Home Equity
Cashing In the Equity: Converting Home Value into Income
Sep 29, 2005, 09:50

When you retire, overall living expenses will likely be one-third less than your pre-retirement costs. If your expected income from investments, Social Security, pensions, and other sources still falls short of your requirements, then a smart move is to tap the equity in your prime asset, the house. You have several options available, depending on whether you prefer to remain in your home or move.

Equity-Conversion Methods – Remaining In the Home

If you decide to stay in the house, four conversion methods are available for tapping income from the value in your home:

1. A reverse-annuity mortgage

2. A second mortgage loan or refinancing

3. A sale-leaseback

4. Renting out an accessory room

Reverse – Annuity Mortgage (RAM)

Many potential retirees have a sizable amount of equity in their homes just waiting to be converted into income. The easiest way to use this equity would be to take out a second mortgage loan; however, most retirees living on fixed incomes cannot qualify for such a loan. For them, a reverse-annuity mortgage (RAM) that pays tax-free income to the borrower-and allows the borrower to retain title and ownership of the home – could be more appropriate.

The increasingly popular RAM is different from other types of loans. As the term reverse suggests, the RAM is just the opposite in function of a typical mortgage. Instead of obtaining a lump sum and then making payments to the bank, you get a steady stream of monthly payments (annuity) from the lender, which allows you to remain in your home and maintain your current lifestyle. Each payment you receive increases the amount owed on the RAM. But that loan does not have to be paid off until you die, sell the house, or move. The exception is a term RAM, which has a specified maturity. Provisions on reverse mortgages vary from one lender to another, but generally you can borrow up to 80 percent of your equity value in the home. The amount of the monthly payments is determined by a number of variables, including the homeowner’s age, the value of the home, the amount, if any, of future appreciation the owner is willing to share, interest rates, and historical appreciation of real estate in the area.

What happens if you or your spouse lives to a ripe old age after taking out a RAM? Will you lose your home and be tossed out? No. as long as the mortgage is not a term RAM and is non-recourse, which means you can never owe more than the value of the home and the lender cannot seek repayment from your other assets, you can stay in the house as long as either of you are still alive. The RAM will come due and have to be paid off only when the house is sold, either by you or your estate. From the proceeds the lending institution then gets back the principal paid to you plus costs, which vary from lender to lender and include closing costs, origination fees, interest, and insurance fees for loan guarantees.

Before taking out a reverse mortgage, consider the following:

1.Certain types of reverse mortgages allow the lender to receive a percentage of the appreciation of the home. By all means, avoid these. You’re better off taking out a reverse mortgage that only requires a charge for interest and closing costs and not a portion of your future appreciation.

2.If you sell or move within five years after taking out the reverse mortgage, the penalty for early withdrawal will be prohibitive.

3. When determining the amount of equity to give up, most homeowners decide to retain some value as a cushion to borrow against and to bequeath to their children.

For more information on both federal and private reverse-mortgage programs, write to either the American Association of Retired Persons (AARP) Home Equity Information Center or HUD, Single Family Development Division.

Refinancing or a Second Mortgage Loan

Refinancing your home with a new mortgage is the obvious choice when you own it free and clear of any loans. You can usually borrow up to 80 percent of the home’s value. But if you have an existing underlying loan on the property, then you can either refinance or take out a second mortgage loan.

When you take out a second mortgage loan to make use of the equity in the home, you leave intact the existing first mortgage. Most older first mortgage loans are at interest rates far below the current prevailing rate of new mortgages, so if you pay off these older, lower-rate mortgages by refinancing them, you would be eliminating their value by replacing them with a costlier, high-interest loan. But you can earn substantial savings by refinancing if the prevailing mortgage loan rate is two points or more below the fixed rate that you’re already paying on t he first mortgage. The savings you earn each month have to be compared to the costs of refinancing over a reasonable period.

As a rule, refinancing costs about 3.5 percent of your loan amount. This cost represents loan origination fees, credit report, title search, and appraisal. Once you’ve determined your refinancing cost, divide that by the amount you’ll save each month in lower payments. The result is the number months it will take to break even.

For example, let’s say you have a $100,000 loan at 12 percent and want to refinance it with a 9.5 percent mortgage, and the cost of refinancing is $3,500.00. At 12 percent, your monthly principal and interest payments are $1,029. At 9.5 percent, the payments are $841 – a monthly savings of $188. When you divide the $3,500 refinancing cost by the savings of $188, the result is 19, which means it will take 19 months to recoup the cost of refinancing.

Unfortunately, if you’re refinancing from an adjustable-rate mortgage to a fixed-rate loan, you won’t know when, if ever, you’ll break even. Adjustable-rate mortgages are predictable only in the first or second year; then the rates vary according to market index rates they are tied to.

If your first mortgage has a favorable fixed interest rate (9.5 percent or less), you may be better off to maintain the value of the existing low-interest loan by taking out a second mortgage. Assume, for example, that you bought a home 15 years ago for $40,000 with a 30-year first mortgage at 8 percent. The payment for principal and interest is $294 a month, and the remaining loan balance after 15 years of ownership is about $30,000. Since the current market value of the house is $100,000, you therefore have about $70,000 equity in the home.

If you refinance the house at 7 percent rate of interest, the lender would advance 80 percent of the market value, of which $30,000 must be applied toward paying off the existing first mortgage loan. Consequently, there would be $50,000 in net proceeds ($100,000 x 80% = $80,000; $80,000 - $30,000 = $50,000). The new first loan would require monthly payments of $550 to amortize principal and interest over a 30-year term. On the other hand, if you arranged a take-out second mortgage for a net amount equal to refinancing ($50,000), at today’s rates the lender would charge you about 8 percent. For a term of 15 years, the monthly payment would be $450. The total monthly payments on the first and second loans for the next 15 years would be $1,000 ($550 + $ 450). After 15 years both the first and second mortgages would be paid in full.


Retirees can also stay in their house with a sale-leaseback arrangement. As the term sale-leaseback suggests, you sell your home to an investor and then lease it back from the investor. Under such an arrangement, the seller/lessee usually receives at least a 10 percent down payment and a 20- or 30- year mortgage for the balance owing. The investor pays the cost or property taxes, insurance, and maintenance.

On a $120,000 house, for example, a sale-leaseback arrangement with a 10 percent down payment and a 20-year mortgage at 10.5 percent could generate $12,936 in gross income to the seller. The seller would pay about $10,800 in rent during the first year, leaving a net income of $2,136. add to that $960 earnings by investing the down payment in 8 percent CDs, and the total annual earnings would be $3,096.

The sale-leaseback can benefit both the investor and the seller/lessee. The investor has tax advantages from the ownership interest in rental property. These advantages take the form of deductions for depreciation, mortgage interest, and certain other costs. The seller/lessee receives a down payment and an interest-bearing note, and he or she is no longer responsible for major house repairs, property taxes, and hazard insurance.

Rent Out an Accessory Room

Consider making use of empty den or bedroom by renting it out to a tenant. You could earn $500 or more monthly in rental income depending on the quality, size, and the amenities of the rental offered.

Remember that your privacy depends on whether the rental unit has a separate bathroom and kitchen. If such facilities are not available, the boarder will have to make use of common-area facilities.

And don’t forget that if you do rent a room, your house is considered to be income property. This means you’ll be obligated to report the rent as income to the IRS. However, it also means you can deduct a proportionate allowance for depreciation. In other words, if 20 percent of the house is rented, then you can deduct 20 percent of the cost of the house each year as a depreciation allowance.

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