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Making the Most of Home Equity in Retirement

Last update on: Apr 21 2016

Some of the biggest mistakes and lost opportunities in retirement finance involve the family residence. A home usually is among the most valuable assets on a family’s balance sheet and one of the largest sources of expenses. Yet, most retirement plans don’t give much consideration to the home and home equity, leaving a lot of money on the table.

In addition to being valuable, the home is probably the most complicated asset. The decisions aren’t only financial. There are emotional and practical considerations, which often explain why many financial advisors don’t delve deeply into the area and why many people don’t make the optimum decisions.

Often, people approach retirement with one of two fixed mindsets about their homes. Some people are determined to sell and downsize. Others want to stay in their current homes. Either decision could be the best one for a particular person or family. But there should be some analysis, and the issues should be probed more deeply than many people do.

First, consider the home mortgage. Should it be paid off by retirement? Until recently, it was uncommon for an American to have a mortgage balance in retirement. More recently, the number of retirees owning their homes free and clear is declining. When a mortgage’s amortization schedule has it paid off by retirement date or a few years after, usually there’s no reason to change that schedule. But what about other situations?

There’s clearly an emotional advantage for many people to not having a mortgage. You know that’s one less large expense to pay each month, and that comfort is of high value to many people. It might even be enough to override any financial considerations.

If the emotional benefit isn’t very high, consider the financial factors. Suppose a person’s mortgage amortization schedule extends beyond retirement. Maybe the mortgage isn’t scheduled for full payment until 10 years or more into retirement. Should this person arrange to pay the mortgage by retirement to clear that debt?

Maybe, or maybe not. If it is a fixed-rate mortgage at recent low interest rates, that’s a good deal. The mortgage likely will be a smaller percentage of monthly expenses over time as inflation pushes up the prices of other things, and inflation means future mortgage payments will be paid in less valuable dollars.

Money has to come from somewhere to pay the mortgage. If it is well-invested and earning more after taxes than the after-tax mortgage rate, it might not be the best financial move to cash out part of a portfolio to pay the mortgage. Also, not paying the mortgage early means you have cash available in case other unexpected spending needs arise. But if the money is sitting in low-earning investments or the mortgage has a high interest rate, paying off the mortgage might be the best use of that money.

Downsizing is another important issue that has both pros and cons.

Many people say they’re going to downsize to reduce expenses. Experienced financial advisors know downsizing doesn’t always reduce expenses.

Downsizing means selling the current residence and moving into a different, smaller residence. Many people overlook significant costs when estimating the benefits of downsizing. It costs money to prepare a house for sale, sell it, and purchase a new residence. There also is the cost of moving possessions to the new residence.

Also, the new home might not reduce costs as much as many people expect. Many people move from a high-cost area to a low-cost area and buy homes the same size or larger because the price per square foot is much lower. Others look only at initial purchase prices and don’t carefully consider all the costs of home ownership. Will you be driving more often and further than in the old location for activities such as shopping, medical appointments, recreational activities, and the like? Will the property taxes and insurance be lower? What about utilities? How will you furnish the new place? Will you have to make more long distance trips to visit the grandkids?

Added together, these costs can be substantial and reduce or eliminate the savings from downsizing.

On the other hand, downsizing could save money in the long term by preventing adult children from moving back in with you.

Downsizing is not an automatic money-saver. Be sure to consider all the angles.

Of course, there are emotional aspects to downsizing. You’ll be leaving a home in which you’ve probably lived a long time. It’s a place in which you are comfortable and that holds many memories. You’ll have to change your lifestyle if you move to a smaller place.

The emotional side is why many people fight downsizing. You have to fully consider the financial costs of staying in the current place (including major repairs and replacements that will be needed over the years) and compare that with potentially lower costs of downsizing. Balance those facts with the emotional factors.

A final consideration is how to tap home equity when needed. As we discussed, freeing home equity is many people’s initial reason for downsizing but often doesn’t generate as much free capital as people expect.

There are other ways to free equity that don’t require you to move.

A home equity line of credit gives you ready access to some of your equity. It is best to set up the line of credit before retirement. Though the loan is backed by the home, lenders also examine your income, and employment income tends to be viewed more favorably than retirement income sources.

Home equity lines of credit usually don’t cost much to establish, and you aren’t charged interest until you actually tap the credit line. You can keep the line active but untapped until a major spending need arises. You have to begin making repayments on a schedule after that.

Since a home equity line of credit does require regular payments with interest after the money is borrowed, it doesn’t meet the needs of some retirees. They’re looking for additional cash sources, not higher fixed expenses.

Another option might be to sell the home to your children in an installment sale but continue to live there in a sale/leaseback. Of course, to do this your children will need enough free cash flow to make payments to you. But when the facts are right, it is a good way for parents to stay in their long time home, benefit from the home equity, and gradually transfer the home to their children. The children eventually get all or most of their money back by selling the home. You need to have all the legal paperwork that would be used in a deal between strangers.

Reverse mortgages also are important ways to tap home equity. They were growing rapidly in popularity until the financial crisis and real estate crash. Their numbers increased again over the last few years. Changes in reverse mortgages a couple of years ago also made them more attractive. Costs and interest rates are lower, and it’s easier to borrow as a line of credit.

We last discussed in detail the new look in reverse mortgages and strategies for using them in our May 2014 visit. You can find that discussion in the Cash Watch section of the Archive on the members’ web site.

When considering home equity in your retirement plan, I recommend being pessimistic. Assume the equity will be less than you think it will be. It is better to have a positive surprise in this area than a negative one.

One key mistake people make with their homes in retirement is waiting too long. Many people who downsize wait too long, causing them to pay a lot of home carrying expenses and repairs they could have avoided. Others wait too long to consider ways of tapping their home equity, and that can foreclose some options or force them to spend down too much of the other parts of their nest eggs.

Retirees and pre-retirees need to think about their homes and home equity early and to think long term. Otherwise, they won’t benefit as much as they could from one of their most valuable assets.

RW December 2014.

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