February 3, 2014
Home equity: A retirement fallback plan
A paid-for home is your safety net. What’s the best way to tap into your home equity?
After Charles Prusky was forced to retire from his job as a machinist-welder at 58 due to illness, it wasn’t long before he and his wife Anne ran out of savings. That made the B.C. couple wonder how they could make ends meet with no employer pension and limited government benefits. The Pruskys had already downsized once, but fortunately still owned a modest three-bedroom bungalow outside Kelowna. So they wondered: how could they best use the equity in their house to provide the necessities of life?
As they soon discovered, planning for retirement comes with the risk of a serious and unexpected setback. If you’re a homeowner, however, you at least have a fallback plan. You should always plan to accumulate enough savings to fund your expected retirement needs, but if you ultimately face financial misfortune, tapping your home equity can make up the difference. What’s the best way to do that? In what follows, we describe three common strategies, each of which the Pruskys considered: a reverse mortgage, a home equity line of credit (HELOC), and downsizing or selling.
Going in reverse
A reverse mortgage is a loan you don’t have to pay off—or even make payments on—until you sell your home or die. So it helps house-rich but cash-poor seniors with limited incomes find a source of funds without ever being forced to sell.
The reverse mortgage is a niche product offered by HomEquity Bank’s Canadian Home Income Plan (CHIP), the sole major provider in Canada. You can purchase one directly from CHIP or by referral through mortgage brokers, financial planners and other advisers.
Consider a typical example, based on details provided by CHIP. Say you’re a 73-year-old couple in Edmonton who have run out of savings but own a mortgage-free house worth $400,000. You could take out a reverse mortgage for $175,000, or about 44% of the value of the house. If you want to bolster your income over a long period, you might take $20,000 as a lump sum—perhaps to cover needed home repairs as well as set-up fees—and also take $500 a month going forward.
The $175,000 credit limit is guaranteed, but how long the $500 payments last depends on the loan’s interest rate, which in this example is adjusted every six months. The overall credit limit could be increased at some point because of rising home values, although that is not guaranteed either. If interest rates don’t change and the credit limit isn’t raised, the $500 monthly advances could continue for 15 years until the amount you owe reaches $175,000. In that case, you’ve had the benefit of an extra $110,000 in spending over those 15 years, while the accumulated interest cost would be about $65,000. You would have kept your house and—assuming prices didn’t drop precipitously—retained most of your home equity. After you reached the limit you would still be able to stay in the house and the loan would continue to accrue interest, but you wouldn’t be able to draw additional funds. When you ultimately die or sell the house, the loan is paid off in full.
Reverse mortgages have some uniquely attractive features. “You can stay in your home forever. You don’t have to make payments and it’s pretty easy to get approved,” says Robert McLister, mortgage broker and editor of CanadianMortgageTrends.com. Of course, this comes at a cost. You pay a higher rate of interest than you would for a conventional mortgage: currently 4.99% for a variable rate or a six-month term, which is about 1.5 percentage points more than you’d pay for a HELOC, McLister says. If you go with a five-year fixed rate, you’ll pay 5.79%. (CHIP gives you half a point off if you pay the interest as it’s incurred, as you are required to do with a HELOC.) You have to be at least 55 to get a reverse mortgage, and your borrowing capacity is limited to 50% of the home’s appraised value, depending on age and location.
There are also hefty fees and restrictive rules on reverse mortgages. Plan on about $2,300 in setup fees, McLister says, although a big chunk is currently waived if you go with a five-year term. Additional lump-sum advances must be at least $10,000 and the standard fee is $50 a pop (although that is also currently waived). Moreover, there can be early prepayment penalties, which are particularly onerous in the first three years (they’re waived if you die or halved if you move to a nursing home).
In the past, many financial experts advised against this product, but HomEquity Bank has made improvements in recent years. “Reverse mortgage rates are a heck of lot better than they used to be,” McLister says, adding that CHIP variable rates got as high as six percentage points above prime in 2009. Also, reverse mortgages were once available only as lump sums. That wasn’t convenient for seniors looking to supplement monthly income.
People who borrow from CHIP usually do it for important, practical purposes like paying off higher-interest credit-card debt, covering home-care costs, making trips to visit children, or just helping with day-to-day expenses. “We don’t hear much about clients using it for frivolous things like world cruises,” says HomEquity Bank president Steven Ranson.
In the end, it’s up to you to determine whether the costs and restrictions are worth the obvious benefits. As Ranson puts it: “Our view is you pay a bit of a premium in return for getting to stay in your home as long as you want, and you never have to make a payment and never have to requalify for the loan.” There’s simply no other way to get those features. At least the interest and principal compounds quietly in the background and is then deducted from the proceeds when the home is eventually sold.
When you put everything together, a reverse mortgage can make a big difference, as you can see in the table, “Using a reverse mortgage to get by.” We continue with the example of the 73-year-old couple with a $400,000 paid-for home who took out a reverse mortgage with a monthly draw of $500 ($6,000 a year). A typical couple with no savings might expect $32,000 in combined federal benefits, so the reverse mortgage would increase their cash flow by almost 20% to more than $38,000, which they can enjoy tax-free and without impacting their Guaranteed Income Supplement entitlement.
