Home Equity Strategies for Retirement
The outlook is not entirely bleak, however. One bright spot that may help Baby-Boomers achieve secure a retirement is the record high-level of home ownership and the related growth in home equity. Home equity, the difference between debt owed on a home loan and the value of a home, accounts for at least fifty percent of net wealth for more than half of all U.S. households according to the Survey of Consumer Finance. In much of the country, historically low interest rates have spurred refinancings and kept housing markets strong, both factors in boosting home equity growth.
Unfortunately, too many homeowners tap into home equity savings through cash-out refinancings, second-mortgage home equity loans, or home equity lines of credit (HELOCs) to pay for vacations, new cars, and other current consumption expenses producing no long-term wealth appreciation. These homeowners may be seriously eroding their ability to finance retirement. By cashing out home equity now, they are spending what has been a vital cushion in old age for past generations.
Homeowners who manage their home equity prudently, on the other hand, will enter retirement years with a substantial nest-egg to complement their other retirement savings accounts. This article describes seven specific ways in which the home equity nest-egg can be used to enhance retirement income planning.
1. Downsize - The traditional way to tap home equity in retirement is simply to move to a less expensive dwelling. The strategy is straight forward: sell your home for $250,000, replace it with one costing $150,000 and you've freed up $100,000. Within IRS guidelines, you can now sell your home and realize up to $250,000 in tax-free profits if you're single; $500,000 if married.
This strategy makes even more sense when you consider that maintenance costs and the headaches of a large family-home are done away with for the retiree. Yet emotional attachment to a home is strong and we all know retirees who simply refuse to move from the home they have lived in for so many years.
2. Reverse Mortgage - Retirees remaining in their homes can still tap their home equity as a source of retirement income. An entire industry has grown up around the "reverse mortgage" concept which allows seniors over 62 to tap into their home's value without making any repayments during their lifetime. A reverse mortgage (also known as a HECM - Home Equity Conversion Mortgage) requires no monthly payment. The payment stream is "reversed": instead of making monthly payments to a lender, a lender makes payments to you, typically for the remainder of your life, if you continue to reside in the home.
Origination fees and closing costs for reverse mortgages are high. Some people try to avoid these fees by instead borrowing against their home equity for retirement living expenses with a regular home equity loan or home equity line of credit (HELOC). However, this is not always a smart strategy. The reason is that with either a conventional home equity loan or a HELOC loan, you will have to make regular monthly payments that may be at a higher interest rate than can be earned on the loan proceeds without undue risk. Also, if you use loan proceeds to pay for routine living expenses, you risk running out of money. A HECM, on the other hand, can be structured to provides income for the rest of your life.
There are many pros and cons to reverse mortgages and a complete discussion is beyond the scope of this article. Suffice it to say that the reverse mortgage strategy is a sound one for many retirees. As with any major financial decision, it is essential that you seek qualified advice before committing to any particular deal. Federal guidelines, in fact, require reverse mortgage applicants to participate in counseling sessions prior to taking out a loan.
3. Purchase Service Years - One of the lesser known facts of financial life is that many public and some corporate pension plans allow their employees to purchase additional years of service credit - sometimes at bargain prices. For example, for an up front lump-sum payment a teacher with 20 years service might be eligible to buy 5 additional years and thereby qualify to retire early.
The cost of buying service years can vary greatly from plan to plan. A dwindling number of pension plans require only a fixed dollar payment for each service year purchased regardless of age; however, most plans now have an actuary compute the cost based upon the employee's age, income and other variables. In either case, it is worthwhile to learn about these options. Although up front costs are steep, you may find that financing the purchase of service years through a home equity loan or HELOC is a sound investment. Bear in mind you are looking at the purchase of an annuity: in exchange for an up front lump-sum payment, you are promised a steady stream of future payments. As with any major financial decision, always seek qualified financial advice.
Also, inquire about other non-pension benefits you may qualify for by purchasing additional service credits. For example, some employers base retiree health care benefits on the number of years of service. Purchasing additional service credits may qualify you for valuable benefits you might not otherwise be eligible for.
4. Company Match - According to the Investment Company Institute, 75.5% of companies match their employees' 401k plan contributions. The most common match level is $.50 per $1.00 employee contribution up to the first 6% of pay. Yet despite the "free money" allure of company matches, a surprisingly large number of workers do not participate in their companies' 401k program or do not contribute enough to receive the full employer match.
Workers electing not to join their employers' 401k plans cite financial constraints as the primary reason. Yet the long-term financial impact of non-participation will likely be far more significant than the short-term discomfort of re-arranging budget priorities. Not only do non-participants miss an immediate and guaranteed 50% return on their investment, they also lose time and the benefit of compounding on their retirement savings growth.
In the right circumstances it can be a sensible to borrow from a home equity line of credit (HELOC) to fully fund a 401k. This strategy involves moving funds from one savings category (home equity) to another (retirement savings) and makes most sense if: 1) the employer match is significant, 2) HELOC interest rates are relatively low, 3) the loan can be repaid in a relatively short period either from higher expected income and/or adjusting budget priorities and, 4) the participant commits to adjusting lifesty