Converting Home Equity Into Retirement Income
Posted on April 25, 2008
It’s a sad fact, but many Baby Boomers have lived a “keep-up-with-the Jones” lifestyle and now that they are approaching retirement a growing number of them are finding that the only wealth they have accumulated is the equity in their homes . . . homes that often are larger than what they need in retirement. An increasing number of these Boomers will find themselves short of funds and unable to live the lifestyle to which they have become accustomed. They will start looking for ways they can supplement Social Security or other retirement incomes. The equity in their homes will be one of the few sources they can turn to for additional money.
For these people, the way in which they convert their equity will have an enormous impact on the income stream it can generate. The down real estate market we are experiencing often results in slow sales and sellers having to take deep discounts in order to entice buyers. Although most or all of the profits from a home sale may be tax free, the extremely low interest rates currently being paid for deposits make it difficult to realize much in the way of an income stream. Even $500,000 deposited at today’s low rates produces less than $1,000 per month in interest income.
Sellers needing to convert real estate equity into retirement income will provide wonderful opportunities for long-term investors and often result in win-win situations for them and the buyers. There is a way the goals of both can be met without either feeling they have had to sacrifice to put the deals together. The key is seller financing using direct principal reduction loans. I know, you’re probably thinking, “What is a direct principal reduction loan?”
A direct principal reduction loan is one made with 0 percent interest. The buyer pays off the principal without the seller adding any interest. This may seem like an unusual arrangement, but its one I’ve used for many years. This is not a loan for sellers with mortgages or speculators who want to flip for a quick profit. The advantage for sellers is that they can get a higher price for their property and they don’t have to worry about the buyers refinancing and paying them off if interest rates drop a point or two. There is simply no advantage to paying this type of loan early because it would take the total balance of the remaining payments in order to pay it off.
Granted, this type of financing doesn’t fit the typical model of bank loans that require 20 percent down and a mortgage for the balance. Both the down payment and the length of the loan is a matter to be negotiated between the buyer and seller. Here’s an example of how selling this way can work for both parties.
Assume the seller owns the property free and clear and is asking $100,000 for it. After several months on the market, the best offer has been $80,000. If the seller accepts this low offer and puts the sales proceeds in a bank at today’s interest rate of 2-3 percent, it will only earn about $150 - $200 per month. If the buyer were to fully finance the purchase for 15 years at 6 percent interest, he or she will pay the bank about $675 per month for 180 months. On the other hand, if the buyer planned to keep the property, and financed the purchase using a direct principal reduction loan, the seller might be able to get $121,500 payable at $675 per month for 180 months.
In this example, the buyer gets the property for the same monthly payment he or she would make if it were purchased for $80,000, but the seller would get an income stream 3-4 times as much as the interest he or she could earn on the money in a bank. But most importantly, if the buyer were to sell the property before the loan was fully paid or wanted to pay it off early, he or she would have to pay the total amount of the remaining payments. It’s a way to convert real estate equity into a retirement income that is a win-win proposition for both parties.
Here’s a tip! If you’re a Baby Boomer who will be converting real estate equity into retirement income, don’t limit yourself to conventional thinking. Buyers, especially long-term investors, are more interested in value than price. Value is defined as the combination of what you pay and how you pay it. Since every property is different and every seller is different, conceivably there could be as many different ways to buy and sell properties as there are combinations of properties and people, so don’t limit yourself.
I would offer the same advice to investors, don’t limit yourself to conventional thinking. There are hundreds of ways to buy properties other than putting 20 percent down and financing the balance with a bank. The more equity sellers have, the more options they can offer. Creative financing is a way to negotiate value without beating sellers up on price. Using all seller financing, combining bank and seller financing, combining seller and third party financing, or combining all three can offer a huge array of financing options that can allow you to purchase investment properties that will cash flow.
There will be an expanding range of opportunities as more and more Baby Boomers hit retirement age. My philosophy has always been that deals should be good for both buyers and sellers. Using direct principal reduction loans is a way investors can meet their cash flow needs while allowing sellers to convert their real estate equity into retirement income.
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