Transitioning from One House to the Next in the Post Financial Crisis World

Over the course of the last year we’ve assisted many clients as they move from one dream house to the next. In many cases, the transition hasn’t been as smooth and easy as it was before 2008 when obtaining a mortgage was like buying a shirt, and it only took a month or two to sell a home in many real estate markets across the country. For those readers who are contemplating buying and/or selling personal residences in the near future, here are some themes we’ve recently addressed that may be helpful. Of course, your Aspiriant client service team stands ready to help you work through the details, and develop a strategy that is customized to your personal situation.

Buy first, sell later?

In a perfect world you’d sell one house before buying the next. This would free up equity in the former home, allowing you to know exactly how much cash from the old house you could use toward the purchase of the new house, and it would avoid debt service and maintenance requirements on multiple properties. In reality, that sequence of events, while usually financially less risky, can be harrowing for families. It typically involves having to move from the old house into temporary quarters (a short-term rental, a family member’s home), and then, eventually, into the new house. In our experience, most clients identify and decide to buy the new house before selling the existing home. Of course, there are risks with this strategy.

How am I going to pay for the new home?

Deciding to purchase a new home always requires a plan for paying for it. Having a “soon-to-be-former” residence in the picture adds a new variable for consideration.

The starting point for developing the strategy is determining if a mortgage will be part of the longer-term picture. If so, in the current very low interest rate environment, we’ll often recommend that the client borrow the maximum amount that the bank will lend, and the client’s resources will be able to service, up to and even beyond the $1.1M maximum level qualifying for the mortgage interest tax deduction. If additional, durable debt is optimal for the client after considering the pros/cons of liquidating other (typically investment) assets, an even bigger mortgage could be appropriate if the property value supports it.

If there’s a short-term need for additional resources to bridge the purchase of the new house until cash is available from the sale of the old house, we’ll consider additional mortgage borrowing by way of the primary mortgage and/or by putting a home equity line of credit on the property if it’s available, reasonably priced compared to other sources of short-term debt, and not subject to prepayment penalties. In many situations, temporarily borrowing on margin against the client’s investment portfolio is a more convenient, less expensive debt source as long as the investment portfolio is big enough to cover the need without putting the account at risk of a margin call if investment markets suffer short-term downward volatility.

Once we’ve figured out the optimal debt strategy we’ll look to the clients’ cash reserves and, if necessary, will develop a plan with the client for selling other assets to raise the remaining money needed to complete the home purchase.

Is it still easy to get a mortgage?

Working with a bank, directly or through a mortgage broker, to secure a mortgage continues to be the most common way to secure mortgage financing. That said, getting a mortgage today isn’t as easy and straightforward as in the years leading up to 2009.

First, many mortgage brokers and banks are overwhelmed with a surge in mortgage refinancing in response to low mortgage rates, and are dealing with new lending rules that slow down the process. In some cases we’ve advised clients to pay a slightly higher rate for a loan if working with the more expensive bank/broker means that there’s a higher likelihood of closing the loan on time without hassle.

Second, the credit crisis coupled with FNMA underwriting guidelines has caused many lenders to place more emphasis on income-to-payment ratios in their loan underwriting process. As a result, even people with very large balance sheets but fairly low income are having significant difficulty securing loans. Aspiriant clients have generally been able to avoid this result because of our longstanding relationships with private client banks which usually remain comfortable lending based on the client’s balance sheet and profile.

As far as mortgage products are concerned, we have advised clients for many years, and continue to advise clients to consider adjustable rate loans or loans with relatively short fixed interest rate periods instead of long-term fixed rate mortgage products. We expect clients to benefit from taking the interest rate risk over a full interest rate cycle instead of paying a bank to take the risk. See the article from second quarter 2005 at: http://www.aspiriant.com/library/insight/05q2/article05_pg01.html for more on this topic.

Can Mom and Dad be “the bank”?

Today’s low interest rate environment offers a fantastic opportunity for family members with excess wealth to help children, grandchildren, siblings, etc. with home purchases.

Each month the government establishes minimum interest rates that must be charged on loans between related parties that are made during the month to avoid tripping on gift tax issues. These “AFR” rates are based on the term of the loan:

 

Loan Term

AFR Rates for October 2010

Short-term AFR

Less than 3 years

0.41%

Mid-term AFR

3 – 9 years

1.73%

Long-term AFR

More than 9 years

3.32%

Like a mortgage, related party loans can be interest-only or amortizing. If they’re secured to the house and the borrower hasn’t already exceeded the $1.1M deductible mortgage balance limit, the interest will be deductible by the borrower (the family member lender recognizes the interest income on his/her/their tax returns). Additionally, the family member lender could decide to use the annual gift tax exemption (currently $13k/person/year) to forgive some or all of the interest and/or principal on the mortgage, thereby transferring value to the borrower without triggering gift tax. The title company (or attorney if you live in a non-escrow state) can help draft and secure the related party loan, usually for a minimal fee, during escrow.

I bought the new house...what if I can’t sell the “old” house?

There have been several instances this year where clients have not been able to sell existing home as quickly as they had expected. This can be frustrating, and expensive! Four common ways of dealing with this situation are:

  1. Grin and bear it. Continuing to own the vacant (or staged) home until it sells is the best course of action for some clients. In some situations, the house was listed at what turned out to be an inopportune time, and letting it remain on the market...or pulling it off until the next popular buying season comes along, may be the best way to optimize the asset. That said, this involves taking the risk that the market doesn’t improve anytime soon...or, even falls...while continuing to bear all the costs of ownership.
  2. Reduce the price to sell. Some clients can afford to sell the former house at what feels like a low price in order to unload the property, get out from underneath the maintenance costs, and move on.
  3. Temporarily rent the house. Renting the house while you hold out for a higher sales price may be a good way to reduce/offset the carrying costs. It’s also a convenient way to avoid holding an empty house, especially if you’ve moved away from the neighborhood. Of course, this strategy involves you becoming the landlord responsible for making fixes that need to occur…or paying to outsource the role to someone else. It also exposes you to the risk that the tenants don’t take good care of the house, and there’s the possibility that the rental period is prolonged because the housing market takes even longer than expected to turn around.
  4. Some combination of the above.

Your client service team, with input from your real estate agent, can help you evaluate the best course of action for you based on your objectives and your available resources.

What else do I need to think about?

It’s important to title real estate in a manner that is consistent with your estate plan, pre-nuptial agreement, or other legal structures you have in place. If you own the property jointly with someone other than your spouse, make sure that you are observing arrangements you have with that person to ensure “clean” transactions; for example if you own a house 75%/25% with your brother and your arrangement is to split costs in that manner, make sure you’re paying (only) 75% of the expenses.

Another important consideration is making sure that your homeowner’s and umbrella insurance policies are current and cover both homes until you sell the old house. If you decide to rent the former residence before selling it, make sure the homeowner’s policy for that home reflects the rental situation.

Sandi Bragar
Director - Wealth Management