Homeowners Over 62: You May Be Sitting on Tax-Free Cash

If you’re a homeowner who is approaching retirement, you may have an extra tool in your financial toolbox to help make ends meet: your home.

Every monthly mortgage payment and appreciation has increased your home equity position, and you can tap into that value with a home equity line of credit (HELOC) or a reverse mortgage.

How reverse mortgages and HELOCs work

HELOCs allow you to draw money over time from a maximum amount while reverse mortgage proceeds can be taken as a lump sum, line of credit, monthly payment or a mix of those options. A HELOC or a reverse mortgage can help strapped retirees with enough cash flow avoid taking too much out of their 401(k) and individual retirement accounts (IRAs) early in their retirements. Home Equity Conversion Mortgages (HECMs), the most common type of reverse mortgage loan, are reserved for homeowners age 62 or older.

The money you receive from a HELOC or a reverse mortgage is typically considered loan proceeds, and it’s not treated as ordinary income.

"Typically, the money you get through the reverse mortgage is tax-free and generally won’t affect your Social Security or Medicare benefits," the Federal Trade Commission explains about reverse mortgages. "Generally, you, your spouse, co-borrower, or your estate repays the loan when you die, sell your home, or move out."

But keep in mind that’s because you’re not earning money, you’re borrowing it. And you have to pay interest on those payments. However, the interest may be tax-deductible if you spend the proceeds on home projects to qualify for the deduction. Interest on reverse mortgages is generally only deductible when it’s actually paid, which is often when the loan is repaid.

The risks of HELOCs

A home equity line of credit is a revolving line of credit that uses your home as collateral. You do not have to borrow against a HELOC right away and can pay off the credit line before it matures. HELOCs have an initial draw period followed by a specified repayment period if you do not want to pay off the debt early.

HELOCs serve as backup cash sources and can assist with large, one-time expenses, such as home repairs. Homeowners risk foreclosure if they miss a HELOC’s regular monthly payments, and variable interest rates leave homeowners exposed to higher payments if the Federal Reserve decides to raise interest rates. These risks make HELOCs more suitable as contingency tools instead of the default option to maintain an expensive lifestyle.

Reverse mortgages work differently. These financial products provide monthly distributions that are pulled from your home equity. You don’t have to repay a reverse mortgage during your lifetime, as long as you meet basic requirements like keeping your home in good condition.

You still have to pay property taxes and home insurance if you take out a reverse mortgage. Interest also adds up, and your heirs may be left with very little home equity if you use a reverse mortgage. Many retirees gravitate toward this financial product for a steady income stream after retiring. It may serve as a good complement to Social Security, but you shouldn’t rush to take out a home equity conversion mortgage if Social Security benefits are sufficient to cover your living expenses.

A risk of borrowing against home equity is that interest and fees can make it expensive over time. It can also be hard to rebuild home equity as a retiree since you aren’t making a steady income anymore. Some people run out of home equity and then end up having to downsize and being forced out of their homes.

When using equity can actually help

While HELOCs and reverse mortgages can be especially risky if they are used to enable bad spending habits, they can be useful as emergency lines of credit. HELOCs tend to have lower interest rates than most types of loans since they are secured credit lines.

Reverse mortgages can also serve as financial safety nets for care costs that you may incur later in life, but it may be good to delay accessing home equity for as long as possible. Tapping into a small portion of equity and leaning heavily into Social Security benefits to fund your lifestyle reduces some risk while letting you tap into the equity that you have built over many years.