The American Dream tells us that we should own a home. And many people do indeed buy their first home while they are still young. However, throughout the years they will move around, upgrade, and refinance. Many people will never really “own” their home. Instead, they will have always have a mortgage on it. Finally, as they retire and separate from the working world they may want to take advantage of lower interest rates, or buy a second home for retirement. When they go to apply for the loan, they expect and easy one, two, three approved. But they may be in for a surprise.
Most lenders will base their loan approval primarily on the borrower’s debt-to-income ratio. They do not like to see this ratio rise above 40% (so if you make $1,000 per month, the most they want to get you into is a loan with a repayment plan of $400 per month). Unfortunately, a retiree that has a sole income of social security has a relatively small income. Combine this with the fact that he or she may have other loans, like autos, home equity, another mortgage, etc. they may have trouble qualifying for the loan since much of their already small income is taken up by other loan repayments. Despite having substantial assets in savings, IRA’s, 401(k)’s, and the like, they are turned down for the loan because they do not have the income the lender deems necessary.
One might argue that the borrower could just cash in a portion of their IRA or 401k and outright pay for the house. While this is an option, pulling that much money from the retirement account may not be wise. The borrower will owe taxes on the money. And after taking a substantial amount out, they will more than likely move into the 25% or higher tax bracket, meaning they have to take even more out to have the after taxes money needed. Now, with their retirement account significantly depleted, a downturn in the market could wipe them out more than they can recover from.
Instead, a recent change in the underwriting rules is making it easier for retirees to obtain the loans they seek. In order to boost their income, and thus lower the debt to income ratio, the borrower can now count their retirement plan assets, even if they are not currently drawing from them. There are some little nuances that go into each calculation, but it basically works like this: John has an IRA worth $500,000. The underwriter will take this into consideration, and discount it by 30% in order to account for market fluctuations. This $350,000 that is left over is divided by 360 (the term of the loan in months). The product of $972 is now added to John’s monthly income, giving him the boost that he needs to qualify for the loan, regardless of if he ever plans to draw anything from his retirement savings.
Once you are retired you are supposed to be on easy street. Every day is Saturday, and you do not have to worry about working to provide an income. Buying a house, or refinancing your mortgage, should not be a hassle. But until now it has been a pain for many people who are trying to enjoy their golden years. Even with perfect credit and substantial assets, they have been being turned down because on paper their incomes look low. With this latest rule change, counting retirement assets as though they were an income stream will help millions of retirees be better able to afford their American Dream.