Retirees, Make the Most of Your Home Equity
A home equity loan or home equity line of credit may be perfect for your retirement finances. But don't delay; a fee increase is coming.
A debt-free retirement has been the ideal scenario for so long that older adults often overlook a valuable financial resource: their home. Collectively, homeowners age 62 and older have a record $6.5 trillion of “tappable” equity, according to data analytics firm Black Knight. Individually, home equity accounts for more than a quarter to almost half of the median net worth of retirees, depending on age, according to the Federal Reserve Bank of Philadelphia.
Many financial planners believe tapping that wealth in retirement or just before makes sense if done wisely for the right reasons. For instance, the money can be used for some laudable goals: to pay off higher-priced credit card debt, remodel a home with features to help you age in place, delay taking Social Security until you qualify for the maximum payout, buy long-term care insurance or pay the tax bill for a Roth conversion. Your home’s equity might be the lifeline you need to avoid drawing from your investments during a market downturn or taking on more portfolio risk to make up for any investing shortfalls.
The ultimate way to cash in on that equity is to sell your home and downsize or rent the next one. But most retirees don’t want to move, and even if they do, downsizing in today’s heated housing market presents its own challenges.
The alternative is to borrow from your home equity with your home as collateral. You can refinance an existing mortgage and take cash out, borrow with a home equity loan or line of credit, or apply for a reverse mortgage. Each option comes with opportunities, limits and costs.
Lenders can’t discriminate against you based on your age, but you must prove you have the income and assets to repay a loan. A lender will ask for documentation including copies of award letters (for Social Security or a pension), payment stubs, recent savings or investment account statements, and 1099 forms for the past two tax years. Lenders generally want to see a “two-year history and three-year future” for most income sources, according to LendingTree.
Generally, borrowers with higher credit scores and lower loan-to-home-value ratios get the best rates. Reverse mortgages work a bit differently, requiring underwriting but not a credit score.
No matter how you tap your home’s equity, you’ll pay closing costs including the lender’s origination fee plus fees for third-party services, such as the appraisal, title work and recording the lien with the county. The fees can be paid out of pocket or rolled into the loan. You’ll have a three-day cooling-off period after closing in case you change your mind.
Most seniors with home equity to tap are candidates for refinancing because the rate on their first mortgage is significantly above the market average, according to Black Knight. By refinancing, they can improve their rate and take cash out. In a cash-out refinance, the existing mortgage is replaced with a new larger one that reflects the home’s current appraised value. You can take cash out of the difference up to a limit.
In mid-September, the national average fixed rate hit an all-time low of 2.9% for 30-year mortgages and 2.4% for 15-year mortgages with a 0.8 and 0.7 mortgage point, respectively, according to Freddie Mac. The rate on a cash-out refinance will be about an eighth to a quarter of a percentage point higher than for a no-cash-out refinancing, says Adam Smith, a mortgage broker in Denver.
If you want to refinance, don’t delay. Mortgages backed by Fannie Mae and Freddie Mac that close after Dec. 1 will be more expensive. To cover projected losses from the pandemic, the federally backed home mortgage companies will add a 0.5% fee to the interest rate on conforming loans (those less than $510,400, or $765,600 in high-cost areas in 2020).
Lenders will let you borrow up to 80% of your home’s value, including the new mortgage and the cash you take (75% for a second home or investment property). With a loan-to-value ratio of 80% or less, you’ll avoid the cost of private mortgage insurance. If you have any other home equity debt, you must pay it off or roll it into the new mortgage up to the limit.
Your monthly mortgage payment including the principal, interest, property taxes, hazard insurance and any homeowners association fees should consume no more than 28% of your monthly gross income.
Closing costs are typically 2% to 6% of the new loan amount. Use the TriRefi calculator to determine whether it’s better to pay out of pocket or roll the cost into the loan or interest rate.
Home Equity Borrowing
A home equity loan, also called a second mortgage, provides a lump sum payout that may work well for a one-time expense, such as a specific home project or car purchase. It offers the predictability of a fixed rate of interest and repayment in equal monthly payments over a term of five to 20 years.
A home equity line of credit is a revolving line of credit that you can tap whenever you like by using a check, a credit or debit card connected to the account, or an electronic transfer. You’ll incur a variable rate of interest on any outstanding balance. You could use the HELOC to pay for completed phases of a remodeling project or ongoing or variable expenses, such as medical bills, or just keep it available for an emergency.
Be aware that lenders may reduce, freeze or cancel lines of credit if they anticipate or experience a rising number of defaults, as they did during the Great Recession. Despite the pandemic-related economic uncertainty, lenders haven’t yet curtailed borrowing for existing lines of credit, says Keith Gumbinger, vice president at HSH.com, a financial publisher. However, JPMorgan Chase and Wells Fargo stopped taking applications for new HELOCs this past spring and had not resumed by mid-September.
