We discussed paying off the mortgage and home equity in the last article and how our house decisions are both financial and emotional, and very personal.
There's also a spiritual component. We want to seek God's guidance for any major home or home-financing decisions to ensure that we wisely steward the gifts he has given us. We also want to guard against greed and materialism, which can lead to unwise choices.
Paying off the mortgage is only one of the many vital decisions retirees need to make about their housing situation.
For example, would downsizing to a smaller house, a condo, or patio home—moving to something less costly—better suit your wants and needs?
Or, does paying off the mortgage and keeping your current home make more sense than downsizing? If so, and you need to make some repairs or want to do some upgrades, what is the best way to pay for them?
Perhaps you want a larger home for lifestyle purposes but with less maintenance that could actually be more costly to buy than what your current house is worth. If so, does it make sense to use savings or take out a new mortgage to make the change? Are there other options?
The Blessings of "Home"
Houses are more than a financial asset (or liability, depending on how you look at it) because they're our homes. They're where we live and make memories. They're also where we may have invested a lot of time and money making them functional, comfortable, and appealing.
The concept of home is found in the Bible. It has both physical and spiritual connotations.
Isaiah 32:18 seems to express the value that God places on our homes as a place of sanctuary: "My people will live in peaceful dwelling places, in secure homes, in undisturbed places of rest."
Isaiah 65:21–22 conveys the blessings of home:
"They will build houses and dwell in them; they will plant vineyards and eat their fruit. No longer will they build houses and others live in them, or plant and others eat. For as the days of a tree, so will be the days of my people; my chosen ones will long enjoy the work of their hands."
And Proverbs 3:33 says that God "blesses the home of the righteous."
In our fallen world, homes can be a burden or a blessing, but they're usually a mix of both. Retirees will find that their homes are increasingly important, especially as they age and spend more time there. This is why the decisions concerning them can be difficult.
There are several options for retirees who own a house with sizable home equity. Which one makes sense for you and me depends on our objectives and financial situation.
1. Need to reduce total housing expenses? Sell the house and downsize.
Many retirees sell and then downsize to reduce total housing expenses. But if you sell, you will still have to live somewhere. If "somewhere" doesn't cost less than where you live now, you're back where you started.
If you sell a sizeable paid-for house or one with a lot of equity, you may be able to purchase a smaller one with no mortgage, even if you had a mortgage on the larger one. That can be a big help in managing expenses in retirement.
You could sell and rent, but then you'll need enough income to pay the monthly rental payment. (Some say it can be less costly to rent than to own. I've never done a detailed analysis of that, but I can see how it might be true.)
If you're thinking about renting (which may be a good choice for many), keep in mind the "Rule of 300" that I explained in the last article.
2. Want to keep the house but need to make repairs (or want to make upgrades)? Use savings or take out a home equity loan (HEL) or home equity line of credit (HELOC).
If you have an older home, you know the challenges: once you get past 10 to 20 years, you have what seems like a continual string of things that need to be repaired and replaced. Plus, there are ongoing challenges with yard maintenance.
Retirees who want to stay put need to make financial allowances for such things, and here are some ways to go about it:
Spend some of your non-retirement savings (you may have designated for other purposes) or withdraw a lump sum from your retirement savings.
Optimally, you'd use non-retirement, after-tax savings instead of drawing from your retirement savings.
If that's not possible and you use some of your retirement savings (which are in a traditional IRA), you will have to pay taxes on it. Plus, that could push you into a higher marginal tax bracket as the IRS requires that you add the withdrawal amount to your other income in the year it's withdrawn.
You can avoid the taxes by using money from a Roth IRA since you can spend it tax-free. However, if only some of your savings are in a Roth, it might be better to leave them alone for as long as possible to have that tax-free income later in life when tax rates may be much higher.
Take some cash out of the house using either a home equity loan (HEL) or a home equity line of credit (HELOC).
If you don't sell your house, the only other way to get at the equity is to borrow against it.
The benefit is obvious: you can use the equity for any purpose. The main drawback also becomes apparent: you're drawing down equity while also making monthly payments.
Borrowing may make sense if you want to stay in your current home but need a lump sum for maintenance, home improvements, or to spend on something else. You have to make sure you can afford the monthly payments. Plus, as we discussed in the last article, it's wise to pay the loan back as soon as possible.
I'm not crazy about the idea of taking on debt, especially if you have a paid-for house, but I'm not too fond of the idea of using retirement savings (and paying the taxes on them) either.
There are two main ways to borrow against your home: a home equity loan (HEL) or a home equity line of credit (HELOC), and they differ in some critical ways.
One is the way interest is calculated. With a home equity loan (which is basically a mortgage), interest is calculated monthly and repaid based on a pre-determined loan amortization schedule.
