Sunday, April 28, 2013

Inadequate Retirement Account (IRA): Home Equity

Note: This is the fourth installment of a series of posts with advice for households that haven’t been able to save enough for retirement. The first post was Inadequate Retirement Account (IRA).

If you're approaching retirement and haven’t saved enough in retirement accounts, it's likely that the majority of your wealth is home equity[1]. You may find yourself in your early 60’s with the prospect of living primarily off Social Security benefits while residing in your largest financial asset.

Maybe you’ve had the thought in the back of your mind that you saved for retirement by paying off the mortgage. If so, you have some serious planning to do because home equity is difficult to spend. Even if you sell the house to free up the equity, you will still need a place to live. If the new place doesn’t cost significantly less than where you live now, you’re back where you started.

Should you sell your house when you retire? Should you pay off the mortgage? Should you buy a smaller house or rent?

Housing and mortgages in retirement are complicated issues because there are several factors, financial and non-financial, to consider, including:
  • Emotional value. Houses are often more than a financial asset; they’re our homes. It may be impossible to put a price tag on the memories. Is it important to you to leave your home to your children?
  • Changing housing needs. You may need a larger home for the children and grandchildren to visit for several years after you retire. You may find at some point that you don’t need all that room and you could do without the maintenance chores. Later in life, you may find that your home isn’t well suited to your physical limitations. Can it be modified to work for you? Your housing needs may change significantly once or even twice during a 30-year retirement.
  • Taxes. The tax deductions you enjoyed before retirement may have far less value after you retire. You may have to pay a capital gains tax when you sell your home, though the first $250,000 of gain is excluded ($500,000 for a married couple) in most cases. If your home has lost value since you purchased it you cannot deduct a capital loss on your main home sale.
  • Liquidity. Real estate is highly illiquid, which means that an asset can take a long time to sell or that it has large costs associated with selling, or in the case of your home, probably both.
  • Risk. A home with a mortgage is exposed to foreclosure risk.
The issues surrounding the emotional value of your home are purely personal. Only you can know if keeping your home has more value to you than moving and thereby gaining the ability to spend some of your wealth that is currently in the form of home equity.

The income tax deductions for home mortgage interest and property taxes are the most popular deductions among the middle class. Should your income tax rates drop after you retire, which is likely if you have limited savings to invest, those deductions will be less valuable and your after-tax housing costs will increase accordingly. Furthermore, you may have been paying mortgage payments for many years by the time you retire so that those payments will consist largely of principal and will provide diminishing tax savings.

You also need to be aware of property tax costs and home insurance costs if you continue to own a home after you retire. Paying off the mortgage doesn’t make these go away and both increase fairly constantly along with inflation and property values. Check your latest mortgage payment statement to see what percentage of it is escrowed to cover these two costs. The principal and interest will go away when you pay off the mortgage but taxes and insurance remain and grow over time.

The biggest housing issue for retiring homeowners who haven’t been able to save enough for retirement may be one of liquidity.

I have a client who has been able to save enough for retirement and he recently asked if I thought he should pay off his mortgage. Doing so would take a third to a half of his liquid assets (mostly stock investments) and convert that amount into illiquid home equity. As he pointed out, though, he would reduce his spending by the amount of interest on his mortgage (currently under 4%).

I asked him if he might one day need the cash he would use to pay off the mortgage for living expenses.

"Probably," he replied.

“How, then,” I asked, “will you get the money back out of your home to spend?”

There aren’t a lot of fast and cheap ways to get the cash back once it becomes home equity. He could sell his house and buy a smaller one or rent. He might take out a reverse mortgage. A home equity line of credit doesn’t make much sense because you have to start paying it back immediately and the rates are higher than a mortgage.

He realized that if he paid off his mortgage he would lose access to a lot of liquid assets and it wouldn’t be easy to get that liquidity back. If he could pay off his mortgage with say, 10% or less of his wealth, the mortgage interest savings might have been worth it. He decided it was not in his case.

On the other hand, Laurence Kotlikoff, an economist I respect and the creator of E$Planner software, uses a tool called consumption smoothing to calculate the amount of consumption (the amount you can spend) over your lifetime. He claims that he has run many scenarios through E$Planner and rarely finds one where paying off the mortgage isn’t a winner.

It isn’t always a big winner, though.

You might want to run your scenario through E$Planner's free web software and see what works in your situation[2]. The amount of annual spending you might free up from home equity may help you make up your mind about selling or staying.

