Retirees are going to have to access some of the wealth trapped in their home. The question is how? Using a conventional HELOC (home equity line of credit) can be especially risky for retirees.
HELOCs are typically a second mortgages, offered by banks and credit unions, that allow homeowners to write checks against the equity in their home. Most borrowers who are over 62 don’t realize they may have a better option with a Home Equity Conversion Mortgage, also known as a government-insured HECM.
In part one of this article, we covered the role of home equity to help pay for expenses in retirement. We noted that home equity is where most people’s wealth resides. Unfortunately, home equity is hard to access (it’s not liquid) and selling the house is the last thing people want to do.
Choices, Challenges, Risks
People really have two choices to access home equity: a conventional home equity line of credit (HELOC) or a home equity conversion mortgage (HECM) insured by the government’s FHA insurance program.
The biggest challenge to using a conventional HELOC in retirement is qualifying for the loan. Most retirees don’t have enough monthly income to meet the bank’s debt ratio (debt/income) requirements. And underwriting criteria for second mortgages has tightened up considerably since the last recession.
People who are 62+, and still employed, may be tempted to get a HELOC because:
- They don’t know they have another option
- HELOCs can be cheaper than HECMs
- They don’t understand the risks of HELOCs
The three biggest risks with HELOCs for people 62+ include:
- Making monthly payments
- Unexpected payment increases
- Bank unexpectedly cancelling the loan
Risk 1 - Making Payments
Our 62+ year old clients tell us that making mortgage payments is one of their biggest budget challenges. When people get a conventional line of credit, a HELOC, their loan balance tends to go up over time. Obviously, this means the minimum required payment goes up too.
Sometimes, people draw money out of their HELOC to make the monthly HELOC payment. They’re creating sort of their own version of a HECM, but without any of the safety nets. Yes, it’s a little bit like using a Visa to pay the AMEX bill. Eventually, this strategy falls apart because no more money can be withdrawn and by then the ongoing required payments are large.
But there is a bigger danger (Risk type 2) beyond keeping up with the minimum payments; and that is unexpected payment shock. To understand this, we must get a little bit technical on how HELOCs work.
People who don’t grasp this set themselves up for tremendous emotional distress down the road. I’ve seen it in my office many times – it’s a combination of anger and fear.
HELOC interest rates are comprised of an index (usually Prime) plus a margin (usually somewhere between 0% - 5%). The current Prime rate is 4%. Which means that most HELOC interest rates are between 4% to 9%.
Most HELOCs allow the homeowner to borrow money and make an interest-only payment for ten years. If the rate (index + margin) is 6%, and they owe $100,000; their interest-only payment is ($100,000 x 6%)/12 = $500 per month.
However, the ability to access the line and make an interest-only payment eventually ends (usually after ten years). Then, the borrower must make monthly payments that will pay off the balance by the end of the loan – usually over the next twenty years. This is called making an amortizing payment.
Risk 2 - Payment Shock
This transition from 'interest-only' to an 'amortizing' payment is called ‘recasting.’ An amortizing payment, on a $100,000 loan, at 6% interest, over the remaining twenty years, increase to $716 per month. That’s a 43% payment increase.
What happens if rates are rising and the loan recasts? That creates an ugly payment shock.
Sometimes the best way to explain a concept is with an example. Imagine a hypothetical borrower, in their mid-50s, who took out a $180,000 HELOC on 9/1/07. It was a standard HELOC: 10-yr draw, 30-yr term, at a rate of Prime+1%. The loan will recast on 9/1/17, which means they can no longer access money, nor can they make an intereste-only payment. Now they have to start paying it back.
When our borrower took out the loan, they had no idea what ‘recast’ meant. All they knew was housing prices had gone up considerably and they needed to access some of their newfound wealth. Maybe they had some concerns in late 2007 about being laid off.
Fast forward ten years, to 2017; the loan is going to recast and rates are rising. The Prime rate has already gone up 3/4%. Let’s say rates continue to rise 1% per year and they go back to where they were when the loan started. Below is a chart of the Prime Rate over the last ten years.
Most people don’t realize how artificially low rates are because of Central Bank intervention. No one knows where rates are heading, but let’s model what happens to our borrower if rates return to what they used to be.
The following chart shows what is going to happen to our borrower’s payment over the next four years. Notice the blue line, which represents the minimum mandatory payment. Their payment goes from $750 to almost $1,800. Who can afford a thousand dollar payment shock?
The steep increase in payment later in 2017 is because the loan recasts (meaning the borrower has gone from interest-only to an amortizing payment). On top of that, the payment keeps increasing because the index (the Prime Rate) keeps going up. Realize, most HELOCs do not have an annual interest rate cap and their lifetime cap is 18%. There is essentially no interest rate protection with HELOCs.
Now you see why these types of loans are so risky for retirees. Today’s payment of $750 per month, an interest-only payment, is probably already difficult on a fixed income. The recast payment jumps to $1,187 per month. And then rising rates take the payment higher to $1,778 per month.
That’s a payment shock of $1,028 per month. If $750 per month was difficult, you can bet $1,778 per month is a complete budget buster.
What if a retiree can't afford that new larger payment? They’re forced to sell the house or face foreclosure. I’ve shown this analysis to many financial advisors and they’re always shocked at the risk people face without knowing it.
Retirees should think long and hard about introducing this much uncertainty into their financial future. If you’d like us to run some numbers for your specific situation (or someone you're trying to help), let us know. Feel free to use our online HELOC calculator.
Risk 3 - Cancellation
The third risk might be the worst of all. In the fine print of the loan documents, HELOC lenders have the right to freeze or reduce a line of credit without your permission. Tens of thousands of people were shocked to learn this in the last recession.
Their ability to access their home equity and use it the way they had been was unexpectedly cancelled. One day they received a letter that said something like…
“You no longer can access any remaining line of credit you may have. We are concerned about falling house prices and we have frozen, reduced, or cancelled your line of credit.”
Imagine the people who were using their line of credit to supplement their retirement income. That is a type of stress people don’t need later in life; especially if they’re dealing with any type of health challenges.
Home Equity Conversion Mortgages are a better wealth management tool for retirees because they do not have these three big structural flaws.
Government-insured HECMs can never be cancelled, even if the house is worth less than the homeowner’s loan amount. There is no monthly payment with a HECM, and the unused portion, the homeowner's borrowing power grows over time. This growth feature has powerful wealth management application that we will cover in a separate article.
The following chart shows several key differences between a conventional HELOC and the line of credit feature in a home equity conversion mortgage (HECM).
If you know of someone who needs more income in retirement, or just a bigger financial safety net, please have them contact us so we can educate them on options around using home equity to meet their needs and on the differences between these two solutions.
The wrong choice can sink your retirement; the right one can make a positive difference in a retired homeowner's long-term security and comfort.
In part one of this article, we discussed the three key questions to evaluating any home loan: price, impact on cash flow, and long-term wealth impact. This article explained how there is a safe way for retired people to access equity and a riskier (but more familiar) way.
About the Author
Kent Kopen earned his Reverse Mortgage Specialist credential in March 2007. Last year Kent earned the CRMP (Certified Reverse Mortgage Professional) designation. There are less than 150 CRMP designees in the United States. Mr. Kopen also provides education, tools, and strategies to professionals who offer financial and legal advice to others. "Our resources help financial advisors, CPAs, and estate planning attorneys help seniors optimize their home equity to provide greater security and peace of mind."