Putting it all on the line
If you want to save on interest costs, you may be able to borrow through a home equity line of credit. HELOCs have more attractive rates than reverse mortgages (currently prime plus 0.5%, or 3.5%) and you can borrow up to 65% of the home’s value. Moreover, you can take money out when you need it instead of receiving it in large lump sums or regular monthly payments.
HELOCs are designed for people who have sufficient income to pay at least the interest each month. So if you’re an income-strapped senior, there’s a good chance you won’t qualify even if you have tons of home equity. If you don’t have much income but do somehow have a HELOC—maybe you qualified before you retired—you might be able to borrow from the line of credit to pay the interest. However, that strategy can backfire because the bank may review your credit and cut your limit. They may even call the loan (requiring you to repay the balance immediately) if they decide your creditworthiness is deteriorating.
“If you miss payments on a HELOC, or if your spouse dies, it can be called in, which is a real concern,” says McLister. A couple may get approved for a HELOC based on combined pension income, but if one spouse dies and the pension income is cut back it would reduce income available to service the loan. If you run into trouble with a HELOC, you might be forced to sell your home before you’re ready.
If you keep those risks in mind, HELOCs can make sense for seniors in certain situations. Say you need a lump sum, have lots of home equity, and also have a great employer pension, even though you have little in savings. In that case, you may have enough income to pay the interest and reduce the risk the bank might eventually cut you off. Just make sure you still have plenty of income to pay the HELOC interest after the death of either spouse, and remember even then there’s no guarantee your credit limit won’t get cut back.
Another possibility suggested by McLister is for seniors in their 70s to start off with a HELOC with a balance no higher than 20% of the home’s value. That would provide lower interest rates to start with, but also plenty of extra borrowing capacity that should let the homeowner switch to a reverse mortgage later on, if need be.
Dropping down a size
Downsizing or selling your home to free up cash makes most sense when there are also non-financial reasons to move. A large house and garden can become a burden, and stairs can become a risk as you become less mobile. There may come a time when moving to a condo or bungalow is attractive. Or you may be ready to move to a warmer climate, be closer to children or grandkids, or away from the bustle of a major city. If you plan to move for one of these reasons and you also need extra cash, it’s natural to buy a cheaper place so you can pocket the difference. If you’re ready for a retirement or nursing home, the proceeds from selling your home can help fund the cost of those facilities.
On the other hand, if you love your home and continue to function well in it, downsizing is probably not the best way to tap the equity. Not only is there an emotional price to giving up the place you love: there are also hefty transaction costs. These include real estate commissions, legal fees and disbursements, home inspection, moving, sales taxes, and land transfer tax in most provinces.
The transaction costs of selling a $450,000 house and buying a $250,000 condo could easily amount to $40,000. So in that case you spend $40,000 to net $160,000. By comparison, if you were to take out a reverse mortgage for $162,300 to net $160,000 after closing fees, you could enjoy your home for another seven or eight years before the accumulated interest reached that $40,000 break-even point (adjusted for inflation).
The bucks stop here
Whichever method you choose, tapping home equity is a major decision that needs to be thought through. This is probably your last major pool of money, so use it wisely, particularly if you’re still fairly young and active. Once it’s gone there may not be much left to pay for needs that arise later. These include health-related expenses like home-care workers, renovating a house for reduced mobility, or moving to a retirement or nursing home. Having extra money in your 80s—when such challenges are most likely to arise—can make a big difference.
Generally, you should run down financial savings before tapping home equity. That’s because you pay more to borrow than you can earn from safe investments, especially after tax. A five-year reverse mortgage costs 5.79% (plus set-up fees), and you’d be lucky to earn 3% interest on a five-year GIC. If you invest in stocks you may do better, but you’d amp up risks and could end up doing far worse. (If you’re eligible for GIS, it’s wise to hold some money in a RRIF and keep withdrawals as small as possible while using a reverse mortgage. That’s because RRIF withdrawals reduce your GIS entitlement but reverse mortgage draws do not.)
As for the Pruskys, they had already downsized once and wanted to stay in their modest bungalow. They’d looked into a conventional mortgage and HELOC, but didn’t qualify because of limited income. So they went with the reverse mortgage, borrowing $50,000 against the $225,000 value of the home. Those funds covered basic expenses until Charles passed away three years later and Anne a year after that. “It really improved the quality of their life,” says daughter Judy Sennett, a financial planner with BMO Investments in Vernon, B.C.
Seniors often worry a reverse mortgage will result in nothing for the kids, but the conservative lending limits usually ensure there’s plenty left in the estate. With the Pruskys, the loan had only grown to $58,000 when they passed on, a modest proportion of the home’s $250,000 value by then. When Sennett sees clients in a similar situation, she doesn’t hesitate to recommend a reverse mortgage. “If people want to stay in their house and need the extra cash flow, this is often the best way to do it.”