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Making Your Money Last

Retirees, Should You Buy or Rent When Downsizing?

Run the numbers to compare both options, although nonfinancial factors play into the decision, too.

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You are empty nesters and you are thinking: Our five-bedroom family home sure seems a bit, well, large, not to mention a money drain. It's time to move to a smaller place. But now you need to decide whether to buy or rent.

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The idea of renting a house or apartment can be challenging for many longtime homeowners. Owning real estate "is hardwired" into the American psyche, says Rich Arzaga, chief executive officer of Cornerstone Wealth Management, in San Ramon, Cal. But, he says, "ownership is more expensive than people imagine." And it may be more important for many retirees to secure income from investments than to sink money into a new house.

Deciding whether to buy or rent when downsizing depends on many factors. You should estimate your cash-flow needs, and assess the relative costs of home prices and yearly rents for comparable properties in a community. You also need to make certain assumptions, such as for investment growth, annual rent hikes, and the costs of home maintenance, property taxes, and homeowners and renters insurance.

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Your decision will depend a lot on nonfinancial, emotional issues, as well. Do you love the idea of owning your own place and fixing it up the way you want? Or will it be a big relief after years of ownership not to worry about the lawn or a broken sump pump?

Darrow Kirkpatrick, 54, ran the numbers and decided that renting was a better option than buying when he downsized two years ago. Kirkpatrick, who retired as a software development manager four years ago, and his wife, Caroline, now 56 and a retired school teacher, sold their four-bedroom house in Chattanooga, Tenn., for $245,000. After traveling for six months, they moved to Santa Fe, N.M., to be near their son.

They rent a two-bedroom house for $1,450 a month and pay little in maintenance. Renting "makes our monthly expenses predictable," says Kirkpatrick, who writes a blog, "Can I Retire Yet?" (www.caniretireyet.com). "We don't get blindsided with roof repairs."

Renting also fits into their new lifestyle. The Kirkpatricks don't know if they're going to stay in Santa Fe for the long haul. "If it doesn't turn out right, it's relatively easy to leave," he says. Also, Darrow and Caroline drive around the Southwest often. They're not as worried when they leave the home for long stretches as they would be if they owned. "I have more peace of mind locking up and leaving," he says.

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In making a decision, first consider how long you expect to stay in your new place. Renting may be the better choice if you're not sure where you want to settle long term. "If you're buying and selling a home every three to five years, renting is likely to be superior to owning," says James Ciprich, a certified financial planner with RegentAtlantic, in Morristown, N.J.

During these moves, you're paying real estate broker fees and closing costs -- and the house probably won't have time to appreciate to cover those expenses. Throw in some remodeling and the replacement of an appliance or two, and the equation shifts even more toward renting.

Ciprich recalled one client who moved from New Jersey and bought a home in Florida. She didn't like Florida and within two years she was back north. "She lost money on the sale of the house," he says.

Another consideration is your cash-flow needs in retirement, Arzaga says. "Renting will save you a lot of capital and lower your expenses," he says. For example, if you pull out $300,000 in equity from a home sale and it's invested at 6% a year, that's $18,000 in earnings the first year. Even after taxes, that can go a long way toward rent, he says, and your ownership-related expenses will "either go way down or disappear."

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One important factor in Kirkpatrick's financial calculations, he says, was the "opportunity cost" of tying up his money in a house rather than investing it. He figured he could earn more on his investments than he would get in house appreciation, which has run an average of 5.4% a year since 1968, according to the National Association of Realtors. Meanwhile, the annualized return for Standard & Poor's 500-stock index was 10% during that period. And while many people think paying rent is a waste, Kirkpatrick figures that the expenses associated with homeownership are a lost cost.

Compare Your Options

To help illustrate these points, Arzaga ran some calculations for Kiplinger's Retirement Report. He looked at a hypothetical 65-year-old couple in the 25% tax bracket who sold a five-bedroom house this year and cleared $550,000 after expenses. He ran three scenarios: buying a $230,000 three-bedroom house with cash, buying that house with an 80% 30-year mortgage and renting a comparable three-bedroom house for $1,250 plus utilities.

Arzaga assumed that the couple's investments -- $100,000 in a traditional IRA and $100,000 in a taxable account (before the sale) -- would grow at an annualized rate of 6.9% before inflation. (He ran a separate calculation for a couple with $1 million split between an IRA and a taxable account.) He made assumptions for ownership-related costs and annual rent increases.

Arzaga concluded that renting tops buying in the short run. The analysis showed that renting was a better financial option than buying for the first ten or so years after downsizing. For instance, if the couple with $200,000 in investable assets rented, they would have $576,202 in total assets (home sale proceeds and investments) 10 years later. If the couple bought the house with cash, they would have $542,800 (home equity and investments). The couple buying with a mortgage would end the 10 years with $572,071 (home equity and investments). "It takes a few years to burn off the initial and recurring ownership costs," Arzaga says. The same trend occurred for the couple with $1 million.

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Buying with a mortgage is the better option generally after 10 years, Arzaga found. Starting in year 11, buyers who had a mortgage began to surpass renters in total assets. (Buyers who put down all cash lagged a bit.) In year 11, the couple who bought with the mortgage had more in total assets than the renter -- and the gap widened as the years went by, Arzaga says, "due to the tax-free growth of equity in the house, whereas the investment account is likely to be taxed every year."

Renters have more liquidity, according to the analysis. Because the renters had no money tied up in a house, they could add the extra capital from the house sale to their investments. Because Arzaga assumed investments would grow at a faster rate than the home value, the couple had additional cash flow for health emergencies or other needs.

Consider the couple with $1 million in investable assets. If they rented, they would have more liquid assets each year for 30 years than if they bought. In year 20, for example, the renting couple had $1.9 million in the taxable account, while the homeowners who paid cash had $1.5 million and the homeowners who took out a mortgage had $1.6 million.

Still, many downsizing retirees opt to buy. But even here, you need to make a choice. Debt-averse retirees who decide to go the purchasing route tend to buy their new, cheaper houses with cash. But you may be better off taking a mortgage for at least part of the purchase and plowing the balance into stocks and bonds, as Arzaga's analyses show.

While you may intend to stay in your new digs for a long time, downsizing seniors need to be realistic about their aging-related needs. You may need to move into assisted living earlier than you expected, for instance.

Nonfinancial factors can play into a decision for older retirees. "People need to think of lifestyle needs and amenities they can retain by renting," says Andrew Carle, director of the Senior Housing Administration program at George Mason University, in Fairfax, Va.

Carle points to "independent living-plus" communities as an important rent-only model. These communities offer residents, usually 55 and older, loads of amenities, including meals, transportation to doctor visits and shopping, and recreational activities.

Ruth Beauregard, 83, moved three years ago to an independent-living community in Bluffton, S.C., owned by Bloom Senior Living, which operates seven communities in four states. Her unit includes a bedroom, living room and kitchen.

After Beauregard and her husband sold their 13-room house on three acres in Massachusetts seven years ago, they bought a five-bedroom house ten miles away. After her husband died three years later, she decided she wanted to move to a place where there were many people around and many things to do. "I've made a lot of friends here," she says.

Her $2,395 monthly rent includes three meals a day, weekly housekeeping, all maintenance, exercise classes, activities such as movies, and even free manicures. At dinner, "five people are at my table with tablecloths and cloth napkins, and we all socialize." As for the rent, "I have enough set aside to pay my way," she says.