factors that will be important to you after retirement, such as proximity to healthcare and social activities.

Therefore, it is essential to carefully weigh the pros and cons before making a decision. Buying a retirement home before retiring can be a great option for some, but it may not be the best choice for everyone. It is important to consider your financial situation, future plans, and potential changes in tastes and needs.

Frequently asked questions