Borrowing home equity is complicated and expensive since real estate is not a liquid investment. You can get a HELOC and use the funds as needed, but that has its costs: either you need to pay off the loan, which defeats the purpose, or you need to pay interest monthly on the borrowed amount. A reverse mortgage is an option that comes with high expenses. Along with loan origination fees, closing costs, and mortgage insurance premiums, you have ongoing monthly interest and fees to pay. The upfront fees can be steep—a standard Home Equity Conversion Mortgage (HECM) charges a 2% mortgage insurance premium on the full value of the home (not the loan amount). The alternative HECM Saver loan has a lower mortgage insurance premium of just 0.01% of the home’s value, but it comes with a higher interest rate. Generally these options are really seen as “back up” plans to access cash when other options are exhausted.
Selling may seem to make sense except when the market is sluggish. Many pre-retirees may have been anxious to sell their homes during the economic downturn, and even if they hadn’t lost equity and could ask a higher price for their homes, buyers dried up. Either they couldn’t sell their own properties in order to buy another one, or they couldn’t qualify as credit tightened. You just can’t count on being able to sell and access the equity in your home for retirement income.
All that said there may be times when tapping into home equity for retirement income may be a good strategy.
The IRS gives every homeowner an amazing gift—up to $250,000 in tax-free gain for individual filers and $500,000 for couples who file jointly. In order to access this tax-free gift, you must live in the property for two of the previous five years before you sell it, along with having some equity, of course. I can’t think of another investment where you can get a tax break along the way (the tax deductible mortgage interest and property taxes) and then receive a tax-free benefit at the end. The caveat is you have to sell your property to take this gain, but it may be worth it.
If a homeowner isn’t able to sell right away, they can always rent out the property for a few years until a sale is feasible. The tax-free gain would still apply as long as the ownership and use test are met (i.e. owning and living in the home for at least two of the previous five years before sale). Of course trying to sell a property with a tenant occupying it could bring a whole new set of issues, so that might not be ideal, but the benefit might be worth the hassle for some people.
Home buyers using this strategy will have to do their homework and purchase in areas that have the best growth potential. Buyers will want to make sure they are in a good school district, and are generally in a good location so the property is popular with future home buyers.
Your home can be a place to live as well as an investment in your future. Just go into it with potential appreciation in mind as a future strategy to downsize and purchase something smaller, or to sell out and invest the tax-free gain. There is no guarantee your home will appreciate, and of course none that you’ll be able to sell at the time you want to, but if you are able to work this strategy, it can be a boost to retirement income.
Nancy L. Anderson, CFP ® is a Resident Financial Planner at Financial Finesse, the leading provider of unbiased financial education for employers nationwide, delivered by on-staff Certified Financial Planner™ professionals. For additional financial tips and insights, follow Financial Finesse on Twitter and become a fan on Facebook.
