Creative Home Equity Strategies for Retirement
by Tim Paul
Published on this site: November 23rd, 2005 - See
more articles from this month
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: 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,
historically 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.
- 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.
- Reverse Mortgage - Retirees remaining in their
homes can still tap their home equity as a source of retirement
income. 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.
Origination fees and closing costs for reverse mortgages
are high. Some people try to avoid these fees by instead
borrowing against their home equity for retirement living
expenses with a regular home equity loan or home equity
line of credit (HELOC). However, this is not always a smart
strategy. The reason is that with either a conventional
home equity loan or a HELOC loan, you will have to make
regular monthly payments that may be at a higher interest
rate than can be earned on the loan proceeds without undue
risk. Also, if you use loan proceeds to pay for routine
living expenses, you risk running out of money. A HECM,
on the other hand, can be structured to 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 is
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 deal. Federal guidelines,
in fact, require reverse mortgage applicants to participate in counseling sessions
prior to taking out a loan.
- Purchase Service Years - One of the lesser known
facts of financial life is that many public and some corporate
pension plans allow their employees to purchase additional
years of service credit - sometimes at bargain prices. For
example, for an up front lump-sum payment a teacher with
20 years service might be eligible to 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
these 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 up front lump-sum payment,
you are promised a steady stream of future payments. As
with any major financial decision, always 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 health care 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.
- 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 company
matches, 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 of compounding 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 relatively 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 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 result in tax savings to offset investment
risks.
- 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 "pay interest to themselves"
rather than 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 pay
to yourself won't come close to replacing the interest lost
by not having the 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.
- 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) 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 tax deadline without adequate cash and, so,
fail to make any IRA contribution for that tax year. In
some cases, people miss the opportunity even though they
are in line to receive a substantial tax refund within weeks.
Unfortunately, when the deadline passes, the opportunity
to make an IRA contribution for that year is lost. The foregone
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 with a tax refund
- 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.
The strategies outlined in this article certainly do not
make sense for everyone. If you have trouble handling debt
or controlling spending, taking on more debt is absolutely
the wrong thing to do. On the other hand, if you are a financially
responsible person, these seven strategies may help you think
critically about your own situation and about ways the equity
in your home might be used to enhance your retirement income
planning.
Tim Paul is a financial management executive with
more than 25 years experience. His websites focus on personal
finance issues and include http://www.sagetips.com
, http://www.529rewards.com
and,http://www.reverse-mortgage-information.org
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