Conventional wisdom says homeowners should pay off their mortgage before they retire so they do not have to make a large monthly payment on a smaller income. Yet, some retirees might find it more beneficial to keep making that mortgage payment.
Consider a couple who sells their home to downsize and receives a chunk of cash from years of building up equity. If they do not use that equity to pay cash for the new home, they suddenly have significantly more liquidity. They can add that money to their nest egg, invest it, and earn returns that may be higher than what they will pay in mortgage interest. They can then gradually withdraw their earnings for additional retirement income.
The big question is this: Is it possible to qualify for a mortgage after retirement?
Financial planners and mortgage lenders say, yes. So do Fannie Mae and Freddie Mac, two of the biggest players in the mortgage market. They are government-sponsored enterprises that buy mortgages from banks and home financing companies, provided those mortgages meet certain standards.
Under the Equal Credit Opportunity Act, lenders cannot discriminate against borrowers based on age; retired borrowers, like working borrowers, simply need to show that they have good credit, not too much debt, and enough ongoing income to repay the mortgage. Demonstrating proof of income may be different than it would be for working borrowers, but retirees who qualify can even take out a 30-year mortgage; lenders cannot base their decisions on an applicant’s life expectancy.
Retirees and near-retirees interested in qualifying for a mortgage after retirement should understand how lenders will evaluate them.
Mortgage qualification requirements for retirees: Income
For any mortgage, Fannie Mae instructs lenders to look for income that is “stable, predictable, and likely to continue.” For borrowers who work and earn a salary or regular wage, that requirement is easy to meet. They can provide paystubs and W-2s to document their income history, and they do not need to prove that their income is expected to continue at the same level for the foreseeable future.
Not so with retirees. Fannie Mae considers distributions from 401(k)s, IRAs, or Keogh retirement accounts to have a defined expiration date because they involve depletion of an asset. Borrowers who derive income from such sources must document that it is expected to continue for at least three years after the date of their mortgage application. Lenders can only use 70 percent of the value of those accounts to determine how many distributions remain if the accounts consist of stocks, bonds, or mutual funds, since those assets can be volatile. The retiree must also have unrestricted access to these accounts without penalty: for example, individuals usually cannot withdraw money from 401(k) accounts before age 59 ½ without penalty. Freddie Mac has similar requirements.
Social Security income that a borrower is drawing on his or her own work record is considered income that does not have a defined expiration date, but income being drawn on a family member’s record, such as survivor benefits or spousal benefits, must be shown to be payable for at least three years from the mortgage application date. Retirees can document this income using their award letter from the Social Security Administration and/or proof of current receipt.
If a borrower does not have to pay taxes on certain income, then lenders can increase that amount by 25 percent (they call this “grossing up”) when calculating qualifying income since other qualifying income sources are considered on a pretax basis.
Just because a lender is allowed to gross up income does not mean they have to, said Casey Fleming, author of “The Loan Guide: How to Get the Best Possible Mortgage” and a mortgage advisor with C2 Financial Corporation in San Jose, California. Some lenders will increase qualifying income by a smaller amount, such as 15 percent, while others will not do it at all.
Corporate or government retirement or pension income is not considered to have a defined expiration date, nor are part-time job earnings, rental income, or self-employment income. Interest and dividend income falls into this category, too, unless the underlying asset that produces that income will be depleted.
Annuity income can be used to qualify as long as the borrower can document that it is expected to continue for at least three years, said Joe Parsons, senior loan officer with PFS Funding in Dublin, California. (Learn more: Is it OK to retire with a mortgage?)
Regardless of whether the income has a defined expiration date, lenders require retirees to document the regular and continued receipt of their qualifying income using one or more of the following: letters from the organizations providing the income, copies of retirement award letters, copies of signed federal income tax returns, IRS W-2 or 1099 forms, or proof of current receipt. Freddie Mac’s requirements to document retirement income are similar to Fannie Mae’s.
Borrowers who only take sporadic withdrawals from retirement accounts rather than regular withdrawals might have trouble qualifying, such as the couple in this account from the Los Angeles Times. But the solution may be easy as long as there is no time crunch to get a mortgage: just start taking regular withdrawals for two months or more before applying for a loan.
Married couples applying for a loan together should consider how their spouse’s death would affect their ability to keep paying the mortgage. Would they lose a significant amount of pension or Social Security income that they are using to qualify? Lenders, however, cannot address this matter in the loan application.
Indeed, lenders would be very hesitant to even broach the subject, Parsons suggested.
