Using home equity as a financial resource
As another year of anemic economic activity ends, seniors and baby boomers have an opportunity to consider whether it’s time to try to convert locked-up home equity into cash for current expenses. Many seniors will make this decision at a time when the economic downturn has sapped retirement savings and forced a juggling act among food, medical and housing costs. These same challenges are right around the corner for many baby boomers.
While the vast majority of seniors’ wealth is tied up in their homes – an asset that tends not to produce any income – there are ways to free locked-up home equity. But with each option, there are significant trade-offs that could impact short-term cash-flow needs, long-term tax and wealth transfer objectives, as well as Medicaid eligibility.
For example, the most obvious option is for baby boomers or seniors to sell their home in order to live off of freed-up home equity and savings resulting from eliminating housing-related maintenance costs. But these days, there’s a lot of risk associated with investing in financial markets, and there’s no guaranteed reward.
Here in Maine, the median sale price for single-family homes in 2008 was $178,000, and the average monthly rent for a two bedroom apartment in the same year was $846.95 according to U.S. Census data maintained by the State Planning Office. The numbers increase when limited to wealthier parts of the state, like Cumberland County, where the median home price in 2008 was $225,000, and the median price for a two bedroom apartment rental was $1,031, according to the same Census Data.
Setting aside transaction costs associated with selling a home and investing the proceeds, the numbers may not work for those who also want to save some of that wealth to leave as a gift for the next generation. Both seniors and baby boomers have a low risk tolerance for investments due to a short time horizon. They are unlikely to be able to generate enough money to cover the rent. Assuming a senior or baby boomer could earn 3 percent from relatively safe investments, their earnings would translate into $445 per month from proceeds of a sale at the statewide average price, or $562.50 for revenue generated from an average sale in Cumberland County. In both instances, that would still leave almost 50 percent of the rent unpaid.
For those seniors not interested in or able to worry about passing on any substantial wealth, selling the home early and moving to a rental could be a good option because freed-up equity could cover rent for many years, even without investing the sale proceeds. Plus, there’s the added benefit of eliminating housing maintenance costs, though it is always worth considering whether rent includes expenses like heating, electricity and snow removal.
Another alternative to consider is a sale-leaseback transaction. The basic idea is that a homeowner sells the house to an investor, usually a family member, who then leases the home back to the original homeowner under a lifetime lease agreement. Typically, the owner/seller will get a down payment from the buyer, followed by monthly payments from the buyer. These payments may cancel out rental payments that the former owner may make. Essentially, a sale-leaseback allows a homeowner to finance a sale and generate some cash, while staying in his or her home.
There are some potential pitfalls to this arrangement. For starters, these transactions can be complicated and often require the assistance of legal counsel. Additionally, it can be tough to navigate a new set of relationships among family members when children turn into investors in their parents’ homes. The buyer then becomes responsible for home maintenance, and it is not always easy to be responsible for maintaining more than one home. However, for those seniors with strong relationships with their children or family members, a sale-leaseback may be a good option.
There are two other viable options for seniors with close family relationships – retaining a life estate or obtaining a support mortgage. A life estate is a legal term for the right to occupy and possess a piece of property for the rest of a person’s life. It also includes a set plan for who gets the property at death – which is known as a remainder interest.
A remainder interest is generally not worth as much as the full market value of a property because it is not possible to possess and use it until the life-tenant dies. That means a senior or baby boomer could generate some cash from selling a remainder interest without jeopardizing their ability to stay in their home. This can be an attractive way for children to offer support. In exchange for providing up-front money to support their parents, their parents’ house comes to them with absolute certainty.
A support mortgage provides a way for seniors to be supported during their lifetime, but whether the senior remains in his or her home depends on how the transaction is structured. With a support mortgage, a senior sells his or her home but takes a mortgage on the property of the person who will provide support. The senior can foreclose upon the mortgage if the mortgage fails to provide support, as outlined in the agreement reached by the parties. Maine law recognizes support mortgages, and the courts tend to interpret them in favor of the senior requiring support. But they are complicated and can pose problems if there are interpersonal problems between the senior and the person providing support.
For those seniors wishing to stay in their homes without turning to family members for assistance, reverse mortgages present an alternative. Broadly speaking, a reverse mortgage is a rising-debt/falling-equity loan through which a homeowner grants a mortgage to a lender in exchange for monthly payments or a credit line based on the home’s value and the senior’s age. Reverse mortgages are available to homeowners who are at least 62 years old, and these mortgages give seniors a way to borrow against the equity in their home without any obligation to repay the loan until a triggering event occurs, such as selling the home or death of the borrower and borrower’s spouse.
There are pluses and minuses to reverse mortgages. On one hand, they can be used to free up equity and create a revenue stream without obligating the senior, family members, or the senior’s estate to repay the obligation. Typically, if the home value does not support the amount borrowed, the bank will be protected by an insurance premium the borrower pays for in the transaction, so family members will be able to take other estate property free from any obligation to repay the debt on the home. On the other hand, because of origination fees – capped at $6,000 for most reverse mortgages – and other transaction costs, reverse mortgages tend to be more attractive to seniors with high-value homes.
With all of these options, there are complicated decisions to be made in order to balance short-term needs for cash against long-term hopes for wealth transfer. Seniors and baby boomers should also consider how income generated from any of these transactions could impact eligibility for Medicaid – which provides health care for Maine’s poorest people – as well as the tax consequences of generating income from a sale of their home. The best decision may be to further explore these options and talk to a trusted advisor about what is right for you.
Andrew C. Helman is an attorney with the Portland-based law firm Bernstein Shur, where he focuses on insolvency-related matters in the Business Restructuring and Insolvency Practice Group. In addition to insolvency-related work, Bernstein Shur has expertise in long-term planning issues for seniors, including tax, wealth transfer, and Medicaid eligibility issues. Helman can be reached by telephone at 228-7147, or by e-mail at firstname.lastname@example.org.