Some lenders have tightened lending standards, requiring a higher credit score or reducing the loan-to-value limit for all mortgage and home-equity debt from 80% to 75%, says John Garcia, director of consumer loan processing at Boeing Employees Credit Union in Seattle. Don’t wait to apply until your home is under construction, unoccupied or for sale, or has lots of deferred maintenance or damage because it will no longer qualify as collateral, says Garcia.
HELOCs provide an initial withdrawal period, usually 10 years, when you can borrow up to your limit. During that time, you may choose to make a minimum payment—typically 1% to 2% of the loan balance—or an interest-only payment if you qualify. You can usually prepay more without penalty. As you repay principal, your available credit is replenished.
Many lenders offer a “loan within a line” type of HELOC. During the draw period, you can convert all or part of your outstanding balance from a variable to a fixed rate, usually a limited number of times, and repay that portion over a term of up to 20 years.
After the draw period ends, you must begin making principal and interest payments, typically over 10 to 20 years. Look for a fully amortized repayment plan that will completely pay off your balance by the end of the term, without requiring a balloon payment. If you pay only interest throughout the draw period, you could get hit with a substantially larger payment. To avoid that, pay off the balance in full or refinance into a new HELOC before the repayment period begins.
In mid-September, the average fixed rate for a home-equity loan with a 10- or 15-year term was 5.7%, and the average variable rate for a HELOC was 4.8% (with a loan or line amount of $30,000, a FICO score of 700 and a combined loan-to-value ratio of 80%), according to Bankrate.com.
Some lenders will offer a lower, introductory HELOC rate to qualified borrowers. Make sure you know how long it lasts and what your new rate will be when the introductory period ends. You may qualify for a discount of 0.25% or 0.5% on the rate if you already have or open a deposit account with the lender, sign up for automatic payments or agree to pay an annual fee of, say, $50. Look for a rate cap to keep borrowing costs manageable.
Closing costs for a home equity loan or line of credit can run about 2% to 5% of the loan amount. In exchange for a “no-cost” offer, you’ll either pay a higher interest rate, or the lender will impose a penalty if you close the loan or line prematurely. Pay special attention to miscellaneous fees for such things as inactivity or a minimum balance.
Begin shopping wherever you currently have a bank account, but check other lenders for current rates and offers or request personalized quotes. Then use calculators at bankrate.com, hsh.com or lendingtree.com to run what-if scenarios.
How Reverse Mortgages Work
To tap their home equity, Ray and Anne Smith, of Jasper, Ga., refinanced into a reverse mortgage this past spring. The Smiths, who are in their 70s, draw Social Security and have an IRA, but took the reverse mortgage as a financial cushion. “I wanted to make sure we will be comfortable and can live in this house as long as we want to,” says Ray.
The Smiths’ home appraised for $395,000, and the couple was approved for a maximum payout of $230,000. They were required to pay off their mortgage balance of $80,000, which eliminated their monthly payment of $500 in principal and interest. They took a credit line of $150,000 and immediately withdrew $25,000 to pay off credit cards.
The Smiths can draw from the line when and if they need it, and Ray enthusiastically points out that the line of credit will grow at the same 3.5% rate they will pay on outstanding balances. “Our assets are tied up in investments, and you never know what will happen to them,” says Ray. He says next year he may borrow from the line of credit to avoid incurring tax on income from Social Security and withdrawals from his IRA.
Over the past several years, reverse mortgages have begun to overcome a somewhat tarnished reputation with product changes and additional requirements for financial assessment that have corrected some potentially detrimental features. Retirement income researchers have established reverse mortgages as a viable tool, not just for financially strapped retirees but for well-heeled ones, too. “You may leave more to the kids if you strategically use a reverse mortgage,” says John Salter, a financial planner in Lubbock, Tex., who has studied reverse mortgages.
Contrary to what you may have heard about reverse mortgages, consider these facts: You remain the owner of your home and retain title to it. Because, in effect, you’re receiving loan advances, not income, the money is tax-free, and it won’t affect Social Security or Medicare benefits.
The loan comes due when the last surviving borrower dies, sells the home or leaves it for more than 12 months due to illness. After the borrower leaves the home, lenders must allow an eligible nonborrowing spouse or committed partner to stay. A surviving partner can’t take any more money from the reverse mortgage but must continue maintaining the home and paying taxes and insurance.
You’ll never owe more than the value of your home when you or your heirs sell it to repay the reverse mortgage. If your home sells for more than you owe, you or your heirs keep any leftover equity. If your heirs want to keep the home, they can refinance the reverse mortgage, or they can pay the outstanding debt or 95% of the home’s appraised value, whichever is less.
■ Requirements. To be eligible for a reverse mortgage, borrowers must be at least 62 years old, own the property outright or have paid down a considerable amount of the mortgage, and occupy the home as their primary residence. Lenders will review your income and credit history to ensure you can sustain yourself, keep the home in good condition, and pay for property taxes, hazard insurance and homeowner association fees to avoid defaulting on the loan. If the lender determines you can’t handle those costs, it will set aside funds from your payout in an escrow account and pay those bills for you.
The maximum payout, or principal limit, that you’ll qualify for depends on your age (or that of a younger co-borrower or a nonborrowing spouse, who must meet certain criteria to be eligible), as well as the current interest rate and the appraised value of your home, up to a maximum of $765,600 for a reverse mortgage insured by the Federal Housing Administration in 2020. Several lenders make proprietary jumbo reverse mortgages. The higher your age and home value, and the lower your current mortgage balance and the interest rate that you take, the greater your payout will be.
If you have a mortgage, you must pay it off from the loan or other sources. You can withdraw no more than 60% of your principal limit in the first year, though. Up to an additional 10% of the available funds can be tapped to pay off an existing mortgage debt or make repairs required by the lender.
■ Payout options. A line of credit from a reverse mortgage typically gives you the most proceeds and flexibility. You’re only charged interest on the portion of the line used, and you can make payments at any time.
Unlike a HELOC, the credit line will grow, because the untapped portion of the line compounds at the same rate at which interest and an annual mortgage insurance premium accrue on the balance. With many years and rising interest rates, the line of credit can increase to far more than the original amount.
Borrowers who want guaranteed income can also choose a fixed monthly payment for a set term or for as long as they live in the home.
You’ll get the least payout and flexibility if you take a lump sum. Because you incur interest from day one, it makes no sense to take the money and sit on it.
■ Professional advice. Before shopping for a reverse mortgage, ask a financial adviser how one might fit into your retirement plan. Look for an adviser who has earned the retirement income certified professional designation from the American College of Financial Services.
For a reverse mortgage calculator or to find lenders by state or company, visit the consumer website of the National Reverse Mortgage Lenders Association. Look for a loan officer who is a certified reverse mortgage professional.
You must get financial counseling to ensure that you can meet your obligations as a borrower. To find a counselor certified by the Department of Housing and Urban Development, visit the department’s website and search by map or zip code, or call 800-569-4287. A session costs $125 to $250 over the phone or in person.
■ The cost. At closing, you’ll pay an initial FHA mortgage insurance premium equal to 2% of the home’s appraised value or the maximum limit—$765,600— whichever is less. You’ll also accrue an annual mortgage premium of 0.5% of the outstanding loan balance, which isn’t payable until the loan comes due. The insurance guarantees that you will receive your payout and you’ll never owe more than the value of your home when the loan is repaid.
Lenders can charge an origination fee of up to $6,000, plus fees for third-party services. The fee is equal to the greater of $2,500 or 2% of the home’s value, up to the first $200,000, plus 1% of the amount over $200,000, up to the cap.
You’ll pay a fixed interest rate on a lump sum payout and a variable rate on all other types of payouts. The average fixed rate was 3.8% and the variable rate was 3.3% for loans closed in June (the latest data available), according to HSH.com. Variable rates are based on an underlying index—such as the 1-Year Treasury Bill or the Libor—to which lenders add a margin of 1 to 3 percentage points. In general, the higher the margin you accept, the lower the origination fee.
It pays to shop because lenders vary in the margins, origination fees and closing costs that they charge, says Steve Irwin, president of the National Reverse Mortgage Lenders Association. Some lenders will waive all origination fees, and others will charge up to the $6,000 cap. For example, a lender could have charged the Smiths an origination fee of $5,950, but they paid just $2,000. Get at least three quotes to compare margins, upfront costs and payouts. “Plus, you want to work with a professional who will meet you where you want to meet them—over the phone, the internet or the kitchen table,” says Irwin.
Here’s a twist: You can use a “reverse mortgage for purchase” to buy your next home without ever having another mortgage payment. For more information, go to reversemortgage.org and search “for purchase.”
Is Home Equity Interest Tax Deductible?
The cost of tapping your equity may be reduced on your federal tax return. If you itemize, interest on up to $750,000 of mortgage or home equity debt ($375,000 if you’re married and file separately) is deductible to the extent that the money was used to buy, build or improve your home. (Higher limits of $1 million and $500,000 apply if you acquired the debt before Dec. 16, 2017.) If you refinance, take cash out and pay for a car or vacation, the interest on that amount can’t be deducted.
The interest accrued on a reverse mortgage won’t be deductible until you repay the loan, typically when you leave the house and it’s sold. To qualify for the deduction, the money must have been used to “buy, build or substantially improve” the home.