Home financing options and mortgage terminology can be confusing. Plus, people’s home financing needs change with age and vary in different stages of life. Understanding retirement home equity is an important key to finding financial success in retirement.
Equity is the portion of your home’s value minus the mortgage balance that you accrue over time. When you get a home loan, the bank owns the majority of the home and they charge interest to borrow that money. Every month when you make your mortgage payment, you pay principal and own a little more of your home. The piece you own is your home equity. The more principal you pay the bigger your piece of the pie gets.
Here is a helpful infographic.
How is equity affected during recessions or a crisis like COVID-19?
During 2008, home values dropped because qualifying for a home loan was too easy and real estate prices were inflated and then the real estate market corrected. The banks offered mortgages to unqualified borrowers and it was a big mess. You can read more about this here.
You heard about people losing their homes in 2008 due to foreclosure because they had over-leveraged mortgages. This means they owed more on their loan than the home was worth. They still had to pay their mortgage each month even though their home value decreased. See the infographic for an example.
Because their home value is reduced by $40,000, their equity also decreased by $40,000. So, if they tried to sell their home during the market downturn, they would have lost money because their equity decreased and the home was worth less money. An appraisal must be in line with the market conditions at that time. That’s why you hear people say things like, “It’s a great time to sell right now.” Or, “The seller’s market is really hot!”
In short, equity changes are based on the real estate market prices moving up or down. As home values dropped so did the equity accumulated. In addition, the percentage dropped. In the example on the infographic, the homeowner lost 50% of their equity.
How to Protect Your Equity
A reverse mortgage is one potential way to protect your home equity. When a homeowner has a reverse mortgage, a portion of the equity is guarded from any market fluctuations. For example, if $150,000 of your home equity was in a reverse mortgage line of credit and the next day the market dropped by 15% or 20%, you would still have the $150,000 available for use in the line of credit. The equity is now accessible and is no longer subject to the fluctuations of the market. For retirees, this is very important because 401k’s or IRA’s can change when the stock market fluctuates and often that asset is a primary cash flow source.
Home Equity Line of Credit vs Reverse Mortgage
Home equity is a non-liquid asset. Financial planners talk about the liquidity of assets, and this is simply a fancy way to say how easily an asset can be converted to cash. Equity is non-liquid because you cannot go to the grocery store to buy products using your home equity.
There are some exceptions. You can use equity in a HELOC (home equity line of credit) where you withdraw the equity you have accrued over the years from your house and convert it to cash. This can be used to consolidate debt, or make home renovations, etc. This equity is your asset so it can be utilized however you like, but it must be accessed using a HELOC.
The other exception is the All-in-One loan, which you can read more about here.
A Reverse Mortgage (also often referred to as the HECM – Home Equity Conversion Mortgage) is a specialized loan available only to those 62 years and greater. This loan converts your home equity into a usable asset: cash or a line of credit. Unlocking home equity enables borrowers to eliminate their mortgage payment in retirement, or put the equity to work earning compound interest.
The difference between the HELOC and HECM is that the HECM is a specialized loan for seniors and has some extra precautions built-in. Plus, with HECM, the loan is paid off at the end of the loan term when the borrower moves out. Both HELOC and HECM require property taxes and homeowners insurance to be paid, and the home must be maintained. Here is a chart highlighting the major differences between the two.
|Who Qualifies||Homeowners with good credit||Homeowners who are 62 years & older (credit score is not a factor, credit history is)|
Type of Home
|Single Family Residential, Condos, Townhomes, owner-occupied duplex/quadplex.||Single Family Residential, Condos, Townhomes, owner-occupied duplex/quadplex.|
|Payback||You must pay back the loan in full, within 20 years||The home equity pays the loan balance|
|Investment Earning Potential||You pay interest based on the current market rates||You earn 3-5% compound interest annually|
|Monthly Mortgage Payment||Required||Optional, not required|
|Maintain the Home||Required||Required|
|Interest Payments||Required||Not Required|
|Grow Over time||No||Yes|
|Availability||Lender can reduce or close the account without warning||Anytime during the loan term, tax-free|
|Funds Distribution Options||Like a credit card||Monthly Installments, Lump Sum, Line of Credit|
|Loan Term||10-year draw, 10-year repay||Age 150 of the youngest borrower|
Getting a Return on Your Home Equity
There are two main options when considering investing and getting a return on your home equity. One is to refinance your home and pull equity out in the form of cash. The loan term resets and when you close on the loan you receive a check or wire transfer. Use that money and invest it in whatever assets you choose: stock market, bonds, mutual funds, CD’s, other real estate properties, etc. The other option is to use the HECM line of credit to earn 3-5% guaranteed compound interest annually. Compared to other homeowners who have home equity that is locked up, inaccessible and earning zero – savvy borrowers can earn interest on their equity.
Here’s an example: At age 62, your home is worth $400,000 and you have $200,000 in equity that you want to earn compound interest annually. After 18 years at age 80 with 4% average compound interest, you would have $405,163.30, essentially doubling your money tax-free from your equity.
Three Ways to Access Your Equity
After years of contributing to your loan principal, the home equity has accrued and is likely a significant percentage of the home, meaning you own the majority of your home equity in retirement. Here a few options for accessing that home equity.
The first way to access your equity is to sell your home. When you sell you get to keep the difference of what you bought the home for originally and what you sold the home for. If you made improvements or renovated the home during your tenure, you might see those investments reflected in the new sales price. The difference is the equity you earned and get to keep. When you sell, you pay the realtor a 6% fee on the purchase price.
Refinance Cash Out
The second way is to refinance and pull cash out. You maintain your mandatory monthly mortgage payment and your loan term restarts. This is a common option for people who want to borrow money without having to get another loan payment. Often, if homeowners are making improvements, renovating their home or even sending a child to college, they will refinance and use the accrued home equity. When you refinance you still pay some fees to the bank to process the transaction.
Home Equity Conversion Mortgage
For retired homeowners who qualify, a Home Equity Conversion Mortgage (HECM) is another way to access home equity. Just like its name implies, this specialized loan converts your home equity to a usable asset. Once you convert this equity you can: 1) eliminate your mortgage payment each month, 2) earn 3-5% compound interest on that equity in the form of a line of credit, or 3) purchase a newer, nicer home.
Hope you enjoyed this information about how to make the most out of your retirement home equity. Visit Financial Independence and Retirement for more information on how to preserve and grow your retirement assets.
About the author: Kevin A. Guttman is an author and home finance expert. Since 2004, he’s helped countless homeowners navigate the various home financing options and find the loan program that suits them best. He specializes in making complex ideas simple and easy to understand. To learn more about Kevin visit www.SeniorFlexLoan.com.