Many baby boomer investors aren’t planning or thinking about how to manage their properties as they transition into retirement.
Not so long ago, you could wing it a little. But new banking policy has made that difficult. If you don’t plan your retirement, you risk getting caught out.
Old game, new rules
The Royal Commission in Australia highlighted poor behaviour in banks and put a blowtorch under how banks apply the responsible lending code. (read more about that here).
Banks have been dumbing down staff as part of building very economic and vastly profitable franchises. Expense-to-income ratios of around forty percent would be considered impossible in almost any other industry, even noting that banks have an additional cost around the amount of capital they must hold.
No matter how you look at, banks have become very efficient.
The old days of getting a loan from your bank manager disappeared decades ago. Bankers are simply not skilled or trusted enough and credit managers are now too nervous to put any judgement across their decisions. Banking has become very rules-based, driven by policy that – although robust – is typically blunt.
Some questionable policy areas include:
- The test rates banks use
- The amortisation term banks apply to loans
- Banks’ (sometimes daft) responses to things like interest-only
- The now absolute rule that a borrower must be capable of servicing their loan based on hypothetical models, irrespective of their future intentions.
The policy rules that banks apply are not sophisticated – and there lies the risk. A risk that, for investors going into retirement, is potentially serious.
Happy lenders, unhappy investors?
The crux of the risk sits with how banks discharge a property as security when it’s sold.
If an investor has multiple properties with one lender, and one of those properties is sold, the lender controls the discharge of the property. The investor might be selling a property they consider to be debt-free that is cross-collateralised with another property. However, the bank will see it differently. It will look at the investor’s overall portfolio and affordability and could request the full sales proceeds.
Maybe that is ok, but chances are the property investor intended to free-up cash for something else. The lender is happy. They have been repaid. But what about the borrower?
How banks calculate affordability
Why do banks behave this way and what does it mean for near-retirees?
To understand this, we need to work through how banks calculate affordability. Some of this won’t make sense – but that’s my point.
A property investor could have a loan-to-value ratio of 50 percent on their investments and a debt-free house, but affordability will still be assessed based on an interest-rate of 7.5 percent and amortisation over 30 years.
It doesn’t matter that the investor intends to sell a property or two in a few years and would be debt free. It also doesn’t matter that the actual loan will be on interest-only and on a three-year fixed rate of 3.89 percent. The property is still assessed at 7.5 percent and on principle and interest repayments.
Reality vs. hypothesis
On a one-million-dollar loan, the bank will test the investor’s affordability against a monthly repayment of $7,000 per month, versus actual repayments using the scenario above of $3,240 per month. That’s an over 50 percent difference between hypothesis and reality.
I encounter lots of baby boomers making decisions based on the reality without factoring that the bank is using a completely different calculator.
The next challenge is that typically lenders will only allow for 75 percent of rent income. If we assume a four percent yield and that $1 million of lending is on a $2.5 million property, then the monthly income after deducting 25 percent is $6,250 per month.
In reality, the investor in the above scenario has about $3,000 per month positive cash flow but the bank assesses them as having -$750 per month of negative cash flow.
What happens if you’re already retired?
If an investor is already retired and receiving the pension, they are likely to encounter two further hurdlers. Firstly, the bank will consider them rent reliant (which is a perceived risk). Secondly, the pension won’t be enough to cover living costs.
Chances are, a middle-class retiree’s minimum living expenses will be more than the pension and the bank will already view them as no longer ‘affording’ their mortgage.
Here are some real scenarios to illustrate the point.
- An investor retires with a reasonably big portfolio of properties. They go to sell their house with the intention of downsizing and freeing up some cash. They want to spend time between Australia and New Zealand. The bank assesses them as not affording their mortgages and so makes them pay off more debt with the proceeds. They still downsize, but the cash leftover is half of what they expected.
- An investor (already retired) needs to borrow $2 million to buy family out of some joint properties. His wife is not yet at pension age, but she’s not working. Although they have good cash flow and a clear future plan, the bank declines on affordability even though the loan to value ratio is 40 percent.
- A property investor, near retirement, is made redundant. He wants to retire out of Auckland using proceeds from the sale of his house. The bank takes the sales proceeds based on affordability, forcing them to sell another property to free up the cash they need.
What can you do to plan your mortgages before you retire?
The first thing I’d recommend is sitting down with an experienced mortgage adviser who can ask all the right questions and also challenge your own thinking.
I tend to ask questions that also allude to the possible solutions, such as:
- Which properties should you sell before you retire? That’s made more interesting given the state of the housing market and which properties will be easy or hard to sell.
- Have you considered spreading your portfolio over different banks so that no one bank controls too many of your properties?
- Have you got an unused revolving credit or offset mortgage that will give you access to enough funds when you need it?
- Have you considered borrowing at 3.89 percent and investing into another form of asset, like P2P loans or a managed fund, that yields between six and seven percent? That might give you more liquidity and also a yield arbitrage to create more cash flow.
- What do you do with your KiwiSaver? I’d argue that with at least twenty years still to live, there should be no rush to put it into a conservative fund.
- Have you considered selling a property and then sitting with a financial planner to diversify your investments? Again, you should take this step before you retire or at least plan for it.
By the time you are fifty, I’d recommend you actually have a plan that takes you through to retirement. Whether it’s 65 or 70, there is a hard date that you will stop working and it could come earlier by surprise due to redundancy or health.
Your plan can include retirement savings like KiwiSaver – I contribute eight percent to my scheme now – and how you manage your investment properties and the debt associated with these. It should also include a review of your insurances to make sure they are still fit for purpose.
Don’t procrastinate, and have a plan.
