4 Reasons Why You Should Get a Home Equity Line of Credit (HELOC) Before Retirement
(Seven-minute read time)
As you approach retirement in Ontario, strategic financial planning becomes crucial to ensure a smooth transition from employment income to retirement income. One valuable tool in this planning process that often goes overlooked is a Home Equity Line of Credit (HELOC). This article discusses the basics of HELOC and why it's a wise pre-retirement move. Additionally, we'll give you tips on how to improve your chances of qualifying for a HELOC and compare using a HELOC versus pulling from your investments.
Whether you're looking to bolster your financial flexibility, safeguard against unforeseen expenses, or maximize your retirement readiness, this article will illustrate why a HELOC might be the key to unlocking a more secure and prosperous retirement.
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What is a Home Equity Line of Credit (HELOC)?
A Home Equity Line of Credit (HELOC) offers homeowners a flexible and cost-efficient way to borrow money against their home equity—the part of your property's value that you own outright. Unlike a primary mortgage where you receive a lump sum and repay with fixed installments, a HELOC functions similarly to a credit card: it provides a revolving credit line up to a certain limit, allowing you to borrow, repay, and re-borrow funds as needed. Interest is only paid on the amount borrowed, not the entire credit limit, and you can repay the balance at any time without penalties.
A HELOC can be part of your first mortgage or set up as a separate second mortgage. Combining the HELOC with your primary mortgage may result in a new interest rate and will reduce your debts into one package. On the other hand, adding a HELOC as a second mortgage will keep your primary mortgage intact, avoid any breakage fees, and retain your original terms while still providing access to additional funds through refinancing.
HELOCs are usually available with conventional mortgages (those with at least a 20% down payment) offering substantial funds based on property value. You can typically borrow up to 65% of your home's value through a HELOC, though the total debt secured against the home can be up to 80%, maintaining a minimum of 20% equity.
To learn more about refinancing, check out our article: The Benefits of Refinancing Your Mortgage in Ontario
4 Reasons Why You Should Get a Home Equity Line of Credit (HELOC) Before Retirement
Securing a Home Equity Line of Credit (HELOC) before retirement can offer several timing advantages that align with pre-retirement financial planning. These advantages include:
Easier Qualification: While you're still employed, your regular income can make it easier to qualify for a HELOC. Lenders typically require proof of stable income to approve a HELOC application, and the income verification process can be more straightforward for those who are employed compared to retirees who may have a more complex income structure.
Fraud Prevention: Keeping a mortgage or HELOC on your home helps protect against title fraud. If your home has a mortgage attached to it, even with no balance, it's harder for fraudsters to take out more loans against it. One of the reasons is that financial institutions usually check with the home's owners before approving additional borrowing.
Convenience: Having a HELOC account set up before retirement will save you stress. If you need to access funds quickly, you can get immediate access.
Debt Consolidation: You can use a HELOC to consolidate high-interest debt, potentially reducing your monthly financial burden and interest payments, and setting up a more comfortable retirement.
How to Improve Your Chances of Qualifying for a Home Equity Line of Credit (HELOC)
The qualification process for a Home Equity Line of Credit (HELOC) involves several key factors that lenders consider to determine your eligibility and the amount you can borrow. Understanding these factors can help you better prepare for the application process. Here's what to expect:
Income Verification:
Pre-Retirement: Lenders will look at your current income to assess your ability to repay the HELOC. This includes salary, bonuses, and any other regular income sources. As you're approaching retirement, it's crucial to demonstrate a stable income.
Post-Retirement Plans: If retirement is close, lenders will likely seek proof of your anticipated retirement income sources. This could entail documentation related to pensions, distributions from retirement savings plans (such as RRSPs or TFSAs), and any CPP (Canada Pension Plan) or OAS (Old Age Security) benefits you're eligible to receive. Providing a comprehensive picture of your expected retirement income can support your application.
Credit Score and History:
A high credit score and a clean credit history are crucial for HELOC approval. Lenders will check your credit report for any past defaults, late payments, and overall debt levels. Maintaining a strong credit score can improve your chances of qualifying.
Home Equity:
The equity in your home — the value of your home minus any outstanding mortgage balance — is a critical factor. The more equity you have, the larger the line of credit you may qualify for. Lenders typically require an appraisal to determine the current value of your home.
Debt-to-Income Ratio (DTI):
Your DTI ratio measures your monthly debt payments against your income. A lower DTI ratio indicates better financial health and repayment capability. As you approach retirement, reducing other debts can make your application stronger.
Proof of Assets:
Demonstrating additional assets (savings, investments, other property) can strengthen your application by showing you have reserves to draw upon if income sources fluctuate in retirement.
Consider this Scenario: Getting a Home Equity Line of Credit (HELOC) Before vs After Retirement
Tom and Linda, both in their 50s and earning $150,000 combined, have been thinking a lot about their retirement. Once they retire, their income will be reduced to $50,000. Since they won't make as much money when they retire as they do now, Tom and Linda worry that during their retirement it could be harder for them to borrow money if they need it.
