The Financial Iceberg You Definitely Want to Avoid in Retirement

I’ve worked with a lot of retired seniors over the years who had no clue they were headed dead-on for a financial iceberg. Many signed up for this iceberg on their own, but others did so at the recommendations of well-meaning CPAs, financial advisers, attorneys, and family members.

So, what is this financial iceberg? It’s called a HELOC, or home equity line of credit. Many seniors take out HELOCs to use as a cash source in retirement without realizing they’re risking serious financial pain in the future.

Now, don’t get me wrong, I don’t have anything against HELOCs. Like most financial tools, they’re not inherently good or bad. Their “goodness” or “badness” is determined by how they’re used. The problem is that many seniors use HELOCs for purposes that can put them at risk financially. And when you’re on a fixed income and maybe not in the best of health, you don’t need extra financial risks – especially if such risks can result in the loss of your home.

How HELOCs Work

HELOCs are fully revolving home loans designed for short term funding needs. You can borrow against your HELOC, pay it down (or off), and borrow against it again at your discretion.

HELOCs come in a wide variety of forms, but the most common ones tend to work as follows:

1. Interest-only payments. Most HELOCs have low minimum payments that only cover just the interest. Unless you intentionally make extra payments, the debt isn’t paid down over time.
2. The more you borrow, the bigger the payment. This can become a real financial headache if you use a HELOC to cover big expenses such as medical bills, car repairs, or home maintenance. The more you borrow, the bigger the payment gets and the bigger the financial burden the HELOC becomes.
3. Adjustable interest rates. Though some HELOCs have fixed rates, most come with adjustable interest rates. If interest rates rise, the payment rises as well, which further exacerbates problem #2 above.
4. Ten-year “draw” period and 25-year total loan term. You can borrow and repay in a fully revolving manner and make just interest-only payments for the first ten years of the loan. Once ten years have passed, the bank starts forcing you to repay the both principal and interest over the remaining 15 years of the loan.
5. They can be revoked, chopped, or frozen with little notice. This is less than ideal if you plan to use the HELOC as a long-term financial safety net. If home values fall or credit conditions deteriorate, banks will reduce their risk exposure by reducing extended credit. It’s entirely possible your HELOC could be revoked, chopped, or frozen at a time when you need it most. And don’t assume you’re immune from this if you have great credit.
6. They are typically full recourse loans. If home values fall and you end up owing more than the home is worth, the bank will come after you for the shortage when you try to sell your home. You will either have to pay the shortage or negotiate a short sale to close the sale. And if you can’t keep up with the payments, you may face foreclosure and a deficiency judgment for the unpaid loan balance.

Why HELOCs are Risky in Retirement

Again, HELOCs are great for short term financing, but they can be very risky for retirees who carry balances long term. Why? Because of the recast.

As I’ve mentioned, most HELOCs come with an initial 10-year draw period and a repayment period that lasts another 15 years. The payment during the draw period is just interest-only, which means it’s very low. However, at the ten-year mark, the bank recasts the loan and begins forcing the borrower to repay both principal and interest over the remaining loan term.

In other words, the payment increases (often substantially) to ensure that the loan balance is paid back in full by the end of the loan term.

Let’s take a look at an example to see how this works. Let’s assume Mr. Murphy takes out a HELOC to pay off some credit cards and do some much needed home improvements. He now has a $50,000 balance on his HELOC with an interest rate of 4.75% (which is reasonable for today) that we’ll assume doesn’t change through the entire loan term (to keep things simple).

Because he’s still in the draw period, the bank only requires him to make a low interest-only payment of $197.92/month. For Mr. Murphy, this is a godsend because he was paying far more than that on his credit cards before he consolidated them with the HELOC.

The next ten years pass quickly and Mr. Murphy gets pretty used to making that low interest-only payment. His intent from the beginning was to pay toward the principal, but he always managed to find other uses for the money. He was busy enjoying his grandchildren and traveling, so he didn’t pay it too much thought after a while.

Now imagine Mr. Murphy’s shock when his bank sends him a letter on the 10-year anniversary of the loan. Surprise, surprise! His payment will be increasing to $388.92. The bank is demanding that he scrape up another $191/month – or else.

Unfortunately, Mr. Murphy’s Social Security and pension income hasn’t kept up with inflation over the last decade. He’s also had some medical problems and is now paying for some very expensive medications. The HELOC payment increase couldn’t have come at a worse time. He knows he’d better come up with the cash somehow or he could end up in foreclosure.

Just for fun, let’s assume Mr. Murphy’s balance had been $100,000 instead of just $50,000. How much would the payment increase with that kind of balance? Assuming the same 4.75% interest rate, the interest-only payment would have been $395.83. The fully amortized recast payment would be a whopping $777.83 –  a difference of nearly $400 per month.

If you’re blessed with a large income in retirement, a $400/month payment increase may not be a big deal. But for retirees living on Social Security and a modest pension, that kind of payment increase could be a financial disaster.

It’s also worth noting that many HELOCs come with balloon payments instead of just a higher monthly payment. In other words, the remaining loan balance has to be paid in full at the end of the draw period – or else.

Hopefully it’s now very obvious why I don’t recommend that seniors use HELOCs as a source of cash in retirement. There’s just too much payment risk if the balance is carried long term. Fortunately, there is a much, much better solution available.

The HECM Line of Credit

The HECM, or home equity conversion mortgage, is by far the most common reverse mortgage product in America today. It’s insured and regulated by FHA and it enables homeowners 62 years of age or older to convert a large portion of the value of their homes into tax-free cash without having to give up ownership of the home or take on a mortgage payment. As long as at least one borrower is living in the home and paying the required property charges (property taxes, homeowners insurance, etc.), no mortgage payment is ever required and the loan doesn’t have to be paid back.

The proceeds from a HECM reverse mortgage can be received in several ways, including lump sum, a monthly paycheck, line of credit, or some combination of all of these.

If you’re wanting to tap into home equity to fund your retirement, the HECM line of credit is a vastly superior option than the HELOC for several reasons:

1. No payment is ever required (as long as program obligations are met).
2. If you borrow more, there’s still no payment required.
3. Rates can be adjustable, but if they increase, the payment is still zero.
4. The line of credit cannot be chopped, revoked, or frozen as long as you meet your program obligations. Even better, your available credit will grow and compound larger, which gives you access to more money automatically over time.
5. HECMs are non-recourse. The most that is ever paid back is the value of the home, even if it’s not worth enough to settle the entire balance.
6. No recast. Again, there is never a payment required as long as you meet your program obligations.
7. HECMs are often much easier to qualify for than HELOCs. You don’t need to have stellar credit to qualify for a HECM.

The HECM line of credit completely eliminates the biggest pitfall of the HELOC: payment risk. The HECM line of credit can never be taken away or chopped as long as at least one borrower is living in the home and paying the required property charges. Even better, the available line of credit will automatically grow larger over time, giving you access to more of your home’s equity.

Settling the HECM vs HELOC Debate

A HELOC is a good loan product, but like any tool in a toolbox, it needs to be used for the right purpose. Again, a HELOC is better for short term cash needs. HELOCs can be very risky for seniors who carry balances long term because of payment risk when the loan recasts. I’ve talked with seniors struggling with high HELOC payments who were at risk of losing their home. Believe me, that’s not a fun place to be in retirement!

A HECM line of credit is a far better solution for long term cash needs in retirement. As long as program obligations are met, no mortgage payment is ever required and the line of credit will grow and compound larger. It also will never be locked or taken away, which means you can depend on it to be there when you need it.