Get a HELOC Before Retirement?
By Kevin Estes
This article explores an often overlooked strategy.
Recent Retiree
Imagine you recently retired. Congratulations!
Bad Timing
Unfortunately, the market fell soon thereafter and has continue to slide. Your portfolio is down over 20% in mere months.
Your solid emergency fund has dwindled. You may need to sell assets which have fallen in value.
Home Equity
Fortunately, your home’s worth much more than what you owe on the mortgage. The property’s appreciated and your mortgage balance has fallen with regular payments.
You love your home! Both you and your spouse want to live there as long as you can.
It could make sense to tap into your home’s equity.
What Is a HELOC?
A Home Equity Line Of Credit (HELOC) is potential debt secured by your home. It’s revolving credit - like a credit card.
Unlike a traditional loan that provides a fixed lump sum, a HELOC gives you the flexibility to borrow only:
what you need
when you need it
up to the credit limit.
Key Features of a HELOC
Home Equity Lines Of Credit aren’t like traditional mortgages.
Draw and Repayment
A HELOC typically has two phases:
Draw Period: lasts 5 to 10 years and allows you to borrow funds as needed. Interest is based on the amount borrowed. Longer draw periods offer more flexibility.
Repayment Period: spans 10 to 20 years and requires you to repay the borrowed principal and interest. You can no longer draw additional funds. The outstanding balance usually converts into something like a second mortgage with an adjustable interest rate.
Other Features
HELOCs differ from standard mortgages:
Variable Interest Rates: HELOCs typically charge variable interest rates. Monthly payments may fluctuate with market conditions. Some lenders offer fixed-rate options for borrowers seeking more predictable payments.
Credit Limit: The credit limit is set by lenders based on many factors. The home’s appraised value, amount of equity, and credit history of the borrower help determine the limit. The maximum is often around 80%.
Flexible Borrowing: A big advantage of a HELOC is that you only pay interest on the amount you borrow - not the credit limit. This feature is especially helpful for those who use it sparingly.
Credit Limit Example
Say a home is worth $400,000. The bank is willing to lend up to 75%. The owner has a traditional mortgage with a balance of $200,000.
In that case, the HELOC credit limit would be $100,000:
$400,000 appraisal
less 25% is $300,000
less $200,000 existing mortgage
equals $100,000.
Benefits of a HELOC
A Home Equity Line Of Credit has several advantages:
Access to Funds as Needed: A HELOC is a flexible source of funding. It can be used on college tuition, a home renovation, or ongoing expenses. You can withdraw funds as needed instead of taking out a lump sum.
Lower Interest Rate: Since they’re secured by your home, HELOCs generally charge lower interest rates than credit cards or personal loans. However, the lender’s margin - like an extra 2% - usually drives the interest rate above a new traditional mortgage.
Tax Advantages: The interest paid on a HELOC may be tax-deductible if the funds are used for home improvements. Please consult a tax professional.
Increased Home Value: Using a HELOC for home renovations or upgrades can enhance the property value. Improvements can also make living in the home more enjoyable.
Debt Consolidation: A HELOC can be used to pay off higher interest debts like credit card balances or personal loans. Doing so can simplify finances and save money over time.
Risks of a HELOC
Although a Home Equity Line Of Credit can be a powerful tool, it comes with risks:
Variable Interest Rates: Rising rates can increase the monthly payment and strain cash flow. HELOC payments are in addition to those for other debt - including a traditional mortgage.
Foreclosure: The home serves as collateral. Failure to pay could result in foreclosure. It’s crucial to borrow responsibly and make on-time payments.
Overspending: Easy access to funds can tempt someone to overspend. Loose lending in the early 2000’s let borrowers take out too much debt. Rising interest rates, tighter lending, and falling real estate prices led to the Great Recession.
Closing Costs and Fees: HELOCs often have upfront costs like appraisal charges, application fees, and closing costs. These expenses are sunk whether or not the line of credit is used.
Cancellations: Lenders can freeze a line of credit. That’s more likely if the home value falls or something changes with the borrower’s credit. Some HELOCs automatically shrink the credit limit throughout the draw period.
HELOC in a Down Market
A Home Equity Line Of Credit could help someone postpone selling assets in a recession.
Interest Rates
HELOC interest rates are usually variable. The rate is often tied to the prime rate - a benchmark influenced by the Federal Reserve.
For instance, a loan might be set at the prime interest rate plus a 2% margin. That’s known as “prime plus 2%.”
Interest rates have historically fallen with recessions. The Federal Reserve wants to maintain full employment and takes steps to lower interest rates. Lower rates encourage investment, which hopefully increases economic activity and hiring.
Falling markets could lower HELOC interest rates. Funds may become more affordable when they’re needed most.
Stock Values
Stock prices generally trend down in recessions.
Revenues and profits fall. Less cash flow restricts corporate investments - further limiting short-term growth.
A company with less profit and growth is less attractive. Fewer investors buy and some sell. Lower demand drives down the stock price.
Bond Values
A bond is usually debt owed by a corporation or government. Bonds typically pay a fixed interest rate and then return the original amount borrowed to the investor.
The impact of a recession on bonds is mixed:
Increased Risk Lowers Price: Falling revenue makes it less likely a borrower can pay its debts. Higher default risk lowers demand for the bond.
Lower Rates Raise Price: The price of bonds generally rise when interest rates fall. A bond that matures further into the future is more effected by interest rate changes.
Bonds can help stabilize a portfolio. That benefit may be especially important to investors in or near retirement.
Delayed Sale and Lower Interest Rate
In a recession, a HELOC may help a borrower:
avoid selling assets which have fallen in value and
pay a lower interest rate.
The hope is to never have to use the HELOC.
However, it can provide a temporary safety net in case a recession hits soon after retirement. That’s called an unfavorable sequence of returns.
No Guarantee
A quick market recovery would be ideal. Unfortunately, there’s no guarantee.
Investment prices could continue to fall for a prolonged period. Growing debt and higher monthly payments could be problematic.
Application
It might make sense to apply for a HELOC before retiring. Stable income may give a lender the confidence to approve the line of credit.
The application process can be similar to applying for a traditional mortgage. It would likely include:
an appraisal,
credit review,
income verification,
and more.
There will likely be initial charges like:
an application fee,
appraisal fee, and
closing costs.
Personal Decision
Whether getting a HELOC is the right move depends on your financial situation and goals.
A Home Equity Line Of Credit can provide signficant funding as needed at a relatively low interest rate. Those funds could be especially helpful if markets decline early in retirement.
However, the:
effort to complete an application can be high,
upfront costs may be sizable,
the credit limit could be cancelled,
variable interest rates can reduce cash flow,
easy access could tempt someone to overspend, and
the risk of foreclosure rises.
I hope this helps!
If you’re interested in a review of your situation…
Disclaimer
In addition to the usual disclaimers, neither this post nor these images include any financial, tax, or legal advice.