If You're 62 or Older, Your Home Could Be a Source of Tax-Free Cash

For homeowners nearing retirement, the house they already own may offer a helpful source of funds: home equity.

As mortgage payments are made and property values rise, equity can build over time. That value may be accessed through a home equity line of credit, or HELOC, or through a reverse mortgage.

How reverse mortgages and HELOCs work

A HELOC lets you borrow as needed up to a set limit, while reverse mortgage funds can be received as a lump sum, a line of credit, monthly payments, or a combination of those options. For retirees who are short on cash, either option can help preserve 401(k) and IRA withdrawals early in retirement. The most common reverse mortgage, known as a Home Equity Conversion Mortgage, is available only to homeowners who are at least 62 years old.

Money received from a HELOC or reverse mortgage is usually treated as loan proceeds rather than ordinary income.

The Federal Trade Commission says reverse mortgage money is typically tax-free and generally does not affect Social Security or Medicare benefits. It also notes that the loan is usually repaid when you die, sell the home, or move out, either by you, your spouse, your co-borrower, or your estate.

That tax treatment exists because the funds are borrowed, not earned. Interest still applies, though it may be deductible if the money is used for home improvements that qualify. For reverse mortgages, interest is generally deductible only when it is actually paid, which often happens when the loan is settled.

The risks of HELOCs

A HELOC is a revolving credit line backed by your home. You are not required to borrow right away, and you can pay off the balance before maturity. These loans usually include an initial draw period followed by a repayment period if the balance remains outstanding.

HELOCs can be useful for large, one-time costs such as home repairs, but they also come with risks. Falling behind on monthly payments can put the home at risk of foreclosure, and variable rates can raise borrowing costs if interest rates climb. Because of that, HELOCs are generally better suited as a backup source of cash than as a way to support an expensive lifestyle.

Reverse mortgages operate differently. They provide payments drawn from home equity, and borrowers do not have to repay the loan during their lifetime as long as they continue meeting basic obligations such as maintaining the home.

Even so, property taxes and homeowners insurance still must be paid. Interest continues to build, and heirs may be left with little equity if too much of the home's value is used. Many retirees choose reverse mortgages for steady income after retirement, and they can supplement Social Security. But if Social Security already covers living expenses, there may be no reason to rush into a home equity conversion mortgage.

Borrowing against home equity can become expensive because of interest and fees. Rebuilding equity later in retirement can also be difficult without a steady income. In some cases, homeowners exhaust their equity and are eventually forced to downsize.

When using equity can help

HELOCs and reverse mortgages can be dangerous if they support poor spending habits, but they can also serve as emergency sources of funding. HELOCs often carry lower interest rates than many other loans because they are secured by the home.

Reverse mortgages can also act as a safety net for later-life care costs. Still, it may be wise to delay tapping home equity for as long as possible. Using only a small portion of equity while relying more heavily on Social Security can reduce risk and still allow homeowners to benefit from the wealth they have built over the years.