In 2014, the Bipartisan Policy Center (BPC) launched the Commission on Retirement Security and Personal Savings, led by former Senator Kent Conrad and WL Ross & Co. Vice Chairman Jim Lockhart. The commission will consider and make recommendations regarding Social Security, pensions, defined contribution (DC) savings vehicles, strategies to generate lifetime income and other factors that affect retirement security.
This BPC-staff authored post is the 12th in a series that will outline the state of retirement in America and provide a sense of the challenges that the commission seeks to address in its 2015 report.
For more information on the topics below and in the rest of this series, see our staff paper, A Diversity of Risks: The Challenge of Retirement Preparedness in America.
For many Americans, their home is their greatest financial asset. This is especially true for those at retirement age. Around 79 percent of Americans age 65 and over are homeowners. Of those retirement-age homeowners, 72 percent have no mortgage debt, and average home equity stands at around $213,000.
According to the Consumer Financial Protection Bureau, half of homeowners age 62 and older have at least 55 percent of their net worth invested in home equity. For some retirees, home equity is their only significant asset. The Government Accountability Office has found that, of households headed by someone age 55 and older, 29 percent have no retirement savings and are not covered by a defined benefit plan. Of that 29 percent, well over half (59 percent) are homeowners, indicating that these older Americans have only home equity to rely on to supplement Social Security benefits in retirement.
Seniors can tap into their home equity to provide an additional stream of cash flows or a one-time lump sum of cash during retirement. This can be an important cushion for individuals who have not accumulated assets in an employer retirement plan or who have not saved enough for retirement.
Retirees have several options:
- A reverse mortgage is a loan that allows individuals age 62 and older to use their home equity before (or without) selling their home. Interest accrues throughout the life of the loan, and the loan is not due until either the homeowner passes away or after the home is sold. The borrower can receive payment in a lump sum, regular installments, or a combination of the two.
While a majority of borrowers opt for the lump sum, a recent rule change in 2013 has limited the amount borrowers can receive immediately to approximately 60 percent of the value of the loan. This change should help ensure that borrowers are able to continue covering property taxes and insurance payments.
Reverse mortgages comprise 0.6 percent of the total mortgage market, and the vast majority are issued through the Home Equity Conversion Mortgage (HECM) program, which is administered by the Federal Housing Administration (FHA). The market is very small, with just 2 to 3 percent of eligible homeowners participating. The people most likely to seek a reverse mortgage are those who have little to no savings outside of their home equity and rely almost exclusively on Social Security for their income in retirement. If they have external savings beyond the home, they are more likely to turn to those savings first before drawing upon their home equity through a reverse mortgage.
HECM loans come with a variety of consumer protections. For one, borrowers are required to participate in a counseling session with an FHA-approved counselor, who explains the financial implications of using a reverse mortgage and alternatives, with the goal of ensuring that the prospective borrower is able to make an informed decision.
Furthermore, in 2014, the program tightened lending standards by requiring new borrowers to undergo a financial assessment of their ability to pay for ongoing homeownership costs?such as property taxes and insurance payments. Borrowers with a poor credit history are now required to place funds in a “set-aside account” to ensure that they are able to make these payments.
Yet another 2014 rule revision mandated that lenders defer foreclosing in cases where a surviving spouse is not listed on the mortgage. Previously, if there was an age difference between spouses, the younger had an incentive to quitclaim the home to the older spouse; since the amount of the loan is dependent on life expectancy, removing the younger spouse from the deed increases the size of the loan available. This also meant that the lender could demand repayment or foreclose on the home immediately upon the death of the borrower. The rule revision changed this practice by mandating that lenders defer foreclosure until after the death of the non-borrowing spouse, so long as he or she was adequately disclosed to the lender at the time that the mortgage was closed.
- A home equity line of credit (HELOC) offers homeowners revolving credit with the borrower’s home serving as collateral. This differs from a typical home equity loan in that it is not a lump sum, but a line of credit to borrow up to a credit limit determined by a percentage of the borrower’s home equity.
HELOCs are for a specified time, after which the borrower must repay the loan in full. HELOCs typically have variable interest rates that are tied to a publicly available index rate plus a certain margin?such as two percentage points. Most HELOCs are taken out for home improvement purposes, but they can also provide funds to meet living expenses during retirement. In 2013, one quarter of HELOCs were taken by individuals who were at least 65 years old.
Leveraging home equity is not a magic bullet for retirement security. In fact, reverse mortgages and HELOCs come with steep costs and considerable risks that must be balanced against any potential benefits. Purchasers of HECM reverse mortgages are required to pay a Mortgage Insurance Premium (MIP), costing between 0.5 percent and 2.5 percent of the home value (up to a home value of $625,500), with the MIP depending on the percentage of available funds taken out in the first year. Origination fees can also cost up to $6,000. Reverse mortgages also mean that borrowers might be unable to give their home as an inheritance?as all or most of the equity goes to the lender to repay the loan?unless home prices appreciate substantially.
HELOCs also come with a smorgasbord of fees, which can include origination fees, closing costs, annual maintenance fees, and even transaction costs, which occur every time the line of credit is drawn. HELOCs have a different set of risks than reverse mortgages. They typically have variable interest rates, which means that borrowers face rising costs when rates go up. But perhaps the largest downside to HELOCs is default risk. If borrowers are unable to meet their payments, lenders are able to foreclose and take the property.
In short, using home equity for retirement has both pros and cons. It can be a useful tool to help individuals with insufficient retirement savings?who are “home rich, cash poor,” and desire to remain in their homes?to maintain their standard of living during retirement. But reverse mortgages and HELOCs are complex, have significant costs, and are not without risk.
Ben Ritz and Jillian Zook contributed to this post.