You're a senior citizen and you don't have enough income to live comfortably. What do you do?
It's an all-too-common question, especially with more than half of Canadians carrying debt into retirement. If you own a home with sufficient equity, and you want to keep living in it, two increasingly popular options are a home equity line of credit (HELOC) and a reverse mortgage.
Although both give retirees access to cash, there are significant differences between the two: reverse mortgages are straightforward while HELOCs in retirement are not.
If you borrow modestly and with discipline, however, a HELOC can be the best way to bail you out of a retirement cash jam.
The Home Equity Line of Credit (HELOC)
HELOCs are revolving credit lines offered by banks,brokers and other lenders that let seniors borrow against their homes in small or large increments. They typically require only monthly interest payments, no principal. So if you took out $100,000, you'd pay $292 a month in interest, using current rates of 3.50 per cent.
HELOCs, unlike mortgages, do not require monthly principle payments. However, you can make lump-sum payments whenever you want.
The Reverse Mortgage
HomEquity Bank's "Canadian Home Income Plan" (CHIP) is Canada's only widely available reverse mortgage. The bank lends anywhere from 20 to 50 per cent of a home's value, depending on the applicant's age, location, existing secured financing and property type.
Last month, HomEquity Bank rolled the "Income Advantage," which has notable improvements over the traditional reverse mortgage: Most importantly, the rate is lower. If you make pre-set withdraws each month, you'll pay just prime rate + 1.25 per cent (4.25 per cent today). That compares to rates of prime + 6.00 per cent in 2009.
Other improvements include lower fees, the ability to take smaller monthly advances instead of big lump sums (which rack up unnecessary interest), the option of locking in variable-rate borrowing, and no rate surcharges on existing customers who renew.
Which is better?
To get a HELOC you have to qualify. The lender will check your credit, verify your income and analyze your debt obligations.
With a reverse mortgage, if you're 55 or over with sufficient equity and a marketable house, you generally qualify. And you never have to make a single payment, even if you live in your home past 100.
Where HELOCs have appeal is with interest savings and flexibility. They're roughly ¾ of a percentage point cheaper than the Income Advantage plan, based on current rates. That's over $3,500 of interest savings over five years on $100,000.
But HELOCs aren't without risk. The death of a spouse, new lending regulations, changes in a bank's credit policies or increases in capital costs could all cause a bank to restrict a senior's HELOC borrowing. Additionally, rising interest rates or excess borrowing could potentially hike monthly payments, making them unaffordable for a cash-strapped retiree.
Another consideration is that seniors needing additional cash flow may use the HELOC itself to make the interest payments. The concern there is the bank getting worried when it sees steadily rising debt with no principal payments.
But Louis-François Poirier, National Bank's mortgage product manager, says this alone is generally not enough for his bank to restrict a senior's HELOC, as long as the customer is paying as agreed. "We encourage the customer to make principal payments, but our credit agreement clearly states that the only amount expected monthly is the interest."
One Possible Strategy
For some retirees, the interest savings of a HELOC is worth the tradeoffs versus a reverse mortgage.
If times get tough and the senior can no longer afford the HELOC payments, or runs out of borrowing room, they can usually refinance the HELOC into a reverse mortgage.
But this requires caution. You never want to borrow more from your HELOC than what HomEquity will lend you. "I would want to ensure that if I was taking that risk, that the client was borrowing no more than 80 per cent of what they would qualify for at the time with us," says Jeff Spencer, vice-president of national sales at HomEquity Bank.
If you do use a HELOC to supplement retirement income, it's vital to have an experienced independent financial or mortgage adviser do the math to set an appropriate HELOC limit – one that factors in your age, possible interest rate increases, potential property value declines, and so on.
Retirees should also be mindful of interest rate risk. "Personally, I think it's a good analysis to test one's monthly budget with a 200 or even a 300 basis point increase to their contractual (interest) rate," says Mr. Poirier. A three-percentage point hike would inflate a $292 monthly interest payment (on a $100,000 HELOC) to $542.
Yet another thing to remember is that unforeseen factors can reduce your future ability to refinance. Those risks include a fall in your property value, reductions in maximum lending limits and increases in life expectancy. The Income Advantage eliminates those worries and, to some, that's worth the 0.75 percentage point rate premium over a HELOC.
"For most retirees that have a retirement plan running out to the age of 90, I don't think the annual saving of interest is worth the extra risk that their property declines significantly, or loan-to-value calculations change at our firm, or they don't stay disciplined and use more of the [HELOC] than intended," HomEquity Bank's Mr. Spencer adds.
Borrowing your way through retirement
Mr. Poirier says a small but growing percentage of seniors are supplementing retirement cash flow with a HELOC. The same holds true for reverse mortgages.
But while it's possible to use a HELOC as a "security cushion or emergency fund," he is first to admit that "for seniors, day-to-day expenses should ideally be covered by retirement savings, as opposed to borrowing."
Unfortunately, that won't be a reality for up to one-third of Canadians who rely on their home equity to survive retirement. For many of those folks, the HELOC vs. reverse mortgage debate is one they're sure to encounter.
Robert McLister