In today’s complex financial world, retirees’ finances are stretched further than at any other time in history. For this reason, many retirees living on a fixed income are looking at different ways to stretch their existing income. This may include using home equity to bridge the income shortfall that they are experiencing.
One way retirees can do this is by using a reverse mortgage. A second way retirees have traditionally done this is by using a home equity line of credit, or “HELOC.” So, which is it? Reverse mortgage or HELOC? In this article and the next one, we’ll contrast the two financial vehicles.
Reverse Mortgage or HELOC? Pt. 1: HELOC Features
HELOCs have certain advantages, such as:
- Typically, there are low closing costs involved with a HELOC.
- In many cases, interest-only payments are due for the first 5 to 10 years of the contract.
- In addition, some banks issue HELOCs up to 100% of the property’s value, depending on the type of property being financed and the borrower’s credit-worthiness.
However, just like any financial product, there are features and triggers in a HELOC contract that consumers should be aware of. Retirees who are trying to discover the best way of using home equity to supplement their income would do well to take these features into account.
1. Interest-only Payments
The first feature is the interest-only payment that is typically required during the contract years, or “draw period.” HELOC contracts are most commonly 10-year contracts. At the end of the draw period, the borrower is asked to renew the loan or pay it in full. This is where things can get a little hairy.
2. End-of-Loan Triggers
Here is a fairly common scenario that I see: a couple takes out a HELOC at age 68 to consolidate some debt and to have an extra pool of money for the inevitable home maintenance or unexpected medical procedure. By the time the contract is set for renewal at age 78, the loan balance is hovering around $50,000 with a monthly payment of around $400.00.
Now the contract is triggered to either be renewed, paid off in full, or amortized. Unfortunately, the couple no longer qualifies. They don’t have enough income because they are now fully retired. Or, maybe a retirement account has run out of funds and is no longer producing income. Perhaps the bank has changed hands and they have more stringent guidelines.
All of these circumstances can be compounded further when a spouse has passed away. In that case, the remaining spouse only receives the larger of the 2 social security checks. In some cases, this cuts the remaining spouse’s income in nearly half. At this point, the bank decides not to call the note due. Instead, they agree to amortize the payment over a 20-year period. Now, the borrower (who was used to a $400 interest-only monthly payment) must contend with a payment closer to $800 per month. Ouch.
3. Frozen Accounts
Banks can freeze the credit available from a HELOC at any time. All HELOC contracts that I am aware of give the banks full discretion to do this. We especially saw this happen during the real estate bubble of 2009. Banks became concerned about the value of the real estate that was backing the HELOC loans that they had approved for folks like you and me.
As a result, they triggered a freeze on many accounts. They sent out letters to their borrowers, explaining that they no longer had access to borrow the money that was remaining in their HELOCs. Many people were facing very tough times financially – and were cut off from their home equity right when they needed it most.
Many borrowers who take out HELOCs will either sell their home or refinance the debt before the 5 or 10-year interest-only draw period has come to an end. It’s also not very likely that we will experience another real estate pullback as bad as the one that occurred in the mid 2000’s.
I believe that it is important for people to fully understand these two key features of the loan. You need to know what could trigger these features to come into play for you and your family. Even more importantly, you need to understand how they could affect you if you’re hoping to use a HELOC as part of a retirement strategy.
In my next blog post, I will contrast a reverse mortgage line of credit with the HELOC. Stay tuned to discover which of these is the best financial vehicle to enhance your quality of life.