Owning a house is a great thing. Mostly because we all need a place to live, and if you are fortunate enough to own your own home, you are truly blessed.
Actually, among the developed countries in the world, a relatively large percentage of people do own their homes. The most recent statistics for the U.S. put it at around 65%, but it may surprise you that that puts us at number 42 in the world (number one is Romania at 96.4%!).
Home equity (i.e., the value in your home that is not obligated to a mortgage lender because you have paid it off or because the house has increased in value), is a significant resource if used wisely, particularly while in retirement.
Home equity has been steadily rising since 2010. According to Statistica, “the value of homeowner equity in the United States increased from approximately 6.16 trillion U.S. dollars in 2010 to approximately 14.44 trillion U.S. dollars in 2017.” That’s a lot of equity!!
Let’s make it more “personal.” This table from the U.S. Federal Reserve shows that home equity is a particularly important part of total net-worth for lower-income, older households. These families may not have much, but much of what they do have is in the equity in their home. In contrast, wealthier families have an increasingly lower percentage. This points out the significant role that home equity has in the financial well-being of lower to middle-income retirees, but it can play a part for wealthier households as well.
Here’s a little more data: According to the U.S. Census Bureau, in 2013, the median home equity for persons age 65 and older was $130,000 and net worth was 203,000. That implies that home equity accounts for about two-thirds of the average retiree’s net worth. Most of the remainder are in various types of savings, both retirement and non-retirement accounts.
Here are several ways home equity benefits you in retirement:
Home equity adds financial margin.
Having equity in your home adds to your net-worth and gives you additional financial margin, especially if your house is paid for (which maximizes equity). It isn’t the same margin as a savings account as real estate equity is generally “illiquid,” meaning you can’t easily convert your equity into cash. You would have to sell the house or take out a loan against it, which we will look at later.
If you manage to pay off your house before you retire, you will have additional money to put toward other purposes, such as additional saving or giving. If you are behind in saving for retirement, you could use the money you were sending the mortgage company to add to your IRA instead.
If you are in retirement with a paid-for house, you will gain margin in your expenses as you will need less income to cover your housing expenses. They don’t go away completely, of course, you still have to pay taxes, insurance, maintenance, and utilities.
Set up an equity line of credit for particular purposes
I was a little hesitant listing this one, but it is undoubtedly one of the benefits. I say that because if you put a home equity line of credit (HELOC) on your home, you may be tempted to borrow against it for frivolous things and then find yourself with a large mortgage again.
I have a HELOC on my own home, which is paid for, against about 30% of the equity. I only use it for special purposes and pay it back quickly. For example, I used it to fund the purchase of a small home to rent to my daughter with the understanding that she was going to buy it as soon as she was able. When she closed on the purchase this summer, I immediately paid off the HELOC.
I could go for months or years and never borrow from it again. However, if I needed a large sum of money quickly and for some reasons did not want to take it from savings, the HELOC is an excellent source of low-interest funds. (I especially like the fact that I can make interest-only payments on it when I am using the money.)
Tap the equity to lower your housing expense in retirement.
If you are getting close to retirement and still have a large mortgage payment, one strategy is to downsize, especially if you have a lot more house than you need. If you have substantial equity built up, after you pay off your current mortgage, you can use the equity left over to buy a smaller house for cash.
Not only will that strategy eliminate your mortgage payment, but it may result in lower costs in other areas if you move to a smaller house with lower taxes, insurance, utilities, and maintenance bills.
Leverage equity to create a supplemental income stream in retirement.
I mentioned above that a lot of retirees may be “equity rich and savings poor,” meaning that they have more home equity than they do retirement savings. If that’s the case, and you want to stay in your current home in retirement, then there are a couple of ways to free of the equity for additional income in retirement.
Home Equity Loans
Home equity loans come in different forms, but typically as a home equity line of credit (HELOC) or a second mortgage. With the former, you just borrow money as you need it and then pay the interest until you pay it back. For HELOCs, the interest rate usually varies with the current market. As with any loan, the more you borrow, the more interest you have to pay. With a second mortgage, which could have either a fixed or adjustable rate, you could take the money as a lump sum, put it in a savings account, and use it as you need it. Meanwhile, you would have to make regular payments based on the amortization schedule, which is usually between 5 and 15 years.
