If you’ve taken a hard look at your retirement plan and aren’t entirely confident that you’ll be able to generate the income you need, it may be time to add your home equity to the mix. There’s more than one way to tap home equity to support your retirement, using options like a home equity loan, home equity line of credit (HELOC) or a reverse mortgage.
What Is Home Equity?
Home equity is the amount of ownership you have in your home. You can calculate your home equity by determining your home’s market value and subtracting your outstanding mortgage balance (plus any other liabilities, like a home equity loan). If you have $100,000 left on your mortgage and the appraised market value of your home is $400,000, your home equity equals $300,000.
Home equity is typically a big chunk of a retiree’s net worth—or the value of all your assets minus all your debts. And your ability to fund your retirement using your home depends on how much home equity you have.
According to the U.S. Census, two thirds of the median net worth for householders at least 65 years old comes from their home equity. In 2017, median home equity for the 65+ crowd was $170,000. That can help solve a lot of retirement funding headaches, right?
“Clients often view their home equity as their ace in the hole,” says Elijah Kovar, a financial advisor in the Richfield, Minn. office of Great Waters Financial. “Some want to leave their kids a paid-off home while others think of it as a safety net they can leverage in retirement, if the need arises.”
How to Use Home Equity for Retirement
There is no single best way to tap your home equity for retirement. It all depends on your personal situation.
Home Equity Loan
A home equity loan—also known as a second mortgage—allows a homeowner to cash out some of their home equity. Lenders will typically allow you to borrow up to 80% to 85% of your home equity.
With a home equity loan you get a lump sum of cash when you open the loan. Home equity loans are fixed-rate loans, and you must start to repay the loan immediately. The typical home equity loan term is five, 10 or 15 years.
You can use the cash for anything, but never lose sight of the fact that you’ve put up your home as collateral. If you fail to keep up with payments, the lender can force you to sell the home to cover the loan balance. That’s an argument for borrowing only what you need to fund important projects, not bucket list trips.
If you are eager to age-in-place, for instance, but you need to make some renovations to make your home safer and comfortable for an older you, a home equity loan or HELOC, explained below, could be a smart option. Plus, if you use the money to improve your home, the interest you pay on the home equity loan may be tax deductible.
A home equity loan requires you to jump through some qualifying hoops. Your interest rate depends in part based on your credit score, and lenders will ask questions to ensure you have the income to pay back the loan. There may also be closing costs for a home equity loan.
Home Equity Line of Credit
There’s no lump sum payout when you take out a home equity line of credit, commonly referred to as a HELOC. Instead, you get a line of credit you can tap at any time during the initial phase of the HELOC, called the draw period.
A common draw period is 10 years, though it can be longer. You do not have to repay any borrowed money during the draw period, but if you do, your available line of credit will be readjusted to reflect the repayment.
HELOCs typically are variable rate loans. This means the interest rate you are charged depends on the movement of the underlying benchmark index used by your lender. No interest is charged until you use any portion of the credit line. If you’re concerned about interest rates rising, you may look for a hybrid fixed-rate HELOC, where you can convert money you have borrowed to a fixed rate and still retain the flexibility to make future draws at a variable rate.
As with a home equity loan, if you use the HELOC for a home improvement, you can deduct the interest payments on your federal tax return. You may be able to find a HELOC with no closing costs.
When you are looking to borrow money against your home equity, a home equity loan will likely have a slightly higher interest rate than a HELOC. Recently, the average rate for a HELOC was 4.7% and the average home equity loan rate was 5.7%. But remember: HELOC interest rates are generally flexible whereas home equity loan interest rates are locked in for the course of the loan.
Kovar recommends retirees consider a home equity line of credit “for flexibility” if a big cost pops up. But for planned spending, say for a renovation, a fixed-rate home equity loan is the safer route. “If you are going to need a long time to pay back the money, you don’t want the risk of the HELOC variable rate popping up,” he says.
It’s also important to understand that banks have the right to freeze home equity credit lines during the draw period. This is not common, but it happened during the financial crisis, when some banks got extra nervous amid falling home values. Homeowners who had a HELOC and wanted to use it were out of luck.
A survey by Fannie Mae found that less than half of seniors said they were familiar with reverse mortgages. But even if you do know how they work, you may be circumspect. In the same survey, 20% of participants said they were concerned about “getting scammed” if they took out a reverse mortgage.
In the past, reverse mortgages earned a bad reputation as they were often marketed as a care-free way to put more cash in your pocket, without carefully explaining the risks.
It’s a different market today. The vast majority of reverse mortgages are insured by the Federal Housing Administration (FHA). And over the past few years, the FHA has imposed rules that better safeguard borrowers for its reverse mortgages, which it calls Home Equity Conversion Mortgages (HECMs).
Recently, retirement experts in financial planning and academia have gotten on board with reverse mortgages and HECMs, publishing research that shows how using a reverse mortgage can be a smart way to generate more retirement income.
That said, there are a lot of moving pieces to a reverse mortgage, including potentially steep upfront costs and guidelines about how long you can spend living outside of the house. You may want to consider hiring a financial planner who is familiar with the HECM program to help you figure out if it’s a good fit. Many planners will take on a project for a fixed or hourly fee.
Before you start making plans to age-in-place in your home, think through the upside of a move. For starters, there’s the opportunity to reduce your monthly housing costs—though that, of course, depends on where you move to. Could you find a smaller, less expensive place in the same area, or are you in the market for a big relocation to a less-expensive, more climate-friendly spot?
There’s also the potential to pocket enough profit on the sale to have money left over to add to your retirement investments. Keep in mind that the first $250,000 in profit, or $500,000 for married couples selling a jointly owned home, is free of capital gains taxes.
Run the numbers with a financial planner to see whether it makes sense to buy a new place or to rent instead.
Should You Use Home Equity for Retirement?
Given that home equity is such a big part of your net worth, using some of it to boost your retirement security can make sense. But only if you manage around the risks.
If you don’t keep up with the terms of lines or loans, you could be required to sell your home. To avoid this risk, consider downsizing to reduce your ongoing housing costs and maybe generate profits you can reinvest for retirement income.
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