This article was originally published by Investopedia.
There’s a powerful source of income hiding in your client’s house: Home equity.
Housing wealth represents the single largest asset held by American retirees, yet financial advisors often overlook home equity as a source of income for their clients.
For the average 65-year-old couple, home equity represents about two-thirds of their total wealth. The only other potentially more important retirement asset is Social Security, since it functions as the main source of retirement income for most retirees.
While there’s no shortage of advice focused on Social Security optimization, just look at some recent findings published in the Journal of Financial Planning, which indicate that financial advisors are, for the most part, ignoring home equity as an asset to support a retirement income plan. However, the article also showed that only about 25% of retirees feel comfortable spending home equity as an income source. Even if only 25% of retirees are willing to strategically use home equity in retirement, advisors cannot continue to ignore home equity as part of the equation.
Home equity can essentially serve five different functions in retirement: housing services, cash flow, long-term care funding, legacy asset and investment diversification. The most important function of home ownership in retirement is that it provides housing services. Everyone needs a place to live and owning one’s own home has always been the most popular retirement housing option for Americans. The aforementioned study showed that roughly 84% of retired homeowners want to continue aging in their current homes while only 5% want to rent.
Home equity can also be turned into retirement income to support the homeowner’s standard of living in retirement. There are a number of ways to tap into home equity to improve cash flow. One option is downsizing. By selling their home and buying a cheaper one, homeowners can free up some home equity to spend on other retirement goals. This strategy requires the individual to relocate, though. For those who want to age in place, an option is to rent the home to generate additional income, similar to the set up in the TV sitcom “The Golden Girls.” The homeowner might not always feel comfortable sharing his or her home even if it means improved cash flow.
Another option for generating retirement income and improving cash flow is to tap into home equity through a reverse mortgage. While reverse mortgages have had some issues in the past, the government has continued to improve and update the product over the past decade. The reverse mortgage product that exists today is far less expensive and more economically secure than anything that existed before.
In the past, many homeowners stayed away from reverse mortgages because the terms were misunderstood. The most common misconception about the reverse mortgage program is that the bank takes your house after you pass away. Alex Pistone, president of Retirement Funding Solutions, a national reverse mortgage lender, has this to say about that misconception: “A reverse mortgage is just a mortgage, but with unique and flexible terms. The homeowner can make payments if they choose to, but none are required. They have all the rights of homeownership, including the ability to refinance or sell the home. The homeowner retains title and rights to the equity in the home. At time of death, the home goes to their heirs, not to the bank.”
What this means is that the current reverse mortgage product deserves a second look by many homeowners. With a reverse mortgage, you borrow from a lender with your home as the backing. Unlike a traditional mortgage, you never have to pay back any debt that equals more than the value of the home and you are not required to make monthly payments. Homeowners keep title of the home and are able to take withdrawals in a lump sum amount, set up a line of credit or set up systematic payments in a tenure option that functions like an annuity.
If the homeowner does not feel comfortable spending down home equity as an income source, there are other ways to utilize the home value in retirement. While roughly 70% of seniors will need long-term care at some point, only about 7% of seniors have long-term care insurance. The home can serve as a long-term care funding tool. If the homeowner needs to move into a nursing home, or continued care retirement community or assisted living facility, the home could be sold to support the costs associated with institutional care. While this may not be the most efficient long-term care funding strategy, it might be a more palatable situation for some homeowners.
Furthermore, home equity can also be used as a legacy asset. Many homeowners want to leave a legacy to their children. The home, as their largest asset, could be perceived as the best legacy to leave behind for their heirs. Most adult children, however, do not actually want to live in the parents’ home — they want the value of the home. In many cases, they end up selling it below market value, just to unload the asset and wrap-up the estate. This is a natural part of wealth transfer and legacy planning goals.
Diversifying retirement income is another reason to consider home equity. Many retirees rely on Social Security and a systematic withdrawal approach from an investment portfolio. However, if the market drops 30% to 40% in a year, research shows that selling investment assets at that point greatly decreases the longevity of the investment portfolio.
Setting up a line of credit or reverse mortgage line of credit can create a buffer or non-market correlated asset that can be utilized during down markets to help protect the longevity of a retirement investment portfolio. The concept is simple in some ways. Would you rather borrow from your house at 4% for a year or sell stocks that dropped 40% that year? The math works out in favor of borrowing in that situation. Using home equity in certain situations helps create diversity of income so that retirees can reduce reliance on market returns.
Home equity is the largest untapped resource for your retiree clients. When used correctly, it can support a more secure and happier retirement.
Of course, there is no one-size-fits-all strategy for your clients. Home equity can function differently for homeowners with different goals and concerns. When used in conjunction with a comprehensive retirement plan, it can be a saving grace for retirees who are just getting by with limited savings and Social Security benefits.