Downsizing? Rethink buying before you sell.
In preparing for retirement, a common strategy is to downsize the family home to a smaller and lower cost home. By selling and purchasing a lower cost, smaller house, and pocketing perhaps $100,000 to put into your superannuation, you could benefit from drawing an additional income of circa $8,000 pa. in retirement.
The way that most downsizers go about this, is to buy the replacement house first, then sell their existing house second. The main advantage to doing it in this order is that you only need to move once. That is, you move straight from your existing home into the new home. You can then put your existing house on the market and sell after you have moved into the replacement home. Herein lies the problem.
From our experience, we have seen a number of problems arise when doing it in this order (buying the replacement first, and selling the existing home second). The main problem is: “Putting the existing home on the market for sale but finding out the best offer (what someone is willing to pay) is significantly less than what they thought it would sell for.”
Main Problem in buying replacement house first:
Secondary problems arising from the Main problem:
An alternative way to downsize: Sell existing house first
We believe the best way to downsize is to sell your existing house first before buying the replacement house. There is a significant advantage to knowing how much your have to spend, and you can take your time to find the right replacement home. The only disadvantage is that you may need to rent for a period of time which means moving twice instead on only once. The main points on selling the existing house before buying the replacement house are:
If you still insist on Buying the replacement house first.
You’ve found your absolute dream replacement house and have to buy it now or else it will be bought by someone else (I would argue that an even better dream replacement home would come on the market at the right time after you sold your existing home, but let’s forget about that for a minute.). Steps to take to mitigate the risks:
Careful planning can avoid some of the common mistakes that we see. If you are thinking of downsizing in the future, make sure that you table your plans to do so with your financial adviser.
Written by Dallas Davison.
From our experience, we have seen a number of problems arise when doing it in this order (buying the replacement first, and selling the existing home second). The main problem is: “Putting the existing home on the market for sale but finding out the best offer (what someone is willing to pay) is significantly less than what they thought it would sell for.”
Main Problem in buying replacement house first:
- Putting the existing home on the market for sale but finding out the best offer (what someone is willing to pay) is significantly less than what they thought it would sell for.
Secondary problems arising from the Main problem:
- Incurring holding costs on two properties for a period of time. After experiencing the main problem, we often find that a natural reaction is to wait for a better offer or to take the existing property off the market for a period of time, in the hope that the property market will improve before selling. Either way, there are extra holding costs (rates, insurances, upkeep, and bridging finance). A good rule of thumb to use is that the extra holding costs are likely to be in the vicinity of $25,000 pa. (Rates $3,400; Insurance $3,000; Upkeep $2,600; bridging loan interest $15,000). In addition to these holding costs, there are also likely to be real estate agent marketing/advertising costs incurred that add up the longer that a property is on the market for sale.
- You almost certainly would need to use a ‘bridging loan’ and that means interest costs. A bridging loan allows you to use the equity in your existing property in order to purchase the replacement property. Once your existing property is sold the bridging loan can be paid out. Assuming the cost of the replacement house is circa $350,000, at today’s interest rates, it would cost approximately $15,000 in interest costs for every year that you held onto two properties.
- Selling the existing property for less. If the existing property is sold for less just after the replacement property has been purchased, it’s actually not that bad. Where this problem is exacerbated is in the event that the existing property is taken off the market for an extended period of time and then eventually sold for less. It is not uncommon for downsizers to hold onto the existing property for 2 – 3 years after they have purchased the replacement home (eg. $50,000 – $75,000 extra holding costs) and then to regrettably sell the existing property for less.
- A combination of all secondary problems. After purchasing a replacement home before selling the existing home, the downsizers put the existing home on the market to find that the best offer is some -$30,000 less than what they expected. They decide not to accept such a low offer, and to keep the house on the market until a better offer comes along. 6 months pass, then 12 months. The best offer is still -$30,000 less than where it should be. The downsizers have incurred additional holding costs of $25,000 for the past 12 months and can’t really afford to hold two properties at the same time, but they have come this far and will hold on for a little while longer. They hold on for another 6 months. The offers are still too low. Finally, two years after buying the replacement house, they accept an offer for (you guessed it) -$30,000 less than they thought they would have originally received. After taking into consideration all of the above, the downsizers are -$80,000 behind where they thought they would have been and have effectively wiped out any financial benefit of downsizing. (Property sold for $30,000 less; Holding costs of property x 2 years $50,000)
An alternative way to downsize: Sell existing house first
We believe the best way to downsize is to sell your existing house first before buying the replacement house. There is a significant advantage to knowing how much your have to spend, and you can take your time to find the right replacement home. The only disadvantage is that you may need to rent for a period of time which means moving twice instead on only once. The main points on selling the existing house before buying the replacement house are:
- You know how much you have to spend. By selling first, you then know how much you can spend on a replacement house.
- You don’t need bridging finance. As calculated before, this saves c. $15,000 pa., plus you don’t have the hassle of applying for the loan.
- You don’t have the holding costs of two properties. In fact, you don’t even have the holding cost of one property for a period of time.
- You may have to pay rent for a while, but rent is cheap (possibly free) compared to holding 2 properties. I’m going to assume that you can rent a really nice place for $400 pw. ($20,800 pa.). But whilst you are paying rent, you save approximately $10,000 in property holding costs (Rates $3,400; Insurance $3,000; Upkeep $2,600 are not incurred whilst you are renting). In this example, I’m also going to assume that you sold your existing property for circa $450,000 and you put that in a term deposit paying you 2.65% which pays you interest for 12 months of $11,925. And assuming that you rented for an average of 12 months before you found a suitable replacement home, you’ve actually experienced free rent over this 12-month period whilst you are looking for a suitable replacement home. Free rent!? Yes, if Rent costs you $20,800, but you save $10,000 in property holding costs, reducing your out of pocket cost to $10,800. Then the term deposit interest is paid to you $11,925 meaning that your rent was effectively free for the year… in fact you actually made $1,125.
If you still insist on Buying the replacement house first.
You’ve found your absolute dream replacement house and have to buy it now or else it will be bought by someone else (I would argue that an even better dream replacement home would come on the market at the right time after you sold your existing home, but let’s forget about that for a minute.). Steps to take to mitigate the risks:
- Pay for a licensed valuer to value your existing house. If you like the advantage of buying a replacement house first (eg. move only once) then consider paying for a valuation on your existing house. This should give you a reasonably accurate current market value of your existing house before you have sold it.
- Speak to a trustworthy real estate agent to provide you with a market appraisal. A market appraisal should provide you with a very close estimate of what the estate agent could sell your existing house for in the current market. Unfortunately, there are some unscrupulous real estate agents who over inflate the market appraisal in the hopes that it will lead to you listing your house with them. A trustworthy real estate agent will give you a fair and accurate appraisal which is in your best interest as you have a much better idea of where you stand (We have some trustworthy Real Estate agents that we work with in case you don’t know of any)
- Put in a “subject to sale” offer. Consider making a ‘subject to sale’ offer. This is a contract that allows you to buy the replacement house, but is only binding in the event that you sell your house. Whilst not every seller will accept this type of contract, many will especially in a slow property market and it allows you the benefits of only needing to move once.
Careful planning can avoid some of the common mistakes that we see. If you are thinking of downsizing in the future, make sure that you table your plans to do so with your financial adviser.
Written by Dallas Davison.