What Should You Do with Your Home Equity in Retirement?

While home equity values took a pummeling during the financial/housing crisis of 2008, home prices have been clawing their way back in most markets. Aided by escalating home prices, homeowners' equity has also climbed to its highest level ever: nearly $15 trillion, as of the first quarter of 2018, according to the Federal Reserve Bank of St. Louis.

Not surprisingly, many older adults have a big share of their net worths tied up in their homes. According to U.S. census data from 2013, home equity composed 66% of the net worths of people between the ages of 65 and 69. That percentage trended even higher for older age bands: Home equity accounted for 70% of the net worth of people between the ages of 70 and 74, and 76% of the net worth of people over age 75.

A research paper from the Center for Retirement Research at Boston College noted that few retirees tap their home equity in retirement, either by downsizing or taking a reverse mortgage, and posited a variety of reasons why this might be so. Leaving a bequest was a key one. Traditionally, many older adults have considered home equity as part of their estate plans; their homes are where they live, of course, but they're also an asset that they would pass to their children or grandchildren after they're gone.

The CRR researchers also noted that some older adults quite rationally avoid tapping their home equity because homes are not typically a countable asset in the calculations used to determine eligibility for Medicaid-funded long-term care and other means-tested benefits. Maintaining home equity is a way to maintain a bequest motive without jeopardizing eligibility for such care. Additionally, many older adults are naturally skeptical of the reverse mortgages; they assume that any financial product hawked on basic cable can’t be in their best interests.

But maintaining home equity throughout retirement isn’t ideal in many situations, especially for older adults with significant housing wealth but dwindling portfolio values. For them, tapping home equity in some fashion, either by moving prior to or in retirement or taking a reverse mortgage, can be a sensible move. I’d also argue that many people die with substantial home equity because of inertia: Reverse mortgages seem scary and downsizing is a pain, so they stay put in homes that are too big for them and make do with less retirement income than they really need to.

If you’re an older adult with substantial equity in your home, it’s sensible to be deliberate about the role home equity will play in your plan. There are three key options. You can go the traditional route, remaining a homeowner until you pass away or are unable to remain in your home, thereby passing on the home asset to your heirs. Alternatively, you can downsize or become a renter before or during retirement, moving all or a portion of your home equity into your investment portfolio. Finally, you can explore some type of reverse mortgage.

Each of these paths carries its own trade-offs--financial, logistical, and emotional/quality of life. It's an incredibly personal decision. Here are the key pros and cons associated with each. Note that these strategies aren’t only appropriate for older adults who have their homes paid off in full, but for people with any type of substantial equity in their homes.

Strategy 1: Liquefy Home Equity Via Downsizing/Relocating/Becoming a Renter With this strategy, a retiree pre-emptively liquidates home equity by downsizing into a smaller home, relocating to a cheaper part of the country, or switching from home ownership to renting.

Pros: Liquidating all or a portion of home equity will bring additional assets into the portfolio; in that respect, the investor can diversify away from a single large asset (a home) and into a more diffuse portfolio of stocks, bonds, and cash. Moreover, moving to a smaller home and/or one in a less expensive geographic area can lower carrying costs: taxes, utility bills, insurance expenses, and maintenance outlays.

Moving before or during retirement can also afford the retiree access to amenities unavailable in his or her current setting: safety features (walk-in showers, first-floor bedrooms), exercise facilities, and ready access to transport, for example.

Cons: The big drawback of moving prior to or in retirement to unlock home equity is that the retiree may really want to stay put. Moving is a headache under the best of circumstances, but that's especially the case for those who have lived in the same place for a long time. Stuff has a way of piling up. There can also be a sentimental tug to staying put. You might have envisioned family dinners with all the kids and grandkids in your spacious dining room, or you've known all your neighbors for decades.

And while there can be financial gains, as outlined above, there can also be drawbacks. While most homeowners aren't likely to owe capital gains on the sale of appreciated properties, thanks to the fairly large exclusion amounts, capital gains can be an issue for those selling high-priced homes that have appreciated sharply since purchase. People who downsize could also face sticker shock, as competition to purchase smaller homes is often fiercer than is the case with larger, more expensive homes. Those who choose to move into a rental arrangement--either in an apartment or senior community--expose themselves to rent inflation over their retirement time horizons. Such inflation is a particularly big consideration for all-in-one senior communities where significant services beyond rent, such as meals and transport, are bundled into the price tag.

