How to Use Home Equity to Fix Retirement

In a previous article, I addressed the issue of retirees whose nest eggs have dropped to the point of threatening their long-term financial stability. I discussed two potential solutions: the Band-Aid approach, in which retirees make small living adjustments, and immediate annuities, which provide retirees a stable income. In this article, I will present a third solution: home equity.

Why Home Equity?

Home equity, in many cases, is the largest asset retirees own. Yet most people don't consider their home an investment that can be used for retirement cash flow. Ignoring home equity might be fine for those with adequate retirement portfolios; it's not fine for the rest. Tapping into home equity is sometimes seen as financial suicide, much like holding balances in high-interest-rate credit cards. This is not necessarily true. There are two preconceptions to using home equity that we must tackle:

It's financially better for me to own my home free and clear.
Maybe so, but would you rather not have enough money to live on? Your house has grown in value above what you paid, so why not give yourself the benefit of the gain?

I won't be able to leave the house to my kids.
You can still do that, but it might have a mortgage attached. Chances are, your kids will sell the house. They'll still get an inheritance even after paying off the debt. And besides, would your kids rather inherit a house free of debt or not have you financially dependent on them?

How to Use Your Home's Equity

There are various ways to gain access to home equity. These can include changing debt structure, changing residence, or using a reverse mortgage, and each can have financial, lifestyle, and tax impacts. Let's look at each strategy.

Debt Structure

For home-owning retirees, most will either own their home outright or have a mortgage for substantially less than the value of their home. If the retiree owns the home free and clear, borrowing against the equity can be a source of funds. For example, let's say that Leslie is 75 years old and owns her home that is worth $500,000 debt-free. She could use an extra $200 a month to make ends meet. If Leslie borrows $100,000 with a 30-year mortgage, her monthly payments will be about $465. Assuming her funds are invested at a 3% annual return, Leslie can draw $665 per month for almost 16 years. 

Alternatively, Leslie could set up a home equity line of credit. Interest-only payments would be due on the amounts drawn. Assuming payments are made from the line of credit at 4.5%, the line of credit would reach $100,000 after 10 years.

Both of these strategies should be compared with reverse-mortgage options (see below).

For retirees with a mortgage, let's look at this example. Assume that Phil and Irma are both 80 years old and own a home worth $800,000, with a mortgage balance of $300,000. Monthly payments are $2,684 at an interest rate of 5%. Phil and Irma could use an extra $1,000 per month. One simple option for Phil and Irma would be to refinance their mortgage to a new 30-year fixed loan. Refinancing at 4.5% would lower their monthly payment to $1,520 per month--a savings of more than $1,100 per month.

Another little-known technique involves refinancing into a home equity line of credit. It is often easier and more practical for retirees to qualify for home equity financing rather than a mortgage. In Phil and Irma's case, if they add a line of credit of an adequate amount to pay off the mortgage, their debt/value ratio would be 75% ($300,000 plus $300,000 divided by $800,000). Because home equity lines of credit are typically allowed up to debt ratios of 80% to 90%, Phil and Irma should have no problem qualifying for this. Once granted, they would use the line of credit to pay off the mortgage. Interest-only payments at 4.5% would be $1,125 per month--a savings of over $1,500 per month.

Changing Residence

Downsizing a personal residence can be a financial necessity, a lifestyle necessity (for a retiree who needs assisted-living services), or a lifestyle choice. Downsizing can also involve moving to a different city or state, especially to a lower-cost locale. Clearly, selling one place and buying a less expensive one (assuming no negative counterpoints such as high homeowners fees or property tax increases) will result in greater cash flow. Savings are even greater if the downsized residence is in a lower-cost area.

There are less straightforward alternatives to downsizing when considering changing residences. Moving from ownership to rental or a combination buy-in and rent (for entrance into a continuing care community) will require detailed calculations. Consideration must be given to complicating factors such as potential rent increases, need for skilled or unskilled care, and the presence or lack of long-term-care insurance. Although it would be nice to provide a simple approach, there is no substitute for crunching the numbers in this case.

Reverse Mortgage

Reverse mortgages used to have a bad rap. But since they've been regulated by the government, they warrant serious consideration in the right circumstances. Under the current rules, when a reverse mortgage is taken out:

• The title stays in the homeowner's name.
• Heirs will inherit the home.
• The homeowner can sell or refinance at any time.
• There are no prepayment penalties.
• Appreciation belongs to the homeowner/estate.
• The interest rate can be fixed or variable.
• Proceeds are nontaxable. 
• The reverse-mortgage balance is nonrecourse--it can never exceed the value of the home.

Assuming the homeowner is at least age 62, a typical reverse mortgage is easy to qualify for, requires no payments, and has an interest-rate cap. FHA-insured home equity conversion mortgages can provide one or a combination of the following payments:

• Mortgage refinance (eliminating monthly payments).
• Line of credit.
• Monthly payments for life.
• Monthly payments for a period of time.

Let's look at the reverse-mortgage option for Phil and Irma. With their current loan structure, they will have 12 1/2 more years of $2,684 monthly payments--total remaining payments of over $400,000. A home equity conversion mortgage could pay off the mortgage in full, relieve Phil and Irma from making the monthly payments, and provide up-front cash of $40,000 to $80,000. If Phil and Irma prefer a lifetime monthly cash payment rather than lump sum, they could receive $600 to $800 a month instead of the $40,000 to $80,000 up front. Not bad, right?

Fix a Broken Retirement

Using home equity can be a practical and efficient way of supplementing a retirement shortfall. Besides home equity, Band-Aid approaches and immediate annuities, as discussed in my previous article, can also be viable solutions. The key is knowing there are strategies, whether used individually or in combination, that can fix a broken retirement.

Sheryl Rowling, CPA, is a columnist for Morningstar. Morningstar acquired her Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar.