Factors to Consider when Using Home Equity as a Retirement Fund

Is home equity the mainstay of your retirement fund? Apparently it is for a number of people. Both anecdotal evidence and some consumer surveys indicate that a number of Baby Boomers plan to “retire on the house.” The plan is especially prevalent along the coasts and in resort areas. These are the areas in which home price appreciation has been so strong since 2000.

The retire-on-the-home plan works like this. A person or couple lives and works in one of the populous areas on the coasts for a couple of decades or more. They own a home that appreciated significantly over time. For example, in the Washington, D.C., suburbs where I live it is not unusual for a couple to have purchased a home in the 1960s or 1970s for $50,000 to $100,000 and have that home be worth upwards of $600,000 today.

At retirement, the couple plans to sell the home and move to a lower cost area. They will buy a new home there, perhaps one that is smaller than their current home. They will need only a portion of the proceeds of the sale of their first home to purchase the new home. The extra home equity plus the fact that costs will be lower in their new home will fund a large portion of their retirement expenses.

Again, this is not unheard of. I have known couples who sold their homes in the Washington suburbs and moved to nearby but lower cost areas such as Charlottesville and Williamsburg. In addition to being able to buy the same size or larger homes for less money, their property taxes and some other expenses were lower in the new homes.

A variation of this strategy is to own two homes for decades. One home is a vacation home but is also scheduled for use as a retirement home. At retirement, the couple will sell the principal residence, invest the proceeds, and live in the second home.

As I said, I have known people who have successfully executed these strategies. But they do not work for everyone. There are some drawbacks and uncertainties that should be considered.

The amount of home equity and the ability to sell the principal residence is uncertain. We had a booming home market from 2000-2005. But in many of the hottest areas, prices are falling and homes are going unsold. In many markets, the inventory of homes for sale is increasing rapidly and the amount of time a home spends on the market before selling is increasing. A home simply is not a liquid asset in the way a stock or mutual fund is.
In addition, housing busts are possible in at least some markets. If a market has a diversified economy and prices grow in line with personal income, a home’s value likely is somewhat predictable. But if a local economy depends on a single industry or company, the amount of home equity is dependent on the success of that industry or company. Trouble there could sink the value of your home.

To retire on home equity, you must have the discipline to pay down your mortgage. Too many homeowners are tempted to take out home equity loans or refinance their loans at higher balances and take some of their equity now. It is difficult to retire on home equity when it is constantly being refinanced and burdened with debt.

There also is the bounce back problem. The bounce back is when someone retires to a new area and discovers that he doesn’t really like living in that area day to day. Perhaps he had a good vacation there or it was highly recommended by friends. But after living there for a while, the retiree finds he doesn’t want to spend the rest of his life there. Perhaps it is too far from the grandchildren. Or the daily activities or weather or not what was envisioned. In any case, the bounce back retiree moves back to the previous area or searches for a new one.

Some people do not like downsizing as much as they thought they would. While some look forward to it, others, after living for decades in a large home, have difficulty adapting to a smaller residence. Downsizing requires parting with a number of possessions or putting some in storage. It also means there might not be room for the family to visit.

Of course, the new area might not be as affordable as you imagine. Many smaller cities and towns have luxury homes targeted at retirees springing up. You might be attracted to these and end up spending most of your sale proceeds on the new home.

Or there might be other costs. Perhaps real estate and property taxes are low. But what about other expenses? Utilities and food might be higher. Or you might have to travel farther for regular shopping. Or the recreational activities you favor might cost more. Be sure you have reviewed all the costs of the new area before concluding that you can afford to retire there.

People also overlook the cost of downsizing and moving. There are costs to selling, including real estate commissions and possibly capital gains taxes if the appreciation is high enough. Moving the household goods also costs money, even if it is a local move. These costs must be factored into the plan.

I always urge people to think of their primary residence as a consumer good and not as an investment or retirement fund. When retirement rolls around, things might work out that you can use home equity to enhance your retirement. But basing a retirement plan on home equity can be risky. It is better to save and invest in a diversified portfolio instead of relying on rising home equity.