The big drawback of both of these as income options is that they become an additional expense. In the case of the HELOC, you have to pay interest at a minimum, and with a second mortgage, you have a principal and interest payment to make. This is where a third option comes in: the “reverse mortgage.”
In a recent article, I mentioned using a “reverse mortgage” as a source of retirement income when all others have been exhausted. I recommend that it only be used as a last resort because I think it is better to “keep your equity powder dry” for a time later in life when you may need it for assisted living or long-term care expenses.
However, if it is your only option to ensure that you can retire with dignity, then it can be an excellent source of income that doesn’t require you to sell your house or move. If you decide to go this route, be careful – there are a lot of misunderstandings about them and how they work.
They are complex. Reverse mortgages are relatively complex financial arrangements, and they have a less than stellar past. However, due to recent regulatory changes, they are becoming more acceptable. A reverse mortgage lets you generate income from the equity in your home, and it is virtually guaranteed for as long as you live in your home. It works just as it sounds – like a mortgage in reverse. You “borrow” a certain amount up to regulatory limits, and the equity is given to you as a lump sum or as regular payments. You are essentially borrowing from yourself but with no need to pay it back until the house is sold, which can happen before you are living or after.
There are some catches. First, you have to pay interest on the amounts you receive, which further depletes your equity. Another “catch” is that either you or your heirs may not own your home in the end, but you’ll never owe more than the second mortgage loan amount. Government insurance will protect you if the bank has a problem producing the income and it protects the bank if you use up all your equity before you pass away.
But the benefit to you – a retiree who needs extra income – is that you have the use of your home while also using it to generate an income stream for as long as you live. But before you run out and get one, keep in mind that they are still relatively complicated and expensive. Plus, you have to continue to pay for taxes, insurance, and maintenance.
In my opinion, there are two significant downsides to reverse mortgages. First, you are going to be using up equity that can’t be used for another purpose down the road. I already mentioned long-term care costs as an example. Plus, if you wanted to pass along a paid-for house to your heirs, that option is off the table as well.
But my biggest issue with them is the expense. Unlike a HELOC, which has reasonably low costs, setting up a reverse mortgage is like buying a house. There are origination fees, mortgage insurance premiums, and other closing costs. Then, there are the interest costs that I referenced earlier. For the life of the loan, the lender will use additional equity to pay the interest based on the current market rate plus an FHA premium of 1.25% (and possibly even a servicing charge on top of that.) Because they are in addition to the income you are already taking, these charges can erode your equity pretty fast.
Some people have reported that between 5 and 7% of home equity goes toward fees at the startup of a reverse mortgage. Then the monthly interest charges start compounding for the life of the loan. If you can find a way to generate a guaranteed income stream of at least 3%, such as with a Single Premium Immediate Annuity (SPIA), that may be a better option.
Another concern about these products is their complexity, which I generally try to avoid when it comes to my finances. The more complicated something is, the more difficult to determine whether it makes sense for your situation or not. If you want a reverse mortgage, you will need to work closely with a mortgage broker, but link many financial professionals, they may be paid my commission and therefore have an inherent conflict of interest.
But they may be your best solution. Despite their shortcomings, reverse mortgages can be a good retirement income solution for retirees who are “house rich but savings poor.” Downsizing may be a better way to go, but if you are set on staying put, reverse mortgages are a reasonable alternative. Better to use your home equity as part of an overall financial plan in retirement rather than treating it as a big ATM that you pull money out of every time you have an “emergency.”
Use your equity with care
There is no doubt that home equity is a valuable resource in retirement. It would be wise to give a lot of thought to how you might use it in your situation. Most retirement planners suggest keeping it in reserve for as long as you can since no one knows what the future might hold. But if you are in desperate need of additional income, it can be a good source if used appropriately. Check out my series “Can You Retire?” for more guidance in this area.