A HELOC is just what it says—a revolving line of credit that works much like a credit card that you can take from, spend, pay it back, and then do it all over again. You are charged only on the amount you withdraw, and as mentioned earlier, its "simple interest," meaning interest is determined this way:
First, divide your annual interest rate by the number of days in the year to get the daily interest rate: Daily interest rate = annual interest rate ÷ 365
To calculate your daily interest on a 4-percent rate, we would use this formula:
Daily interest rate = 0.04 ÷ 365 = .00010950
Next, we can calculate the month's average daily balance:
Average daily balance = sum of HELOC daily balances/days in the month.
For example, if your outstanding balance was $10,000 at the beginning of the month, and you borrowed $15,000 on the 15th, your average daily balance would be calculated as follows: $10,000 multiplied by the first 14 days of the month, added to $25,000 (the new balance as of the 15th) multiplied by 17 (the remainder of days in the month).
That figure would be divided by the number of days in the month (we'll assume 31) for an average daily balance of $18,548.
Average daily balance = (($10,000 x 15) + ($25,000 x 17)) ÷ 31 = $18,548.
From there, you can calculate the monthly interest charged. It's the daily interest rate multiplied by the average daily balance for the month. The result is then multiplied by the number of days in the month:
Monthly interest charged = (daily interest rate x average daily balance for the month) x number of days in the month.
So, for our example, in a month with 31 days, the monthly interest charged would be calculated as: Monthly interest charged = (0.00010950 x $18,548) x 31 = $62.96.
Sorry for all this math. Hopefully, it didn't make your head spin. If so, I have some good news. Most banks have a handy-dandy HELOC calculator you can use that will figure all this out for you.
The HELOC's advantage is that it isn't amortized like a traditional first or second mortgage. You can make interest-only payments (which are tax-deductible since we can itemize) and pay back the principal at your leisure (or when you eventually sell the house.)
HELOCs' big drawback is that the interest rate is not fixed and will rise with the prime interest rate (currently 3.25%). But even the interest rate monthly payment would be $166, which would still be manageable.
By the way, regardless of whether you take out a HELOC or home equity loan, the interest may be deductible, just like interest on a typical first mortgage. Like any mortgage loan, the HELOC or home equity loan is secured by your home as collateral, meaning that you could lose the house to a foreclosure if you default on the payment.
(Read more about the difference between HELOCs and home loans.)
3. Want to keep the house but need to convert home equity to income? Take out a reverse mortgage.
This option is similar to #2 above, except with a reverse mortgage, you don't have to make monthly payments. Instead, you receive a lump sum or regular payments to use for any purpose you choose. Most retirees use the money to help cover their expenses, typically later in retirement, perhaps to fund long-term care.
The loan (plus accrued interest) is repaid upon your demise, when you sell your home, or when it is no longer your primary residence.
Just like a home equity loan or HELOC, reverse mortgages deplete equity. They have negative amortization, meaning they add to the outstanding principal rather than pay it down. That may or may not be an issue depending on your situation. (You can read more about reverse mortgages in my previous article on the value of home equity.)
There are a lot of pros and cons to reverse mortgages. They can also be complex and costly. So, be sure to do your homework if you think you're a candidate for one. (I'll discuss them further in #5, below.)
4. Want to keep the house but move later? Stay put and plan to move in the future.
This option may be the most desirable for those in the first five, ten, or fifteen years of retirement.
Your housing needs may change significantly once or twice during a 30-year retirement. You may need the larger home for the children and grandchildren to visit for many years after you retire. But you may find at some point that you don't need all that room, and you could do without the maintenance chores and expense.
Or, as you age, you may find that your home isn't well suited to your physical limitations. Can it be modified to work for you? If so, you could use any of the other options discussed here to get that done.
5. Want to move to a larger or newer (i.e., more expensive) house? Sell and then buy with a plan to fund the additional expense.
Deciding to purchase a new home and move in retirement is a big deal, especially if you need extra cash to make it work. As with the other scenarios, you have some options:
Take a chunk of your retirement savings to buy your retirement "dream house."
Whether this makes sense for you depends on how much you have in savings. You don't want to reduce your income-producing assets if things are tight. Your new house may appreciate in value, but it doesn't produce income (unless you rent it out).
You may be wondering, "What's the big deal? If I have the money, why not use it?" Those are valid questions. I think it's perfectly fine to spend retirement savings on the house, but you may not want to spend so much that most of your net worth is home equity.
One could argue that cash from savings used to buy real estate equity isn't really "spent." That's technically accurate as it can be viewed as an asset transfer from stocks and bonds to real property.
You can justifiably anticipate some growth in the value of your real property. However, you may be changing from income-producing assets to one that does not unless you access your equity via a home equity loan, HELOC, or a reverse mortgage.
Some financial advisors suggest that real estate in various forms (primary residence, second home, rental property, etc.) could comprise up to one-third of our net worth and still maintain a balanced and diverse portfolio.
And, in theory, a retiree could put most (if not all) of their net worth into their home and then use one of those financial methods to take money out as needed for living expenses. Your home equity would then be as large as your net worth.
