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7
Ways Home Equity Can Boost Your Retirement
The
baby boom generation is nearing retirement and it is clear that
millions of aging boomers are financially under prepared. Reasons
are many - poor savings habits, rising medical costs, the demise
of guaranteed corporate pensions, and the dreaded squeeze faced
by many boomers: i.e. having to pay college costs for their children,
care for their elderly parents, and save for retirement, all at
the same time.
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, 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. Indeed,
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.
Some people try to avoid the fees typically associated with reverse
mortgages and instead borrow against their home equity for retirement
living expenses with a regular home equity loan or home equity line
of credit (HELOC). Unfortunately this is seldom a smart strategy.
The reason is that with either a conventional home equity loan or
a HELOC loan, you have to make regular monthly payments that invariably
will be at a higher interest rate than can be earned on the loan
proceeds without undue risk. Moreover, as you use loan proceeds
to pay routine living expenses, you risk running out of money. A
HECM, on the other hand, 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 can be 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 HECM deal.
3. Purchase Service Years - One of the lesser known facts of financial
life is that many public and some corporate pension plans allow
employees to purchase additional years of service credit - sometimes
at bargain prices. This means, for example, that for an upfront
lump-sum payment a teacher with 20 years service might 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 the 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 upfront
lump-sum payment, you are promised a steady stream of future payments.
As with any major financial decision, it is wise to 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 healthcare 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 the company match, 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 that the
compounding effect has 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 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 lifestyles and priorities so that future 401k
contributions are made from current income.
Another consideration is whether itemized deductions (including
mortgage interest) fall above the IRS standard deduction amount
($9,700 for couples in 2004). Many long-time homeowners are at the
tail end of their loan amortization meaning that nearly all of of
their monthly payments go towards principal. For instance, during
the last five years of a typical 30-year mortgage, only about 14%
of the total payments will be interest payments. This means little
or no tax deduction benefit is being realized - one of the principal
benefits of home ownership. In such cases, additional home equity
borrowing (or refinancing) may achieve tax savings to offset investment
risks.
5. Avoid 401k Loans - One popular features of many 401k plans is
the ability to borrow from your vested balance for purposes such
as a car purchase, educational expenses, or a home purchase or improvements.
More than half of all 401k plans offer the loan option, typically
allowing loans up to 50% of the vested account balance or $50,000,
whichever is less.
Many people take out 401k loans believing they are better off because
they will be "paying interest to themselves" rather than
to a bank. But the truth is that a 401k loan isn't really a loan
at all; rather, you are spending down your own hard-won retirement
savings. And the interest you are paying to yourself won't come
close to replacing the interest being lost by not having the borrowed
funds invested in retirement account assets.
The bottom line is that 401k loans are almost never a wise financial
move and even less so for homeowners having the option to borrow
against home equity instead. Among other advantages, interest paid
on home equity loans is generally tax-deductible whereas interest
on a 401k loan is not.
6. Borrow to Fund IRA Before April 15 Deadline - Financial planners
generally agree that it is best to either: 1) make contributions
to an IRA as soon as possible (e.g. January 1 of the tax year) to
maximize the power of compounding or, 2) make steady equal contributions
throughout the tax year to gain the benefits of "income-averaging".
Yet many people find themselves up against the April 15th deadline
without adequate cash and, so, fail to make an IRA contribution
for that tax year. In some cases, people miss the opportunity even
though they are in line to receive substantial tax refunds within
weeks.
Unfortunately, when the deadline passes, the opportunity to make
an IRA contribution for a tax year is lost. The forgone compounded
impact on retirement savings can be huge. Consider that a 35-year
old who misses a $3,000 IRA contribution will have $30,000 (assuming
8% return) less in his retirement account at age 65. It is sensible,
in many situations, to use a HELOC loan to finance an IRA contribution
rather than miss the opportunity forever. The case for borrowing
to fund an IRA is particularly strong if the loan can be repaid
quickly.
7. Take Advantage of IRS "Catch-Up" Rules - Congress created
"catch-up" provisions to give older workers nearing retirement
an additional tool to bolster retirement savings. In a nutshell,
catch-up provisions for the various tax-advantaged retirement programs
(i.e. IRA, 401k, 403b, 457, etc.) permit workers to make supplemental
("catch-up") contributions starting in the year the worker
turns age 50. The amount of allowable annual catch-up varies by
the type of retirement program and is summarized in this
table.
If, for example, you are 55 and plan to sell your house when you
retire at 62, it may be worthwhile to borrow on your HELOC today
to catch-up on funding your retirement account. HELOCs generally
allow for interest-only payments for several years meaning you will
have to pay relatively low, tax-deductible interest until the house
is sold and you are able to pay the principal balance. Again, with
this strategy, you transfer funds from one savings category (home
equity) to another savings category (tax-advantaged retirement account)
to gain the advantage of higher-yield retirement account investments
compounded for a longer period.
Tim
Paul is a financial management executive with more than 25 years
experience. His website focuses on all aspects of HELOC
Loans and includes the Planet HELOC
Blog.
