Introduction
For many retirees, home equity is one of their most significant financial resources. If you need extra funds during retirement for health expenses, home repairs, or daily living costs, borrowing against the equity in your home through a loan or line of credit may seem like a reasonable solution. These options often come with lower interest rates than unsecured loans because your home serves as collateral. However, this type of financing can present serious risks, especially for those with limited income. It is important to fully understand how home equity loans and second mortgages work before proceeding.
What is it?
If you are retired, need extra money, and own a home, you may be able to get the cash you need by accessing the equity in your home. Home equity financing uses that equity to secure a loan. For this reason, lenders typically offer better interest rates for this type of financing than they do for other, unsecured types of personal loans. Typically, you’ll be able to borrow an amount equal to 80 percent of the value of your equity. Home equity financing can be either a loan (often referred to as a second mortgage) or a line of credit.
When can you use it?
You have equity in your home
The equity in your home secures the loan. If your home is already fully encumbered by a first mortgage or other liens, then it is unlikely that you will qualify.
You can afford to service the loan
You should be absolutely certain that you will have sufficient monthly income to service the debt over the life of the loan. Once you have received a disbursement of cash from the lender, you will be expected to begin making regular monthly loan payments within 30 to 60 days. You must continue to make payments until the outstanding balance is paid in full. If you are unable to make the payments, the lender can foreclose (take) your home to satisfy the debt.
Strengths
Conventional home equity financing is readily available from most mortgage lenders
Most banks, credit unions, savings and loan associations, and other mortgage lenders offer home equity financing. It’s easy to shop for.
With a line of credit, you have convenient access to loan funds
Most home equity lines of credit are accessed with checks or a credit card. This makes access to the funds easy and convenient. You present the check or card in the same manner that you would present any other check or card. The lender extends the funds and adds the amount to your principal balance.
Tradeoffs
Your home is at risk
Whenever you post your home as collateral, you take the risk of losing it in the event of default.
You may have to pay closing costs
As with most transactions involving real estate, a mortgage closing must be conducted to finalize your home equity loan/line of credit. You may be required to pay closing costs, which include points, application fees, filing fees, and up-front costs. All such costs increase the expense of borrowing money.
Conventional home equity financing does not have deferred repayment terms
Unlike a reverse mortgage, a home equity loan or line of credit does not allow for deferred repayment. You are not permitted to wait until you sell the home, until you die, or until some other event to repay the outstanding balance. You must begin making payments immediately. If you fail, you risk losing your home.
You may become liable for more than what your home is worth
If the balance of your home equity loan or line of credit exceeds the value of your home, you or your estate may remain liable for the entire outstanding balance. In contrast, if the outstanding balance of your reverse mortgage exceeds the value of your home, you or your estate will only have to repay an amount equal to the value of the home.
Undisciplined borrowers may have trouble paying down principal on home equity loans/lines of credit
Home equity loans are designed to be paid off over a fixed period of time. Home equity lines of credit, like credit card agreements, require only that the borrower make a minimum monthly payment. Some require the borrower to pay only monthly accrued interest. If you are tempted into paying only the minimum monthly payment, your principal balance could remain outstanding for an unreasonably long period of time. This results in additional interest expenses and prevents you from regaining the equity in your home.
Home equity lines of credit may have minimum advance requirements
Many home equity lines of credit require that you take advances in predetermined minimum amounts. For instance, you may not be able to obtain an advance on your line of credit for less than $1,000 at a time. This may be inconvenient if you are traveling and need to pay for an unexpected $500 car repair. (If you obtain a traditional second mortgage, all funds will be advanced to you up front.)
What are the tax consequences of home equity financing?
Generally, interest payments on loans secured by your home are tax deductible, but there are some limitations. See our separate topic discussions, Personal Residence Tax Planning and Home Improvement Loans.
Conclusion
Home equity loans and second mortgages can offer helpful financial support during retirement, but they must be used carefully. Because your home secures the loan, any missed payments could lead to the loss of your property. These loans may be a good fit for retirees with steady income and a clear plan for repayment. However, individuals with tighter budgets may want to explore other strategies. Before making a decision, weigh the benefits and drawbacks, consider how the payments will affect your monthly budget, and seek professional advice to make sure the option supports your long term financial goals.
Scarlet Oak Financial Services can be reached at 800.871.1219 or contact us here. Click here to sign up for our weekly newsletter with the latest economic news.
Source:
Broadridge Investor Communication Solutions, Inc. prepared this material for use by Scarlet Oak Financial Services.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances. Scarlet Oak Financial Services provide these materials for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.