That said, an "all eggs in one basket" approach is probably unwise—a real estate crash will break all of them.
As with any house purchase, you could take out a new mortgage.
That means a monthly payment for 10, 20, or 30 years or more. And if you get a new mortgage, you have to be able to make the payments (there's that "rule of 300" again).
When I had a mortgage, I always tried to keep my housing expenses below 25% of after-tax income. I realize that's very conservative. Now that we're retired and without a mortgage, the number is more like 6%.
One of the challenges with this option is getting a mortgage when you have little or no income (in the traditional sense) and only income from Social Security and income from an investment portfolio. You may need to get what is known as an "asset-based mortgage" unless you can show that you have sufficient income (dividends and interest) from your investment assets.
There's another option, which is to use a reverse mortgage, also known as a "Home Equity Conversion Mortgage (HECM) for Purchase."
It's is an interesting option for those who want to "upsize" (i.e., buy a bigger home, a more expensive one, or both) in retirement.
If you use a HECM, it would require a larger down payment than a regular mortgage, but that could be whatever you can sell your house for, minus sales expenses, plus whatever additional cash (preferably from non-retirement savings) you can add to it.
The benefit of the HECM is that you don't have to make any payment of principal and interest as long you and your spouse (or one of you) live in the house.
I know what you're wondering: "If I'm not making payments, what happens to the interest charges?" This question gets to the heart of what reverse mortgages are all about. And you may see it as a positive or negative, depending on your situation.
A reverse mortgage is called that because the interest payments are reversed. The interest accrues and is added to the principal balance but doesn't have to be paid until neither you nor your spouse lives there as your principal residence. The total principal owed, plus all accrued interest has to be paid when the house is sold or transferred through inheritance.
If the house has retained a value greater than the HECM outstanding principal balance, including accrued interest, there would be positive equity upon sale. If the value of the home falls below that, equity would be negative. However, because HECMs are FHA-insured, if the accrued debt is greater than the sale price, neither the owner nor anyone else has to cover the shortfall.
One HECM lender provided a helpful illustration:
A couple, both 70 years old, uses a reverse mortgage to purchase a new home for $400,000. The required down payment (which they have from the proceeds of the sale of their existing home) is approximately $182,000 or about 45% of the purchase price. (The down payment includes all upfront mortgage insurance premium and third-party closing costs.)
Assuming a beginning loan balance of 218,000 and modest annual appreciation of 4%, here's what their financials look like at 5-year intervals:
- After 5 years, they have a loan balance of $275,764 and $210,223 in home equity.
- After 10 years (at age 80), there's a balance of $333,533 and equity of $257,890.
- After 15 years (at age 85), their loan balance is $403,405, and home equity is $316,298.
- After 20 years (at age 90), the loan balance would be $487,914, but there is still $387,861 of home equity.
Should the borrower decide later that he/she needs to move into an assisted care facility, they may sell the home, the reverse mortgage balance is repaid, and the remaining equity is theirs to do with as they please.
I would be remiss not to mention that without the reverse mortgage, this couple's home equity after 20 years would be $876,000 (full property value).
With a HECM, the remaining equity largely depends on the home's future appreciation and whether you choose to make any repayment to the loan balance.
Does a HECM make sense? Like so many financial products, the answer is "it all depends." I think a HECM may be appropriate for those who:
- are highly motivated to purchase a new retirement home;
- don't have enough (non-retirement) funds in addition to existing home equity (from the sale of a current residence) to buy a new house;
- have sufficient resources (savings and other income) to fund a long retirement, and will not negatively impact savings;
- are eligible to use HECM to purchase the more expensive retirement home and understand there will likely be a negative impact on financial legacy;
- optimally, the HECM is not so large, and the house continues to appreciate, such that there will be positive equity twenty or more years after purchase.
For a more in-depth look at HECM strategies, check out this Forbes article by respected retirement researcher Dr. Wade Pfau.
As I mentioned in the last article, my wife and I live in a (relatively) sizeable single-story home about 24 years old. We are five minutes from our church and shopping and about equal distance from our two adult children.
So, like many retirees, we are thinking through these options ourselves. We need to make some home repairs (and would like to do some upgrades). How can we best fund them? Does it make sense to downsize? What about a newer house of comparable size and functionality?
Since we are currently close to family, friends, church, and shopping, we wouldn't go far if we considered moving. We also want to stay in a single-story house that would afford us a lifestyle similar to our current one.
Plus, I like the cushion that not having a mortgage provides for handling our other major expenses—transportation, food, insurance, healthcare, travel, and giving—in retirement. If I were to spend a lot more on housing, which would reduce savings or increase spending, my overall retirement plan might be less viable.
We haven't made any decisions, but we will carefully and prayerfully explore all the options. We want to be wise stewards of our house and the other resources God has given us. I'll keep you posted.