Keep this in mind, though: $100,000 of home equity isn’t the same as $100,000 in a retirement savings account. You don’t live in your 401(k).

You can spend your 401(k) or IRA savings on whatever you please, but after you sell your home to free the equity, you’ll still need to pay for somewhere to live, unless you move in with the kids. Presumably, part of that replacement housing cost will be paid from the home equity you just liquidated.

A reverse mortgage is an alternative that frees up home equity and allows you to remain in your home. According to the Federal Trade Commission, "In a regular mortgage, you make monthly payments to the lender. In a reverse mortgage, you receive money from the lender, and generally don’t have to pay it back for as long as you live in your home. The loan is repaid when you die, sell your home, or when your home is no longer your primary residence."

There are pros and cons to reverse mortgages, though, so analyze them carefully before making them part of your retirement plan.

One last thing to consider is foreclosure risk. Anytime you have a mortgage there is a possibility that it will be foreclosed in bad economic times, as happened in the recent housing crisis.

People without mortgages rarely lose their home to foreclosure, but it happens. People have lost their homes for relatively small amounts of unpaid back taxes. Still, a paid-off mortgage may give you a sense of financial security that helps you sleep at night.

E$Planner or a similar consumption-smoothing tool can help you determine if selling your house, renting, downsizing, or paying off the mortgage or keeping it will increase the amount of money you will be able to spend in retirement.

Whether or not you want to sell your home and how much financial risk you can live with is something software isn’t going to help you with.

My advice regarding homes and mortgages for households with inadequate retirement savings is that you create some possible scenarios like “pay off the mortgage and stay put”, “sell the house and relocate at age 65”,  “sell the house and relocate at age 75”, and “reverse mortgage and stay put”. Then run E$Planner to get an understanding of your maximum potential spending in each scenario before you exclude any of the alternatives. The results may surprise you.

With the numbers in hand, you have an objective way to decide how important keeping your home really is to you and the value of paying off your mortgage (or not).

What to do with your home and home equity may be the biggest financial decision you make if you don’t have much retirement savings, with the possible exception of what to do about your Social Security benefits.

We’ll talk about that next.

[1] Home equity is the amount of cash you would have if you sold your home and then paid off all encumbrances (first mortgage, second mortgage, home equity line of credit, etc.). To calculate home equity, we don’t usually subtract home selling expenses such as realtor fees or taxes, but in this case I do because we’re considering the net cash you could take away from the sale to fund retirement.

[2] Please don’t let my multiple references to the product give the impression that I have an incentive for hawking E$Planner. I mention it repeatedly because it is one of the few software packages I know that performs consumption smoothing. A free Excel spreadsheet, created by Sherman D. Hanna, Professor, The Ohio State University, is also available but I find E$Planner far easier to use. A free (but simplified) version of E$Planner is available here.


  1. The more I read of your installments, the more confident I feel that I truly will be able to enjoy my retirement (in 1 year 1 month, and 27 days--but who's counting?). I was very fortunate to have a good financial advisor help me make sound investments 20 years ago, and am sooooo very fortunate to work for the University System of Georgia, which has an outstanding pension plan which includes health care coverage in my retirement. I feel very good about the future!

  2. Thanks, and I'm glad you find the posts helpful!

    As these charts show (,you're very fortunate to have a defined benefit plan, and especially one with inflation protection. The number of private workers who have a DB plan has dropped precipitously since 1979.

    While my posts are primarily aimed at households with little or no personal retirement savings and Social Security eligibility, many of the suggestions apply in your situation, as well, including those addressing spending, investing, and home equity.

    Here's hoping you have a wonderful and secure retirement!

  3. I'm looking into retiring soon and the planning process has been very difficult. The first thing I did was look into a checkbook ira account and my investment portfolio. I've also heard seeking a professional financial planner may be very beneficial to your retirement plans. Do you have any advice or tips for my planning process?

    1. James, without understanding your level of financial expertise, it's difficult to give specific advice, but I'm guessing from the information in your question that you may need to hire professional help.

      If you really want to do it on your own, you can order my book "Retiring When Your 401(k) Fails". There is a link on my website or you can find it on It's written for people who aren't financial experts.

      I think you'd be better off in the long run, though, if you found a fee-only financial planner who specializes in retirement planning. True fee-only planners won't try to sell you anything except advice.

      If you need help with that, you can contact me at I'll get some more information from you and try to point you in the right direction.

      Thanks for reading!