Using Your Personal Residence As A Retirement Asset

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In June 2013, the National Institute on Retirement Security published the results of a study entitled “The Retirement Savings Crisis”, Is it Worse Than We Think?” The main purpose of the study was to determine if American households are financially prepared for retirement. The results of the study were rather sobering, as it suggests the majority of households are not as well prepared as they may have thought. Some of the highlights from the study were:

More than 38 million working-age households (45%) do not own any retirement account assets, whether in an employer-sponsored 401(k) plan or in IRAs.
The average working household has virtually no retirement savings. When all households are included – not just those with retirement accounts – the median retirement account balance is just $3,000 for all working-age households and $12,000 for those households near retirement.
92% of working households are not on target to meet their retirement goals.

If this trend continues, Americans will likely need to find other ways by which to support their lifestyle during retirement rather than rely on retirement savings. Typically, the fallback position centers on either the decision to defer retirement by working to an older age or to make sacrifices to lifestyle and spend less. Neither of these is necessarily attractive to someone who has reached the point where retirement is a serious consideration.

HOME EQUITY TO THE RESCUE?

Those who own a home are in a unique position whereby they may have the opportunity to utilize the equity in their home to help fill the income or asset gap should they have a retirement income shortfall.

There are four primary ways by which an individual can access the equity in their home:

Home Equity Loan (or second mortgage)
Home Equity Line of Credit (“HELOC”)
Home sale and downsize
Home Equity Conversion Mortgage (Reverse Mortgage)

Following is a brief overview of each of these strategies. Each has its own advantages and disadvantages. Before deciding to implement any of these strategies it is important to speak with your financial advisor to determine the best course of action given your unique financial position.

Home Equity Loan

A Home Equity Loan allows a homeowner to access their home equity by taking a lump sum of money that will need to be paid back over a certain specified period of time (i.e. 10 years, 15 years or 30 years).

The advantages of a Home Equity Loan include:

A home equity loan carries a fixed interest rate. A retiree can plan on the loan payment being fixed for the entire term of the loan. This can be helpful for those that are on a fixed budget.
The interest the borrower pays on the loan may be claimed as a mortgage interest deduction. According to IRS Publication 936, the Federal Government allows the borrower to deduct the interest from the loan as long as the proceeds were used to buy, build, or substantially improve the borrower’s home. Further, a borrower can deduct home mortgage interest on the first $750,000 ($375,000 if married filing separately) of indebtedness. However, higher limitations ($1,000,000 ($500,000 if married filing separately)) apply if the borrower is deducting mortgage interest from indebtedness incurred before December 31st, 2017.

The disadvantages of a Home Equity Loan include:

The full balance of the loan begins to accrue interest as soon as the funds are disbursed. This may cause the borrower to pay more interest over time.
The borrower must start repaying the loan soon after it is disbursed. These payments may place a constraint on the borrower’s cash flow which could lead them to deplete their investment assets to help fill the income gap.
Because the home equity loan is an amortizing loan, each installment includes repayment of principal as well as interest. As such, the earliest payments on the loan largely interest, with very little reduction in the outstanding loan balance.
To qualify, the borrower must undergo a credit check and prove their financial assets and sources of income to the lender. Proving sources of income for retirees may prove difficult, as many have no employment income.
If the retiree is unable to meet the loan’s obligations, he or she may find themselves in a position of defaulting on the loan, resulting in foreclosure on the home.
Given the disadvantages associated with these loans, according to Allen (2015), a Home Equity Loan is typically an appropriate strategy for those retirees with a high-risk tolerance and sufficient sources of income.

Home Equity Line of Credit (HELOC)

A home equity line of credit is another way for a homeowner to access their home equity. When a borrower is approved for a HELOC, he or she does not receive a lump sum payment. Instead, the funds can be drawn upon when and as needed up to the amount of the credit line.

The advantages to a Home Equity Line of Credit include:

They are typically easier to establish than a traditional home equity loan, and closing costs are typically below that of a home equity loan.
The initial interest rate charged on a HELOC is typically lower than interest rates on home equity loans.
Interest is assessed on the amount the homeowner borrows against the home’s equity, not on the full amount of the line of credit.
The interest the borrower pays on the loan may be claimed as a mortgage interest deduction. According to IRS Publication 936, the Federal Government allows the borrower to deduct the interest from the loan as long as the proceeds were used to buy, build, or substantially improve the borrower’s home. Further, a borrower can deduct home mortgage interest on the first $750,000 ($375,000 if married filing separately) of indebtedness. However, higher limitations ($1,000,000 ($500,000 if married filing separately)) apply if the borrower is deducting mortgage interest from indebtedness incurred before December 31st, 2017.

Disadvantages include:

Interest rates are not fixed and are typically tied to a published interest rate such as the Prime Rate. The rate of interest calculated on the outstanding loan balance will therefore vary over time. In a rising interest rate environment, the borrower can find that the amount of the monthly payment may rise to a level that further squeezes their budget.
If the retiree is unable to meet the loan’s obligations, they may find themselves in a position of defaulting on the loan, resulting in foreclosure.
While the underwriting process may not be as stringent as for a home equity loan, to qualify, the borrower must undergo a credit check and prove their financial assets and sources of income. Proving sources of income for retirees may prove to be difficult as they typically have no employment income.

Home Sale and Downsize

Another way for a retiree to access home equity is by selling their existing home and downsizing.