Tom and Linda have two adult children and a grandchild they’d like to help financially, but their investments are locked in. They also paid off their mortgage five years ago. They heard about something called a HELOC, which would be something they would use to support their family. They're thinking it might be a good idea to get one now while they're still working. So, they book a meeting with their financial advisor to compare their qualification for a HELOC before retirement and during retirement.
Before Retirement: With a stable income and most bills cleared, they could qualify for a HELOC, with an open limit of $498,457.63.
Post-Retirement: Should they decide to wait and apply post-retirement, their reduced income of $50,000 significantly impacts their borrowing ability, limiting the maximum HELOC amount to just $126,758.82.
When comparing the two options, the ability to qualify for a larger Home Equity Line of Credit (HELOC) amount significantly decreases after retirement due to the reduction in income. The reduction after retirement is $371,698.81, or a 74.6% decrease. Therefore, Tom and Linda proceed with a HELOC before they retire so they can use it to borrow money during post-retirement whenever they need it to support their family without affecting their pre-established retirement income.
Benefits of Using a Home Equity Line of Credit (HELOC) During Retirement
Here are some key benefits of using a HELOC during retirement:
Supplemental Income Source: A HELOC can supplement your retirement income, helping to cover living expenses or providing cash flow during periods of low market returns on other investments.
Flexible Access to Funds: With a HELOC, you can draw funds as needed, offering flexibility to manage expenses without having to sell off investments at an inopportune time.
Tax Planning: Although HELOC interest is not typically tax-deductible, using it strategically can aid in tax planning, especially if it prevents you from moving into a higher tax bracket by withdrawing from retirement accounts.
Funding for Lifestyle Goals: Whether it’s travel, hobbies, or purchasing a second home, a HELOC can finance your retirement dreams without significantly disrupting your investment strategy.
Healthcare Costs: A HELOC can provide a readily available source of funds for healthcare or long-term care expenses that may not have been fully anticipated.
Home Improvements: Using a HELOC during retirement allows for necessary or desired upgrades that can boost your home's value and improve your living conditions without straining your retirement savings.
HELOCs typically offer interest rates that are lower than unsecured loans or credit cards because the loan is secured against your home. This makes them an attractive option for financing large expenses such as home renovations, education, debt consolidation, or even to cover emergency funds.
Have You Considered Life Insurance for Your Retirement Plan?
Learn more by reading our article: Life Insurance for Retirement: Discovering the Insured Retirement Program (IRP)
Home Equity Line of Credit (HELOC) vs Pulling from Investments
When facing a need for funds, homeowners often weigh the decision between taking out a Home Equity Line of Credit (HELOC) and pulling from investments, such as RRSPs or other investment accounts. Each option has its own set of financial implications, including tax consequences, potential for loss, and accessibility. Here's a comparison to help understand these implications:
Home Equity Line of Credit (HELOC):
No Tax Consequences: Generally, borrowing through a HELOC does not trigger immediate tax consequences since the borrowed money is not considered taxable income.
Contribution Room: Utilizing a HELOC does not affect your RRSP contribution room or that of any other investment accounts.
Prevents Locking in a Loss: Since you're not selling investments to generate cash, you avoid locking in any investment losses that might occur in a down market.
Timing to Get the Money: HELOCs offer immediate access to funds, providing liquidity without the need to sell investments. The flexibility can be particularly beneficial in urgent situations.
Pulling from Investments:
Tax Consequences: Withdrawing from investments, especially from registered accounts like RRSPs, can have significant tax implications. Withdrawals from RRSPs are treated as taxable income in the year they are withdrawn, potentially increasing your tax liability.
Loss of Contribution Room: Withdrawing from an RRSP results in a permanent loss of contribution room for that amount. Other investment accounts like TFSAs may allow the re-contribution of withdrawn amounts, but timing rules apply.
Locking in a Loss: Selling investments to access funds may mean locking in any losses if the sale occurs during a market downturn. This could negatively impact your long-term investment growth potential.
Timing to Get the Money: Liquidating investments can take time, depending on the type of investment and market conditions. There might also be settlement periods to consider before the funds become available.
Additional Considerations:
Interest Costs vs. Investment Growth: Borrowing through a HELOC incurs interest costs, whereas pulling from investments might mean missing out on potential future investment growth. Balancing the cost of HELOC interest with the opportunity cost of not being invested is crucial.
Financial Goals and Time Horizon: Your decision should align with your long-term financial goals and time horizon. If retirement is near, preserving investments might be prioritized over taking on new debt.
Market Conditions: Market volatility and current investment performance should influence your decision. In a rising market, it might be advantageous to keep investments intact, while in a declining market, a HELOC might prevent locking in losses.
Ultimately, the choice between a HELOC and pulling from investments depends on individual financial situations, goals, and market conditions. Consulting with a financial advisor can provide personalized advice, taking into account the nuances of your financial plan and helping you make an informed decision that minimizes negative implications while supporting your financial health.
Conclusion
Obtaining a line of credit on your mortgage before retiring can offer financial flexibility and security. However, like any financial strategy, it requires careful consideration of your personal financial situation, retirement goals, and risk tolerance. Consulting with a financial advisor can help you understand how a HELOC can fit into your overall retirement plan.
At WealthTrack, we can help you reach your financial goals — book a free 15-minute call with us today to find out how to get started.
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