For many investors, the home is the single largest asset, and although it’s needed for shelter it can also serve as a valuable fallback when other holdings run low in retirement.
But it’s a trick to get at that money, with pros and cons to each option — selling, borrowing through a home equity loan or cash-out refinancing, or taking out a reverse mortgage. Choosing the wrong approach can make the homeowner’s finances worse rather than better, and many advisors urge clients to invest for retirement without counting on tapping home equity.
Lou Cannataro of Park Avenue Financial in New York says to ask, “Why are we tapping into home equity during retirement?” People who failed to live within their means may also be tempted to squander their home equity, he says.
Home equity is the difference between the home’s current market value and any outstanding loans like a mortgage. Long-term homeowners build equity by gradually reducing their mortgage balance through monthly payments, and through the property’s rising value over time.
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But home equity doesn’t offer instant access to cash like a checking or money market account. And it doesn’t provide rock-solid security, either, because prices can and do fall. Still, home equity is a resource worth considering, and there are several ways to free it up:
Sell. This is the most obvious and often the easiest. Many retirees “downsize,” or buy a cheaper home nearby or someplace else, pocketing proceeds left over after buying a new place.
If drawing on home equity becomes necessary, Cannataro prefers downsizing and a reverse mortgage to borrowing through a new mortgage or home equity loan.
There is no capital gains tax on a home-sale profit of up to $500,000 for married couples filing a joint return, or $250,000 for a single person. And the cost basis for figuring profit is not just the original price paid but major improvements over the years as well. Of course, there’s no restriction on how the money can be used, either.
The chief disadvantage is the time and expense of selling. There may be costs for sprucing up, as well as paying a real estate agent’s commission, plus expenses from buying the new, smaller place — fixing things up, travel, moving and so forth.
Cash-out refinancing. This involves getting a new loan against the home and using the cash for purposes other than buying the property. If you owed nothing on a $400,000 home, you might take out a new loan for $300,000, and invest the cash for living expenses.
You’d need an income source to qualify for the loan, and would have to make monthly payments. Generally, you’d have the same options as with a loan for purchase — a fixed- or an adjustable-rate mortgage. Interest payments would be tax deductible.
Home equity loan. Like a mortgage, a home equity loan uses the home as collateral, allowing a lower interest rate than on an unsecured loan like a credit card. A fixed-rate home equity loan is much like a mortgage, with a set payment for the loan’s life. A home equity line of credit, or HELOC, has a floating rate that can rise or fall within set annual and lifetime limits. Although a HELOC will likely start with a lower rate than a fixed loan, the rate may eventually rise to an uncomfortable level. And if it does it might not be possible to pay off the loan with a newer loan carrying a lower rate.
To qualify for either type of home equity loan, the homeowner needs to show a steady and dependable income.
Clearly, the chief downside is the need to make payments, and the risk of having those payments get bigger with a line of credit. Risks can be minimized by borrowing less than the maximum allowed.
A fixed-rate loan generally works best for those who want a lump sum for an emergency or major home improvement and expect to carry the debt for some time. The line of credit can work best for those who just want a resource for emergencies and don’t intend to carry a balance for long periods.
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Ryan Kwiatkowski, director of marketing at Retirement Solutions in Naperville, Illinois, says clients sometimes use credit lines for non-essentials like vacations, especially if a downturn makes it a bad time to tap other investments.
“The couple is able to write a check for the vacation without impacting the portfolio, and once the market appreciates back to its previous level, then the HELOC is able to be paid off,” he says.
A reverse mortgage. This, too, is a loan against a home, but the homeowner is not required to make payments. Instead, interest charges are added to the debt, which is paid off when the home is sold after the homeowner dies or no longer uses the property as a primary residence. The lender generally cannot force a sale, or go after any assets other than the home, even if the debt grows larger than the property’s value.
The loan can be taken as a lump sum, monthly income for life, or line of credit.
“When a client hasn’t saved enough, a reverse mortgage is one way to make it through retirement that we need to discuss,” says Scott Tucker, president of Scott Tucker Solutions in Chicago. Still, he says he prefers downsizing, which does not share the chief negative of the other options: interest charges.
Because there are no monthly payments, the reverse mortgage does not require a steady income for qualification. So these loans have long been considered a good fallback for retirees who have run through their other assets.
The main drawback is that adding interest charges causes the debt to snowball, eventually eliminating the home’s equity and leaving nothing for heirs. Also, lenders protect against the risk of debt exceeding the home’s value by limiting the loan to less than the home is worth at the start. Homeowners in their 60s can often borrow only about half the home’s value. Older borrowers can get more since there’s less time for their debt to grow larger than the property value.
Some advisors recommend getting a credit line as young as age 62, the youngest allowed, because the line grows, under federal rules, at the loan rate plus 1.25 percent a year, even if the home value drops.
[See: 10 Tips to Boost Your IRA Balance.]
“Growth in the line of credit can be a huge benefit to retirees, and can even result in the total amount they are able to borrow exceeding the value of their home,” says Paul R. Ruedi of Ruedi Wealth Management in Champaign, Illinois. “This was probably an unintended loophole and may change someday, but for right now that’s the way it is.”
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Home Equity Options for the Older Investor originally appeared on usnews.com
