2 Ways to Use Home Equity to Fund Retirement

Mention the idea of tapping home equity to fund retirement, and people often think you’re suggesting a reverse mortgage.

But a reverse mortgage is only one option—and people should consider exploring other ways to extract value from their homes in retirement.

Half of all households face the risk of a declining standard of living in retirement owing to inadequate savings, the decline of traditional pensions, and lower Social Security replacement rates. But the majority of older Americans are homeowners—and most of these households have more home equity than financial assets.

Home equity is the current market value of your home minus any remaining mortgage obligation. Your home is an investment, but it’s a bit different from other financial assets. It’s less liquid and more complex to tap, and it provides shelter and meets other human needs.

Of course, any decision you might make about housing is not strictly financial. Your decisions should take other factors into account: Is your home designed in a way that makes it suitable for aging in place? Would a move outside your community separate you from family, friends, trusted healthcare providers, and social support?

We’ll look at those questions next month. But for now, let’s consider financial strategies for unlocking housing wealth. These include downsizing, moving to a less expensive location, and reverse mortgages.

The Role of Housing Wealth in Managing Longevity Risk

Households with inadequate savings stand to benefit most from tapping housing wealth, but everyone faces longevity risk—that is, the risk that you’ll outlive your savings and potentially need to lower your standard of living late in life.

Longevity risk has been a hot topic lately in the wake of the recent bout of high inflation. But inflation is always a risk to the long haul of a retirement plan.

Housing wealth can be considered a hedge against inflation in this context, especially if you live in an area where real estate values have risen substantially and may continue to do so.

“Homes are stores of wealth that aren’t necessarily as liquid as other assets, but it’s important to understand their role because they can provide some longevity protection,” says Joel Dickson, global head of advice methodology at Vanguard.

Housing wealth can also be a good option for funding high long-term-care expenses—although this strategy calls for sound planning because changing your housing can be difficult at a time when your health is poor and quick decisions are required.

Option 1: Sell and Move

A Vanguard study found that among people who retire and relocate, about 60% move to a less expensive location—and typically unlock about $100,000 of equity.

These individuals are typically able to unlock such a sizable sum because they are selling a home that was purchased decades earlier at a far lower price. The researchers found that about 25% of retirees could benefit from selling and relocating to a less expensive area.

The size of equity extraction depends in part on a sort of lottery, Vanguard notes. The lottery “winners” are those who live in locations that have enjoyed strong housing value appreciation. Moving out of these high-cost locations allows them to access a good amount of housing wealth.

The study cites an example of a hypothetical homeowner in Santa Clara, California, where the average house price in 2019 was $1,034,000. The homeowner relocates to a less expensive part of the state with an average home price of $266,000. That homeowner could have unlocked a net difference of $768,000 in home equity, not including potential mortgage and transaction costs.

Vanguard also noted a strategy called “bargain-hunting”—that is, looking to maximize the amount of home equity by shopping for housing in low-growth markets where prices have lagged the national averages.

Another strategy to consider is downsizing your home but remaining in your current town or region.

Many retirees sought out more space while raising families, and maintaining the excess space can be costly: One study found taxes, insurance, upkeep, and utilities account for nearly 30% of retired homeowner costs.

For example, if you live in a high-cost metropolitan area, perhaps you picked your location for its proximity to work or the quality of schools. Could you move farther away from the city center to cut costs and extract home equity? The goal would be to stay close enough to still see family and friends and not disrupt your social and cultural life while also keeping your current healthcare providers.

You can run examples more specific to your own situation at Sperling’s Best Places, which offers a treasure-trove of location information and data ranging from home prices, cost of living, and an array of quality-of-life considerations.

Option 2: Borrow Against It

If you don’t want to move, another option is to borrow against your home equity. Conventional mortgages and home equity lines of credit are one possibility, but the amounts you borrow must be repaid with regular monthly payments. That brings us to the reverse mortgage loan.

Most of these loans are made under the federal Home Equity Conversion Mortgage, or HECM, program, which insures the loans. They’re not very popular with retirees. In 2022, the program processed just 64,437 new loans, according to federal data.

As a financial product, I don’t love reverse mortgages. In a more perfect world, we would support the income needs of seniors through higher Social Security benefits and lower healthcare costs. Reverse loans can be difficult to understand, and they do come with high fees and some risks that have generated a lot of deserved bad press over the years.

The big risk is foreclosures: Reverse loans do not require monthly repayments, but borrowers can default if they fail to make property tax and insurance payments or keep their homes in good repair.

Federal regulation of reverse loans has been tightened in recent years to reduce these risks. And if you just don’t want to move out of your home and need the income, it is possible to use a reverse loan safely.

Both fixed-rate and variable-rate HECM loans are available, but fixed-rate loans are unusual and require that you take the entire allowed credit up front as a lump-sum payment. More often, a HECM is structured as a line of credit that you can use for any purpose—to pay off a mortgage or other debts, cover your living expenses, or pay for healthcare or other big-ticket needs. (It’s also possible to receive a preset annuity-style payment stretched over your life in the home.)

Key things to know about reverse loans:

• They’re available only to homeowners age 62 or over. As the name implies, they are the opposite of a traditional forward mortgage, where you make regular payments to the bank to pay down debt and increase equity. A reverse mortgage pays out the equity in your home to you as cash, with no payments due to the lender until you move, sell the property, or die. The amount you owe increases over time, while the amount of equity falls.
• You don’t have to make debt service payments as long as you live in your house. However, because borrowers continue to own the home, you do need to spend to keep the home in good repair, pay property taxes and insurance premiums, and you must continue to occupy the home as your primary residence.
• HECM loans are insured through the Federal Housing Administration. This backstop assures the lender that the loans will be repaid even if the amount owed exceeds the proceeds from the sale of the home. It also assures the borrower that you’ll receive the promised funds, that you or your heirs will never owe more than the value of the home when it is time to repay the HECM, and that you receive the protections afforded by stringent government regulation of a very complicated financial product.
• Reverse mortgage distributions are not included in the adjusted gross income reported on your tax return. This means they don’t trigger high-income Medicare premiums or taxation of Social Security benefits.
• Repayment of an HECM loan balance can be deferred until the last borrower or nonborrowing spouse dies, moves, or sells the home. When the final repayment is due, the title for the home remains with family members or heirs, who can choose to either keep the home by repaying the loan or refinance it with a conventional mortgage. If they sell the home, they retain any profit over the loan repayment amount. If the loan balance exceeds the home’s value, the heirs can simply hand the keys over to the lender and walk away.

The amount a lender will offer depends on the home’s market value, the age of the youngest borrower, and interest rates (lower rates allow you to borrow a higher percentage of the home’s value).

For more detail, the National Council on Aging offers a useful guide to reverse mortgages. NewRetirement.com also has a detailed guide that includes a loan calculator.