If you’re a homeowner nearing retirement, you may have an extra tool in your financial toolbox to help you meet your needs: your home.
Each month’s mortgage payment and appreciation increase your home equity position, and you can tap into that amount with a home equity line of credit (HELOC) or reverse mortgage.
How mortgages and HELOCs work
HELOCs allow you to draw down money over time at a higher rate while a reverse mortgage can be taken as a lump sum, line of credit, monthly payment or a combination of those options. A HELOC or reverse mortgage can help cash-strapped retirees avoid drawing too much from their 401(k) and retirement accounts (IRAs) before they retire. Home Equity Conversion Mortgages (HECMs), the most common type of reverse mortgage, are reserved for homeowners age 62 or older.
The money you get from a HELOC or reverse mortgage is generally considered a loan, and not treated as ordinary income.
“Generally, the money you get from a reverse mortgage is tax-free and usually won’t affect your Social Security or Medicare benefits,” the Federal Trade Commission explains about reverse mortgages. “Typically, you, your spouse, co-borrower, or your estate repays the loan when you die, sell your home, or move out.”
But remember that is because you are not earning money, you are borrowing. And you have to pay interest on those payments. However, the interest may be tax deductible if you use the earnings on home projects to qualify for the deduction. Interest on a revolving loan is usually deducted only when it is paid, which is usually paid when the loan is repaid.
Risks of HELOCs
A home equity line of credit is a revolving line of credit that uses your home as collateral. You don’t have to take out a HELOC right away and you can pay off the line of credit before it matures. HELOCs have an initial drawdown period followed by a set repayment period if you don’t want to pay off the loan early.
HELOCs serve as sources of backup cash and can help with large, one-time expenses, such as home repairs. Homeowners are at risk of foreclosure if they miss regular HELOC monthly payments, and variable interest rates leave homeowners exposed to higher payments if the Federal Reserve decides to raise interest rates. These risks make HELOCs more suitable as emergency tools rather than a default option to maintain an expensive lifestyle.
Reverse mortgages work differently. These financial products provide monthly distributions from your home equity. You don’t have to pay back the mortgage in your lifetime, as long as you meet basic needs like keeping your home in good condition.
You still have to pay property taxes and home insurance if you take out a reverse mortgage. Interest also adds up, and your heirs may be left with much less home equity if you use the loan. Many retirees turn to this financial product for a steady income after retirement. It can serve as a good supplement to Social Security, but you shouldn’t rush to take out a home equity loan if Social Security benefits are enough to cover your living expenses.
The risk of a home equity loan is that the interest and fees can make it expensive in the long run. It can also be difficult to rebuild home equity as a retiree since you no longer make a steady income. Some people lose their home equity and end up having to downsize and get evicted from their homes.
If you use equity it can really help
While HELOCs and reverse mortgages can be especially dangerous when used to fuel bad spending habits, they can be useful as emergency lines of credit. HELOCs tend to have lower interest rates than most types of loans since they are secured lines of credit.
Reverse mortgages can serve as a financial safety net for care expenses you may incur later in life, but it may be better to delay reaching home equity as long as possible. Entering a smaller portion of equity and relying more on Social Security benefits to fund your lifestyle reduces some risk while allowing you to tap into your own equity over many years.