Mortgage qualification requirements for retirees: Assets
Retirees often have significant assets, but limited income, so Fannie and Freddie have found ways to help retirees qualify based on their assets.
Fannie Mae lets lenders use a borrower’s retirement assets in one of two ways to help them qualify for a mortgage. If the borrower is already using the asset, such as a 401(k), to receive retirement income, the borrower must demonstrate that they will continue to receive regular income from that asset for at least three years. If the borrower is not already using the asset, the lender can compute the income stream that asset could offer. (Calculator: How much should I save for retirement?)
Similarly, Freddie Mac changed its lending guidelines in the spring of 2011 to make it easier for borrowers to qualify for a mortgage when they have limited incomes but substantial assets. The rule allows lenders to consider IRAs, 401(k)s, lump sum retirement account distributions, and proceeds from the sale of a business to qualify for a mortgage. These assets must be “entirely accessible to the borrower, not subject to a withdrawal penalty, and not be currently used as a source of income.” IRA and 401(k) assets must also be fully vested.
Lenders sometimes call this an “asset depletion loan” or “asset based loan,” though it is not a separate loan type, but a way of qualifying. Borrowers can still count income from other sources when they use assets to help them qualify.
Suppose John has $1,000,000 in his 401(k) and he has not touched it. He is not yet 70½, the age at which the IRS requires account owners to start taking required minimum distributions from 401(k)s. He is living off Social Security and the income from a Roth IRA.
A lender could use 70 percent of his 401(k) balance (to account for market swings that could lower the account’s value), or $700,000, minus his down payment (let’s call it $50,000) and closing costs (let’s say those are $20,000) to arrive at $630,000, an amount that he could be expected to use to gradually pay for his mortgage over the next 360 months, or 30 years. That would give him $1,750 a month to put toward a housing payment.
The lender does not have to subtract closing costs if the borrower pays them from a different account; if John did that, he would have $1,805 in qualifying monthly income to put toward a housing payment.
Unfortunately, even if John wanted a 15-year mortgage, the lender would still have to divide his 401(k) balance by 360, not 180, because that is what Freddie Mac’s rules require.
John does not actually have to start dipping into his 401(k) to pay the mortgage, but this calculation shows lenders that he could rely on his 401(k) to pay the mortgage if needed to. He could use the asset depletion method from his untouched 401(k) combined with the income he is already receiving from Social Security and his Roth IRA to qualify and borrow as much as possible.
Fannie Mae also allows borrowers to use vested assets from retirement accounts for the down payment, closing costs, and reserves.
Retirement assets that can only be accessed with a penalty, like 401(k) assets before age 59 ½, can’t be used for income qualification, Fleming said. They can be counted toward reserve requirements, however.
“We don’t want you to be flat broke and busted when you close escrow, so you have to have reserves—typically at least three times the total monthly housing payment,” Fleming said. “If you don’t have enough in liquid assets, we can usually use about 60 percent of retirement reserves.” The 60 percent accounts for penalties and taxes. The exact amount allowed, if any, is up to the lender.
Freddie Mac allows the cash value of a life insurance policy to be counted as a qualifying asset, but if the money is needed to pay for the mortgage or closing costs, the cash value must be liquidated.1 Fannie Mae allows the net proceeds from a loan against a policy’s cash value or the surrender value of a life insurance policy to be used for a down payment, closing costs, and reserves. Any repayment obligations to the policy will be factored into qualifying the borrower as an additional debt obligation in the debt-to-income ratio or by subtracting them from the borrower’s financial reserves.
Of course, using the cash value of a permanent life insurance policy could lead to a reduction in the policy’s value and its death benefit. It can also lead to the policy lapsing altogether and a tax bill under some circumstances. (Learn more: Treat your cash value with care)
Finding the right lender
Most mortgage lenders at banks sell their loans to Freddie Mac or Fannie Mae. They all pretty much follow the same rules, said Paul Ruedi, CEO of Ruedi Wealth Management in Champaign, Illinois. But not all lenders are experienced in issuing mortgages to retirees.
“I have found my ‘go-to’ people in my town,” Ruedi said. “It’s one of the advantages my clients have because I can generally get it done with the folks I send them to.”
Before spending too much time with a lender, would-be borrowers can ask a few screening questions to determine if they have the willingness and the know-how to handle their application.
Ask how the lender qualifies retirement income and how they calculate qualifying income from assets, Fleming said.
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Article first published in January 2017.
1 Freddie Mac, Loan Product Advisor Documentation Matrix, April 2018.