Strategy 2: Tap home equity via a reverse mortgage. Reverse mortgages (also called home equity conversion mortgages, or HECMs) are the road less traveled for many retirees. According to the U.S. Census Bureau, just 2%-3% of eligible homeowners have reverse mortgages. Homeowners must be at least age 62 to be eligible for a reverse mortgage; they can borrow up to $679,650 (2018), assuming their home equity is high enough. Borrowers can take the loan in a lump sum or as a line of credit; the latter is sometimes called a "standby reverse mortgage," which means that credit is available in a pinch (for example, it's an inopportune time to draw from an investment portfolio). (This research paper does a deeper dive into standby reverse mortgages.) Repayment of a reverse mortgage typically isn't due until the homeowner sells the property or dies.

Pros: From a financial standpoint, the big benefit of using some type of reverse mortgage is the ability to benefit from an appreciated asset--a house--during the retiree's lifetime. While retirees happily and readily extract cash flows from their investment portfolios during their lifetimes, there's no rational reason that consuming home equity via a reverse mortgage should be verboten, especially if (and that's a big if) doing so doesn't entail extravagant fees and the retiree understands his obligations. Reverse mortgages are especially attractive to retirees who have substantial home equity and are concerned that spending from their portfolios will cause them to prematurely deplete their resources or be a financial burden on their loved ones.

Cons: One of the big disadvantages of reverse mortgages for many retirees is that they will consume assets (the equity in the home) that they would otherwise leave to their heirs or tap for long-term care costs later in life.

Another major disadvantage is that reverse mortgages can be expensive, even though regulations that went into effect in 2013 generally make the products safer for consumers than they were before. Reverse mortgages are typically more costly than conventional mortgages, and they also come with high closing costs, eroding their appeal for people who don't plan to stay in their homes for more than a few years. It's also worth noting that interest rates have been trending up, so any type of mortgage--reverse or forward--will be more costly than when rates were ultra-low. (The interest rates on reverse mortgages are typically higher than straight 15- or 30-year forward mortgages.)

The products can also be incredibly complicated. For retirees who are considering them, it's crucial to make sure they thoroughly understand the costs and any obligations under the new mortgage. It's also a best practice to get some objective guidance before taking on a reverse mortgage. People who don't have financial advisors should consult with one who works on an hourly basis to help make sure they're thinking through all the key variables. (This article discusses the key considerations that prospective borrowers should bear in mind.) That's especially advisable for homeowners pondering a reverse mortgage on a home that isn't already paid off, as is the case with many homeowners who access reverse mortgages.

It’s also worth noting that with a reverse mortgage, the homeowner still owes taxes and insurance on the home; reverse mortgages also require that the homeowner maintain the property. So even though the reverse mortgage can help cover those costs, all the costs associated with homeownership remain in place.

Strategy 3: Stay put/use home equity as an estate-planning tool. This is the route that most older adult homeowners take, according to the Center for Retirement Research. They stay in their homes until they die or need to move out for health reasons.

Pros: A big advantage to staying put versus relocating and renting instead is that a longtime homeowner without a mortgage can live more cheaply than he or she could by renting. There are also tax benefits to homeownership: While property taxes are an ongoing drag, the homeowner isn't on the hook for taxes on income or capital gains on an ongoing basis. Moreover, the long-term gain on the property often skirts capital gains--in contrast with investment assets. If your heirs inherit your home from you, they'll be able to take advantage of the step-up in basis; in other words, any taxes they'll owe will relate to the difference between your home's value upon the date of your death and its eventual sale price. The step-up makes staying put especially attractive if you would otherwise owe a significant tax bill on your home upon sale during your own lifetime. Another financial benefit--as outlined above--is that homes aren't usually included in the asset count that determines Medicaid eligibility.

Apart from the financial considerations, emotional and lifestyle factors often point older adults toward staying put. Older adults might have the house they want, decorated exactly to their liking, in exactly the neighborhood they want to live in. And even if everything’s not perfect with the house, moving can be a daunting endeavor.

Cons: There are a few big financial negatives to staying put and not liquidating home equity. A biggie, of course, is that many retirees are house-wealthy and portfolio-poor; by not tapping home equity, they're living on less than they truly need to. Tax and maintenance costs on an unnecessarily large/expensive home can also take a toll on retiree finances. And while inheriting a home carries tax benefits to the inheritor, the home is still a large, undiversified asset. During the homeowner's own lifetime, he or she may have more opportunities to sell at profitable moments, but your heirs won't have the same advantage. Cleaning out a home, disposing of possessions, and readying it for sale can also impose a burden on heirs, as any adult child who has performed that function can attest.

And while many retirees feel a sentimental pull toward remaining in their homes, the house that made sense for them 20 years ago might not suit today: It might be too large, have too many stairs, or be missing important safety features.