Advantages include:

The liquidity gained from the sale may be used to purchase a new home that is perhaps better suited to the homeowner’s needs.
When “downsizing”, the homeowner can reduce or eliminate mortgage payments if the new home is purchased for cash or with a smaller mortgage.
To the extent the cost of the new home is less than the proceeds from the sale, excess proceeds can be invested to help provide additional income to help support the homeowner’s lifestyle.
Downsizing to a less expensive home may also reduce carrying costs like the amount being paid for taxes, homeowner’s insurance, utilities, etc.

Disadvantages include:

The decision to sell requires that the homeowner overcome the emotional hurdle of selling the home where many family memories were made.
To the extent the home is sold for more than its cost basis, the homeowner may have to pay tax on the capital gains from the sale. However, homeowners filing a joint return may be eligible to exclude the first $500,000 of capital gain from taxation. ($250,000 for those filing a single return). IRS Publication 523 states that the exclusion is available if you owned the home and used it as your primary residence during at least 2 of the last 5 years before the date of sale, you didn’t acquire the home through a like-kind exchange during the past 5 years, and you didn’t claim any exclusion for the sale of the home that occurred during a 2-year period ending on the date of sale of the home.

Home Equity Conversion Mortgage (Reverse Mortgage)

Lastly, a homeowner that is at least 62 years old may access the equity in their home through what is often referred to as a reverse mortgage. To be eligible for a reverse mortgage the home must be a single-family home or a 2 to 4-unit home with one unit occupied by the borrower. Certain condominiums and manufactured homes (trailers, etc.) will also qualify if they meet the requirements.

The amount a borrower may receive through a reverse mortgage depends on the following factors: (1) the age of the youngest borrower or eligible non-borrowing spouse, (2) the current interest rate, and (3) the lesser of the appraised value of the home or the mortgage limit of $822,325 (as of January 1, 2021) imposed by the FHA on reverse mortgages.

A reverse mortgage is referred to as a non-recourse, asset-based loan that does not require repayment until the borrower leaves the home (Allen, 2015, p. 75). Reverse mortgages are appropriate for those who would like to age in place (i.e. remain in their home), have enough financial resources to maintain the home (i.e. paying property taxes, homeowner’s insurance, etc.), and for those who may be looking to supplement their retirement income or to provide an emergency fund.

The clear majority of reverse mortgages in the United States are Home Equity Conversion Mortgages, which are regulated and insured by the Federal Government by the Department of Housing and Urban Development (HUD) and the Federal Housing Authority (Pfau, 2016, p. 45). For many years, reverse mortgages were sold inappropriately by lenders which often included high-pressure sales techniques and carried sizable loan origination fees. As a result, the Federal Government made changes to the reverse mortgage facility, increasing the regulations associated with them to protect the borrower by ensuring they have the financial wherewithal to continue to maintain the property.

As mentioned above, one of the major benefits of a reverse mortgage is to allow the homeowner to age in place. However, just because the home may be subject to a reverse mortgage does not mean that the borrower must remain in the home. The borrower can sell the home, but just like a conventional mortgage, they must repay the reverse mortgage loan balance when the home is sold. In addition, the homeowner can leave the home to his heirs. The heirs will inherit the home upon the death of the borrower. However, before the heirs receive title to the property, they must repay the reverse mortgage loan balance. If the heirs are not interested in keeping the home, they have the option of selling it. Again, they would be responsible for repaying the reverse mortgage balance upon the sale of the home.

Advantages of reverse mortgages include:

The ability to access the equity in one’s home, within limits, via a lump sum, an open line of credit, or through regular monthly disbursements without having to make loan repayments, as long as the borrower remains in the home. Please note, if the borrower lives with a spouse who is a co-borrower, then the co-borrowing spouse may continue to live in the home should the borrower move to a nursing home or assisted living facility.
Proceeds from a reverse mortgage may be used to pay off an existing first mortgage, home equity loan, or HELOC (within the stated limits), thereby eliminating principal and interest payments on such loans. Since re-payments are not required on the reverse mortgage, the borrower can substantially reduce their monthly out-flows.
According to IRS Publication 936, payments received under a reverse mortgage are considered loan advances. Therefore, disbursements received are not taxable.
A reverse mortgage is especially beneficial for those that do not have sufficient balances in retirement savings. Implementing a reverse mortgage will provide them access to otherwise “dead equity” that can help them fill any retirement income gaps.

Although reverse mortgages have some benefits, retirees need to be aware of some of their disadvantages.

Disadvantages of reverse mortgages include:

Origination fees and closing costs can be high.
The principal amount of the loan plus interest must be repaid upon the death of the borrower, or if the home is no longer the borrower’s principal residence (or the borrower moves out due to health reasons for 12 months or longer), or if the borrower defaults on the terms of the loan.

If you are close to retirement, or in retirement, and are looking for ways to utilize your home equity to supplement your income it is important that you speak with your financial advisor to make sure that any of the above strategies are appropriate for your unique financial situation.

Allen, James, R. (2015). Using the Personal Residence for Retirement Income. Journal of Financial Service Professionals. 69(4). Pp 71-79.
Pfau, Wade. (2016). Reverse Mortgages: How to use Reverse Mortgages to Secure Your Retirement. McLean, VA. Retirement Researcher Media.
Rhee, Nari. (2013). The Retirement Savings Crisis: Is it Worse Than We Think? Washington, DC. National Institute on Retirement Security.
United States Department of the Treasury. Internal Revenue Service. Publication 936 (2019): Home Mortgage Interest Deduction. Internal Revenue Service.