Should You Secure a Home Equity Loan Before You Retire?
Home equity loans can be useful financial tools in retirement. However, these loans can be more difficult to secure after you have stopped working.
Let’s explore the different kinds of home equity loans, how you might want to use them for retirement, and why you should secure the loan while you still have work income.
A home equity loan, also known as a second mortgage, is a type of loan that allows homeowners to borrow money using the equity in their homes as collateral. Equity is the difference between the current market value of your home and the outstanding balance on your mortgage.
Different kinds of home equity loans
There are two main types of home equity loans.
- A home equity loan, also known as a second mortgage, is when you borrow a lump sum of money from the lender that is secured by the equity in your home. You then repay the loan over a fixed period of time, typically 5 to 30 years, with a fixed interest rate.
- A Home Equity Line of Credit (HELOC) is a revolving line of credit that is also secured by the equity in your home. However, rather than receiving a lump sum of money, you can draw on the credit line as needed, up to a predetermined limit. You will only pay interest on the amount you’ve borrowed, and you can repay and borrow again during the “draw period” (usually 5 to 10 years). After the draw period, you must begin repaying the principal, plus interest, over a fixed period of time.
There are pros and cons to each kind of loan.
The main benefit of a home equity loan is the fixed interest rate, particularly if interest rates are relatively low when you secure the loan.
The advantage of a HELOC is that you have access to money IF you need it, but you are not paying interest on those funds unless you actually withdraw money. Even then, you can limit your withdrawal to just what you need and not the full amount that is available in the line of credit.
Getting a loan before you retire, a milestone that many people believe should be debt free, may seem controversial. However, depending on your financial circumstances, a home equity loan may be smart financial move.
Here are some of the reasons you might want to consider getting a home equity loan before retirement:
Back up cash at the ready: The main reason that people consider securing a home equity loan prior to retirement is flexibility. Home equity loans provide a flexible source of funds that you can draw on as needed, which can be useful for managing unexpected expenses or financing home improvements.
Enables strategic financing: A home equity loan is a source of funds that can be strategically used to your advantage.
- You might want to get a home equity loan and use it to bridge to a later Social Security start date. For some people this might result in a bigger pool of funds to be used throughout retirement.
- Pulling from the loan may be a better option than withdrawing from savings when investments are down.
Pay off higher interest debt: Home equity loans typically have lower interest rates than other types of loans, such as credit cards or personal loans. If you are considering retirement, but are carrying debt at a high interest rate, a home equity loan could enable you to pay off those loans and carry the debt at a more tolerable interest rate.
Tax benefits: The interest on home equity loans may be tax-deductible, which can help lower your tax bill. Depending on your circumstances, taxes can be a significant concern in retirement.
Easier to qualify for a loan before you retire: There are a variety of factors that go into determining eligibility for a loan.
However, your income and the source of that income seem to be a primary factors and many retirees report having trouble qualifying even with a pension and Social Security as reliable income sources. (Securing a loan based on income from withdrawals can be trickier.)
So, securing the loan when you have income from work may make it easier to qualify.
Other loan determinants include:
- Loan-to-Value Ratio (LTV): The LTV ratio is calculated by dividing the outstanding mortgage balance on the home by its current market value. The bank may typically require a maximum LTV ratio of 80% or lower to qualify for a home equity loan.
- Credit Score: A borrower’s credit score is a critical factor in determining eligibility for a home equity loan. The bank will review the borrower’s credit report to assess their creditworthiness and ability to repay the loan.
- Debt-to-Income Ratio (DTI): The DTI ratio is calculated by dividing the borrower’s monthly debt payments by their gross monthly income. The bank may typically require a maximum DTI ratio of 43% or lower to qualify for a home equity loan.
- Property Value: The bank will also evaluate the current market value of the property and its condition to determine if it meets their lending criteria.
- Purpose of Loan: The bank will also consider the purpose of the loan and whether it is a good use of funds. For example, using the loan proceeds to make home improvements or pay off high-interest debt may increase the likelihood of approval.
While having an additional bucket of money in the form of a home equity loan may provide flexibility and other advantages, there are some real risks to having this debt when you retire.
The disadvantages of a home equity loan in retirement include:
Risk of foreclosure: If you fail to repay your home equity loan, your lender may foreclose on your home, which could lead to financial instability and the loss of your primary residence.
Reduced equity: Taking out a home equity loan reduces the equity you have in your home, which could impact your ability to sell your home for a profit in the future.
Interest rates can change: If you have a variable interest rate, it could make future payments untenable.
Fewer options later in life: If you secure a home equity loan and then spend the proceeds of the loan, you will have fewer options for flexible funding later in your life.
Many people strive to retain their home equity as a back up plan to help fund a long life or long term care. Explore more about using home equity in retirement.
Depending on the type of loan you secure, modeling a home equity loan in the NewRetirement Planner is possible.
For a home equity loan, you can simply add the loan balance to your mortgage.
Modeling a HELOC is a bit trickier and not as useful since most people use the HELOC as a flexible source of funds for when things don’t go according to plan.
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