Computing your TCO – Total Cost of Ownership

In the previous post I introduced the concept of the total cost of home ownership (TCO) as an important number to know if you are in advancing years facing the prospect of taking on a reverse mortgage to cover medical or long-term care bills. This post fleshes out that calculation, and a second scenario goes to the other end of the spectrum if you are a high earner trying to balance home equity investment versus more savings in market investments.

The goals of TCO are to evaluate the rent-vs-buy decision on equal footing, as well as to balance the ideal amount of equity to put into a home, by computing an “equivalent rent” figure. Renting may not be a viable option, but even evaluating two home equity alternatives via “equivalent rent” lets you evaluate the alternatives more as “apples vs. apples.”

As I noted in that prior post, the conventional wisdom suggests that older people should maximize the equity in their homes and stay in them as long as possible. While this works for seniors with good long-term care (LTC) insurance and substantial savings, this conventional wisdom has forced millions of Americans with no “wiggle room” into undesirable reverse mortgages (technically called “home equity conversion mortgages” or HECM).

Home equity is both illiquid and undiversified, and so, if a senior maximizes home equity to the detriment of more liquid savings, a reverse mortgage becomes the only way to pay for mounting medical and LTC bills. And the common result of that decision is that very little of the homeowner’s estate will pass on to heirs.

Scenario #1 – The low income / high home-equity senior

You can view my TCO spreadsheet in a Google Sheets version by clicking on this link. You can then save it in your preferred format for your alterations via File–>Download. The yellow cells indicate the places where you can alter the information for your purposes, but if you are good at Excel or Google Docs, you can easily modify this spreadsheet to add rows and columns, or change the formulas in the white cells to meet your specific needs.

In this scenario, Fred and Margaret are seniors living off two modest Social Security incomes. They have no savings, but they do own their home, which is worth $300,000, free and clear. They earn close to the median income for two seniors in America today and pay very little in income taxes, so none of their home expenses qualify for tax deductions.

While Fred and Margaret have no monthly house or mortgage interest payments, they do have rising monthly expenses that they need to expend to remain in their home. Property taxes and insurance are big budget hits, but increasingly they also need to pay others to provide maintenance services. This spreadsheet converts monthly expenses into annual costs, applies a tax factor where appropriate (but none in this case) in order to come up with a total monthly cash cost required for them to remain in their home. In this case, a bit over $1000 per month is spent for this purpose (note: your mileage may vary).

Total cost of ownership-1

One factor in reverse mortgages that often trips people up is that, even as equity declines in their homes, given over to the HECM provider, the homeowner remains responsible for the ever-rising monthly costs detailed in the spreadsheet above. If homeowners are already squeezed for cash due to medical or LTC bills, they also likely have difficulty paying property taxes, insurance, and maintenance on that house. This requires them to take out even more of their equity to pay those bills, money that will never be clawed back on the house sale.

The critical second part of this exercise is to calculate the “opportunity cost of home equity.” This is the amount that you could have earned in a safe investment equal to the size of your home equity. If I am estimating this for a senior, I put this rate quite low, assuming that this home equity is best alternatively placed in lower-risk, more-liquid market investments.

Much of the earnings from low-risk investments will likely be treated as taxable ordinary income, so this amount is reduced for estimated additional taxes paid.

Total cost of ownership-2

In this case, that $300,000 in home equity, if placed in safe investments, would yield about $950 per month after taxes, which would mean that the monthly total cost of ownership for this home is about $2000 for Fred and Margaret. If they could obtain good (perhaps even subsidized) senior rental housing for less than $2000 per month, their home equity would be preserved, or even grow, as more liquid savings. That equity would also then be available for paying unexpected bills without needing to live at the mercy of the reverse mortgage industry. Any remaining funds then cleanly pass on to Fred and Margaret’s heirs.

One argument against this analysis is that their home equity, if they stayed in that house, might grow at an even faster rate than the 4% rate I have used. As I noted in that earlier post, some people profit nicely on real estate, but once you hit 65 years old, putting all of your investment eggs in one illiquid, undiversified asset can be as risky as investing it all in Tesla stock. And if you do wind up with a reverse mortgage, those equity gains wind up going to the lender anyway. If you have enough additional savings to weather the eldercare storm, then remaining in your house becomes much less risky.

This analysis also assumes that you are okay with downsizing and leaving your home. As I like to say, money is choice, and if the only “free cashflow” you have is tied up in your home equity, then you have very little choice on this decision. If you choose to remain in your home, you should at least understand the costs of that decision.

If you are moving to smaller property instead of a rental, you can think of the difference in home equity invested as your “money is choice” nest egg to be used to self-insure against medical and LTC costs. Whether you rent or buy, this analysis assumes that any home equity that you free up from your house goes into savings and is not spent on other expenses that fritter away that equity.

You can estimate the cost of renting in the bottom part of the spreadsheet shown below:

Total cost of ownership-3

In this case, and if their estimates are accurate, Fred and Margaret could save about $700 per month in net over the cost of staying in their home. Importantly, this analysis assumes that you will maintain or grow the invested value of that former home equity. However, if LTC expenses do cut into that nest egg, Fred and Margaret will still probabilistically be better off than locking in a choice-destroying reverse mortgage.

Scenario #2 – The high-income home buyer

The top part of this spreadsheet through row 29 can also be used to evaluate how much equity a higher-income home buyer should put into a new house purchase. When the interest rates on a mortgage are at record lows and market returns remain pretty good, this becomes an important decision, especially if you can lock in a low mortgage interest fixed rate.

In this case, you should enter your marginal tax rate, the rate you pay on each additional dollar of income, in line six instead of letting the spreadsheet calculate it for you. If you are paying enough in taxes and interest to still qualify for itemizing your deductions, you can set lines 11 and 12 to “yes” to calculate the after-tax cost of these items.

If you are more aggressive in your investment risk tolerance, you can also put a higher rate in line 27 to reflect your expectation of higher returns. You should also separately estimate the earnings you expect from any money that you do not put into your house equity to measure your alternative income stream.

Putting less equity in your house also leverages both the risk and return that you will eventually get from any appreciation in your home’s value. That is not a bad position for a younger, higher-income home buyer, although it is a risky position to be in if you are a senior with no additional savings.

Being able to put money into a tax-sheltered retirement fund rather than tying it up in home equity also better ensures that your “money is choice” options remain high for your post-work future life. The trick here is to not buy so much house that the high mortgage payments prevent you from saving for retirement.

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