This article appears in the November 2022 issue of Advisor’s Edge magazine — our second last print issue. If you’re a print-only subscriber, learn more about our digital transition and how to continue to receive all the best news and features on Advisor.ca.
After years of rising real estate prices, some clients may be tempted to use their home’s equity to fund their retirement. Inflation and volatile investments are only adding to demand for this type of solution.
However, many advisors say to approach this option with caution.
Mark Slater, senior wealth advisor and portfolio manager with CIBC Wood Gundy in Toronto, said home equity should only be used as a “temporary way to access money for a major purchase,” not to fund routine expenses.
“You should have a plan to pay it down soon so you don’t have 10, 15, 20 years where interest is compounding and you’re paying interest to the bank, in the case of a home equity line of credit (HELOC), or that interest is compounding and eating into the value of your home equity, in the case of a reverse mortgage.”
If clients use home equity too early in life, the impact of compounding is even greater.
With life expectancy increasing, clients accessing home equity in their early 70s could see rates compound for 30 years, said Jason Pereira, senior partner and financial planner with Woodgate Financial in Toronto.
He used the example of a reverse mortgage with an interest rate from 7% to 9% that lets a client access up to half of their equity. “I’ve seen this happen: when they first retired they took out 50% of their home equity, and it was compounding over 8% a year at the time. Their nest egg got eaten up pretty quickly.”
How does a HELOC, which typically has a lower interest rate than a reverse mortgage, compare? Say the client is approved for a $650,000 HELOC on their $1-million home, Slater said. The interest rate (at press time) was prime +1 (6.45%) and the client is required to pay interest only on the outstanding balance.
The client needs to draw an extra $1,000 a month to supplement their retirement income. “They would exhaust the HELOC in 23 years, would have drawn approximately $273,000 in capital, and paid about $377,000 in interest over that period.”
Interest rate risk is another consideration when using home equity, Slater cautioned. Using the same example, “if the borrowing rate went up to 7.45%, they would exhaust the HELOC in 21 years, would have drawn about $245,000 in capital, and paid about $395,000 in interest.”
That’s why home equity should only be considered after analyzing all other options, he said. These include working longer, saving more, investing more aggressively, reducing lifestyle expenses or downsizing.
In June, the Office of the Superintendent of Financial Institutions introduced new reverse mortgage rules aimed at reducing the risk for lenders. If borrowers owe more than 65% of the loan-to-value (LTV) ratio on their loan, they will have to pay down the principal before they can borrow more. These rules come into effect in late 2023.
Pereira called the changes “completely immaterial,” and said OSFI would have to set the LTV ratio much lower to make a major difference.
Using home equity responsibly
If home equity is the only option for your client, there are ways to do it right.
Treena Nault, certified financial planner with Nault Group Private Wealth Management in Winnipeg, suggests setting up a HELOC before the client retires.
“When it comes to applying for debt, lenders are going to look at the client’s income,” Nault said. If they have a higher income, they could be approved for more money, she noted. “If we can get that all set up while they’re still employed, we’ve got it in our back pocket for when they are retired.”
Nault said home equity is best used for funding a lump-sum purchase, like a vehicle. And only clients who’ve proven they can stay on budget and pay off debt should use it.
Further, advisors must ensure there is no conflict of interest. Recommending clients use home equity to add assets to their investment portfolio could appear to be more in the advisor’s interest than the client’s.
“Model this in the financial plan and use reasonable assumptions, like the FP Canada guidelines,” Pereira said. “Show on paper how it’s a net benefit to the client using realistic, conservative assumptions. If it’s solely used as an asset preservation vehicle for advisors, that violates the client’s best interest. It will be very easy to prove if there’s ever a case where you’re taken to the tribunal because you don’t have the supporting evidence.”
Nault said advisors should “educate clients on why they might not want to do it.” For instance, model what would happen if interest rates went up.
And consider all options, including withdrawing from their investments instead, she said. “If we sell and the market is down 10%, for example, we’re taking a 10% hit. Does it make more sense to borrow at 4% because that’s costing us a lot less? Or maybe we want to deregister some registered investments, and we haven’t done that yet this year because you’re in a low tax bracket. Well, then maybe it does make sense to take it from the RRSP instead.”
Overall, using any type of home equity to fund retirement should be a last resort.
“It’s a great solution for a problem that should never exist with proper planning,” Pereira said. “It makes sense when you’re close to the finish line, and you’re running short. The further away you are from the finish line, the greater the risk.”