Sitting on Housing Wealth? How to Safely Turn Home Equity Into Retirement Income
Unlocking home equity to supplement your retirement savings sounds great in theory. But before you commit, make sure you fully understand the costs and complexities involved.
Home equity is what a house is worth today, minus whatever is still owed on the mortgage. A $600,000 home with $100,000 left to pay carries $500,000 in equity.
Years of rising property values mean some homeowners have far more wealth tied up in their house than in retirement savings. The problem is that home equity isn't money you can easily spend.
This guide explains how retirees can use that equity, the options available and what to consider before turning housing wealth into retirement income.
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If you sell your home
Selling clears the debt entirely, but it often returns less than homeowners expect because the listing estimate doesn't account for the costs of selling.
Alex Byder, founder of BD Homebuyer, buys residential property directly from sellers and regularly sees this gap. "Almost every seller I meet has anchored on a number they saw online," he says, "and that number has nothing subtracted from it. Cut 10% off the listing estimate before you plan anything around it.
"On a $650,000 sale, that is $32,000 in commission, roughly $12,000 in inspection items, and $4,000 a month in carrying costs for every month it sits. Sixty days on the market is normal, so budget for it."
The same arithmetic determines whether downsizing frees up much money. A smaller home in a newer or more convenient location may cost nearly as much, while sales fees absorb some of the difference.
If you borrow against your home
Borrowing lets retirees access equity without selling. There are three main options:
- A home equity loan provides a lump sum with fixed monthly payments. It suits a known expense, such as adapting a bathroom.
- A home equity line of credit (HELOC) provides an amount that can be drawn when needed. Interest is charged only on what is used.
- A reverse mortgage requires no monthly loan payments. Interest is added to the balance, and the debt is settled when the house is sold or the owner dies. It is available from age 62, with the most common version insured through the Federal Housing Administration (FHA).
Timing matters, however. Retirees can struggle to qualify for traditional loans, while opening a reverse mortgage earlier can provide advantages that waiting doesn't.
Why retirees can struggle to borrow against their home
Having substantial equity doesn't automatically make borrowing easy. Lenders are more interested in the income available to repay the loan.
Banks approve home equity loans and HELOCs partly by comparing monthly income with monthly debt payments, known as the debt-to-income ratio.
Equity doesn't count as income. Consider a homeowner with $700,000 in equity, no mortgage, $3,200 a month from Social Security and a pension, and $900,000 in retirement savings. They may be financially secure but still have relatively little qualifying monthly income.
One way around this is asset depletion.
The lender treats retirement savings as though they were being paid out monthly, often dividing the balance across 360 months. A $900,000 balance could therefore add $2,500 a month of qualifying income.
Not every lender offers this. Credit unions and smaller local banks may have more flexibility than large banks operating under stricter lending rules.
Why a reverse mortgage credit line works differently
If a home equity loan or HELOC is difficult to qualify for, a reverse mortgage offers another way to borrow. It can be set up as a line of credit rather than taken as a lump sum.
The homeowner draws on the approved amount only when needed, while the unused portion grows at the loan's interest rate plus half a percent.
Someone who opens a line at 62 with $200,000 available and leaves it untouched would have roughly $514,000 available by 77 at 6.5% annual growth.
Someone who waits until 77 gets an amount calculated from scratch based on their age, rates and home value. That gap is the cost of waiting. [Ed note: Please could you clarify why the rules are different for someone older?]
A reverse mortgage credit line can also be more dependable than a HELOC. Banks can freeze or cut HELOCs, while a reverse mortgage credit line cannot be cut because of market conditions, as the Congressional Research Service's overview explains.
How a reverse mortgage can protect retirement savings
A reverse mortgage credit line can also help retirees avoid selling investments when markets fall.
Selling after a downturn means selling more shares to raise the same amount of cash, leaving fewer invested when the market recovers. Planners call this sequence of returns risk.
Barry Sacks, a tax attorney, and Stephen Sacks, professor emeritus of economics at the University of Connecticut, examined this strategy in the Journal of Financial Planning. They found that opening a credit line early and using it selectively gave retirement savings better odds of lasting 30 years than keeping the home as a last resort.
Say a $1 million portfolio falls 22% to $780,000 and the retiree needs $50,000. Taking it from investments means selling 6.4% of the reduced portfolio. Taking it from the credit line allows those investments to remain in place and potentially recover.
Note that borrowed money isn't considered as income, which can matter when retirement withdrawals would otherwise push income high enough to trigger higher Medicare premiums.
What a reverse mortgage costs and when it makes sense
Reverse mortgages are expensive to set up. Upfront government mortgage insurance premiums cost 2% [Ed note: should this be 'up to 2.5%'?] of the home's value, up to the FHA lending limit. On a $600,000 home, that's $12,000 before lender fees, appraisal and legal costs. Monthly mortgage insurance premiums then cost half a percent a year on the amount borrowed.
In return, the debt cannot exceed what the home sells for, the unused credit line keeps growing, and no monthly loan payment is required.
A reverse mortgage doesn't make sense for everyone. Someone planning to sell within about five years may not be able to justify the upfront cost, while using one for an optional lump-sum purchase can be expensive.
If you can comfortably qualify for a HELOC and only need occasional access to money, this lower-cost option may make more sense.
What to do this year
Anyone between 60 and 65 with substantial equity and modest savings can start comparing these options before they need the money.
Get a HELOC priced while income can still support the application. Then ask what a reverse mortgage credit line opened at 62 could be worth compared with opening one at 75.
The decision that protects a retirement is rarely made when the money runs short. It is usually made years earlier.
Related Content
- 10 Things You Should Know About Tapping Home Equity
- Turning a Reverse Mortgage into a Retirement Investment Tool
- Sell, Borrow or Stay? How to Use Home Equity in Retirement
- I'm a Financial Professional: Here Are Four Ways You Can Use Debt to Build Wealth
- Extra Cash? Should You Pay Off Debt or Invest?
