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Making the Most of Your Home’s Equity in Retirement

Making the Most of Your Home’s Equity in Retirement

April 16, 2024

            Deciding what to do with your home in retirement is a pivotal decision that can significantly shape your golden years.  Surprisingly, many retirees overlook their home equity as a valuable asset, simply because they're unaware of the myriad of options available to them. As financial planners, it's our mission to illuminate these possibilities and guide our clients toward choices that align with their goals and aspirations. Gone are the days when tapping into home equity was seen as a last resort.  Recent years have ushered in a new era where leveraging home equity is viewed as a strategic tool to enhance retirement cash flow efficiency. This shift in perspective opens a world of possibilities for retirees looking to make the most of their assets.

           Until 2012, the concept of one using home equity during retirement was typically only viewed as a last resort once all other assets had been depleted.  Further, reverse mortgages garnered a bad reputation when they were first introduced due to irresponsibility by both lenders who targeted inappropriate candidates and borrowers who overspent the loan proceeds early and were unable to keep up with their home expenses leading to foreclosure. However, in more recent years the concept of home equity utilization during retirement has been vastly expanded to be viewed as a tool to improve a client’s retirement cash-flow efficiency.  More specifically, incorporating a client’s home equity into the plan earlier adds flexibility with regards to when to begin claiming Social Security, or, the withdrawal rate from their investmenta assets which can have a significant impact on their retirement cash flow and legacy.

            There are several ways we can access a client’s home equity to supplement their retirement income which include downsizing to a smaller home, a home equity loan, a home equity line of credit and a home equity conversion mortgage or reverse mortgage.

1. Downsizing - Many times, a client will have a larger home during their working years while they are raising a family and will believe that they no longer need the same account of space once they enter retirement as their children move into their own homes. We can make assumptions regarding the size and cost of the house to which they will downsize in retirement and can then assume a future cash infusion that can be used to fund their retirement combined with the lower costs of a smaller home.  It is helpful to be able to show using financial planning software the impact on how much more they should be able to spend due to the future cash infusion.  Ultimately, this allows a client to quantify their decision by determining what they would do with that extra income in retirement, such as more vacations, gifts to children, country club membership, etc. and compare it to the benefits of a larger house.  They can then decide if the downsize is worth it to them.

2. Home Equity Loans and HELOCs (Home Equity Lines of Credit) - While trade-offs and providing “what-if” scenarios are meaningful for a client to help them think about their retirement qualitatively, we can also help them take their thinking about the use of home equity more strategically by discussing the financial tactics that can be implemented by using the home equity tools identified, regardless of whether they downsize their home. Whether to use a home equity loan, home equity line of credit (HELOC) or reverse mortgage will need to factor in costs in terms of interest and ongoing payments, and, their intentions with the home that they plan to use as collateral for the loan.  Essentially, the same strategies can be executed with the three tools, however, the decision to use the home equity loan or HELOC instead of the reverse mortgage is dependent on the importance of paying the loan back during their lifetime and the importance of passing the house to heirs.  

3. Reverse Mortgages - The costs and rules of a reverse mortgage are more complex. For a borrower to qualify for a reverse mortgage they must be a minimum of age 62 and are able to borrow a maximum of $625,000.  The loan can be structured to provide ongoing payments in the forms of a lifetime annuity or fixed-period annuity.  Or the terms can provide for a lump sum payment to be given to the borrower or a line of credit offered for the borrower to decide how much to use and when.  Fees include a monthly servicing fee of up to $35, and mortgage insurance premium of up to 1.25% of the outstanding loan balance and a mandatory counseling fee of approximately $125. In addition, the interest that is accrued is commonly set at the one-month London Interbank Offered Rate (LIBOR) plus a lender’s margin of 2.5 percent with a lifetime cap of the initial interest rate plus 10 percent. 

            The key difference between the traditional mortgage and the reverse mortgage is that the borrower does not have to pay back the reverse mortgage loan until the last person living in the home dies.  At that point, the loan must be repaid plus accrued interest up to the value of the home either through the sale of the home or other means. 

            Determining the most substantial arbitrage can be achieved in a client’s retirement plan using a reverse mortgage, HELOC or home equity loan we must determine the purpose of the equity access and estimate the overall value it will add when compared to not accessing the equity.  As such, there would be different circumstances I feel that a client accessing their home equity would be beneficial.

            It may be appropriate for a client to open a HELOC before retirement that has access to a substantial portion of the home’s equity.  If they apply while they are still working, it would be easier to qualify because they will have more income to show for the loan approval.  The purpose of the HELOC would be to provide for flexibility within their retirement plan for unexpected large expenditures.  Further, if we have this line of credit available and it comes to a point where their retirement distributions are being heavily funded by IRA distributions, we could work out a strategy to postpone their IRA distributions (other than their Required Minimum Distributions) and fund their lifestyle with the line of credit.  Ultimately, once the house is sold, the line of credit balance could then be paid off. 

            I would only recommend the use of a home equity loan if there were a specific large expenditure.  The home equity loan should provide the lowest interest rate and a fixed term which should cost the least in interest over the payback period.  I would not recommend adding a loan to a client’s balance sheet who is entering retirement with the goal of creating an arbitrage.  If we were to invest the proceeds, we would need to be able to guarantee a rate of return higher than that of the mortgage interest rate which is very difficult to do and, in my opinion, it is not a risk worth taking.

            Finally, if the intention of a client is to stay in their home for the rest of their life, it may appropriate to explore the benefits of a reverse mortgage.  With tax-free access to this home equity early, the substantial flexibility is added to the rest of the financial plan and can create a substantial arbitrage when compared to leaving that equity untapped. Yes, at the time that the second of them dies they would need to pay back the amount of money that borrowed.  

            As discussed, there are several strategies available to create an arbitrage utilizing a client’s home equity.  However, because of the emotional attachment with which many clients look at their home equity and debt, it is vitally important that the facts related to the strategies are clearly illustrated to achieve the buy-in necessary for execution.