If you are like most Americans, you’ll need a good plan for tapping into your home equity in retirement. Most Americans hold a large portion of their savings in equity after retirement. While equity is a nice figure to help boost your net worth, it’s more than a little troublesome to convert to cash. While there are plenty of options for tapping into home equity, there are many costs, benefits and downsides to any potential strategy.
You might be able to assess the sale price in your home by looking at comparable housing. Your equity is loosely calculated by subtracting your home’s sale price by the balance left on your mortgage. However, the assessment of your home is far greater than what you’d actually bank if you ever wanted to convert equity to cash.
Cashing in your equity means making a large financial transaction, and those transactions have large costs. It’s important to be mindful of these costs before retirement so that you get the most out of your home and net worth.
There is only one way to tap into the full value of your home’s equity, and that is to sell your home. Selling is a long complicated process. It involves contracts, realtors and negotiations. However, in the end you get a check for the market value of your home.
Downsides: Unfortunately, this option comes with a lot of downsides. After you sell and jump into the renting market, you’ll find that your housing costs will incrementally increase due to rent inflation. When you own a home, you dodge housing inflation. Selling also requires hiring a lawyer and paying selling commissions. You might get the full value of your home, but transaction costs are highest.
This strategy involves selling your current home to purchase a much smaller, more manageable home. In selling and downsizing, you get to bank the difference in home prices. However, by buying instead of renting you can avoid rent inflation and retain property ownership.
Downsides: This might be thought of as the best of both worlds, but it is likely the most costly. In this scenario, you are not able to cash in the full value of your equity, since some of it will transfer to your new home. You also take on the selling burdens and the added high transaction costs of buying a new home.
Banks sell an unconventional loan known as a reverse mortgage. These mortgages allow you to borrow your home’s equity without a mortgage payment. Instead, after you pass away your house is sold and the proceeds go to refund the bank the money you borrow. Any residual value on the home after the sale goes to your estate as an inheritance.
Downsides: You need to retain a portion of equity in your home to assure that the bank will earn back the loan after you have passed away. You have to pay interest on the loan. You risk foreclosure if you can’t maintain tax and homeowner’s insurance payments. This option might have the lowest transaction costs, but it also restricts you from cashing in on a great deal of equity.
There is no right answer to how best to tap into your home’s equity. In fact, you’ll notice from the strategies I’ve listed that equity is greatly overvalued since costs are high to convert to cash. However, if you plan now, you can begin to account for those costs and maintain a reasonable living on your home’s value in retirement.
JP is an MBA and works in finance. He is the author of the blog My Family Finances where he writes about how families can better manage their money and budgets.