The residence usually is one of the most valuable assets retirees own. It also is one of the worst-managed assets. Few people realize the home can be used to increase retirement cash flow or know how to do so efficiently. In the last few visits we discussed reverse mortgages and issues related to moving in retirement. Let’s put these topics together to consider how to make the best use of home equity in retirement income.
While your house is your home, it also is both one of your most valuable assets and your highest expense. Most people consider their home equity primarily to be left for their children or to be used in a pinch to pay for long-term care or high medical expenses. Instead, consider how it can be used for your financial benefit.
The first strategy to consider is downsizing. Downsizing is moving from your current home to one that costs less and is less expensive to own. To many people, downsizing is moving to a smaller home, but that’s not necessarily the case. If you move to a less expensive area, you can purchase a home that costs less to buy and own without being smaller than the old home.
Downsizing can have two benefits.
First, downsizing creates additional liquid assets. You sell the old home and purchase a new home that is less valuable than the old home. The difference is cash in hand for you that can be invested to generate additional retirement cash flow. Or you can use it to pay debt. Either way, eventually it increases retirement cash flow.
The trick, as we covered in the November 2015 visit, is not to overestimate the amount of cash downsizing will create. It costs money to buy and sell homes and move your goods to the new home (or acquire new furnishings and accessories). Many people overestimate the cash they’ll net from selling their old homes, so they ?downsize? to a home that’s more expensive than they really should have purchased. The result is a lot of real estate activity without increasing their nest eggs by much. A good rule of thumb in most areas is that the costs of buying, selling, and moving will cost about 10% of the value of your current home.
Second, downsizing should decrease your monthly expenses. You’ve moved into a home that’s less expensive to own, so your monthly cash flow available to pay for expenses other than housing should increase.
Downsizing also could have nonfinancial benefits by making your life easier and less stressful. You’ll have less home to clean and maintain. It also might be easier for you to move around the home, and the neighborhood might be more suitable to this stage of your life.
The second strategy to consider is a reverse mortgage, also known as a home equity conversion mortgage (HECM) as we discussed in the November 2015 issue.
A HECM is a loan backed by the equity in your home. You don’t make loan repayments during your lifetime. The loan is paid from the sale proceeds after the home no longer is your primary residence. If you live a long time and the interest compounds to a large number, you won’t owe more than the equity in your home. The lender or the federal government will take the loss.
You can take the HECM as a lump sum, line of credit, or an annuity. For example, you can arrange for a monthly annuity that will last as long as you live.
You still have to pay taxes and insurance on the home, and you’ll be responsible for maintaining it. But you receive part of your home equity in cash without having to move.
The major disadvantage of a HECM is that it is a relatively expensive way to borrow. Because of the costs, you’ll be able to borrow much less than the full equity of your home. The percentage of the home’s value you can borrow will depend on your age and the level of interest rates when you borrow.
Here are the key points when planning how to use these strategies to benefit from your home equity.
Downsizing is best done sooner rather than later. There are social and emotional aspects to leaving a long-time home, so the longer you wait the more difficult the move and subsequent readjustment will be. Age, of course, makes the physical act of moving more difficult. Physical limitations could make the move more expensive because you have to hire people to do things you would have done a few years earlier.
Also, the lifetime benefits of downsizing are greater when you act sooner. The financial goals of downsizing are to increase your nest egg (resulting in higher income) and decrease monthly expenses. The sooner you make the change, the greater the lifetime financial benefits.
Downsizing also should occur before using a reverse mortgage. If you take out a reverse mortgage and decide to downsize later, you have to pay the reverse mortgage and all its accumulated interest and fees from the sale proceeds. Taking out a reverse mortgage will foreclose downsizing in the future for many people.
A reverse mortgage is very flexible. Traditionally a HECM was used to pay for medical expenses or home maintenance late in life when other cash sources were exhausted or to set up an annuity to supplement Social Security and any other income. Those uses still are available. Another option, as we discussed in December 2014 and November 2015, is to create a reverse mortgage line of credit. You can use the line of credit to avoid reducing your nest egg when markets are down or unexpected major expenses arise. Then, pay down the line of credit from future investment returns.
A HECM also can be used before age 70 if you retired but want to maximize Social Security benefits. You can supplement nest egg withdrawals and any other income with cash from either a HECM line of credit or monthly payments for a set period of years. After Social Security benefits begin at 70, you can choose to repay the reverse mortgage over time or wait to have the loan paid from a future sale of the home.
I don’t want to downplay the practical and emotional aspects of your home. Too many people, however, overlook the options for managing their home equity. There are ways you can turn your largest expense into a source of extra cash flow. The earlier you incorporate these ideas in your retirement plan and ensure you are in the right home for the long term, the more financially secure you’ll be through retirement.
RW January 2016.