Avoiding a Common Retirement Pitfall: The Paper Tiger

Is your home an asset? The average American will answer yes. But how do you define the word asset? Renowned author and businessman Robert Kiyosaki says, “An asset puts money in your pocket, and a liability takes money out of your pocket.” As a business owner, Kiyosaki is evaluating a specific entity in terms of income generation. By this definition, most primary residences are liabilities. Even if you no longer have a mortgage, you are still required to pay taxes, insurance, utilities, and maintenance costs – all are expenses.

An asset puts money in your pocket, and a liability takes money out of your pocket.

Robert Kiyosaki

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Author of Rich Dad, Poor Dad

Another way to evaluate an asset is through the lens of net worth, or a tool that is useful. Consider a family balance sheet which may list a home valued at $500k in the asset column. If that family has a mortgage with a principal balance of $300k, that loan would be listed under liabilities. This scenario would leave that family with a positive net worth of $200k in equity - the difference between the home’s value and the lien against it.

When someone refers to their home as an asset, they are probably counting their equity position in their net worth. While this may be technically true from an accounting perspective, there is one glaring issue: Liquidity.

Liquidity refers to your ability to access cash. Equity looks good on the balance sheet, but you can’t spend it. The definition of a paper tiger is something or someone that appears to be powerful but is ineffectual and unable to withstand challenge. If a large portion of your net worth is represented by equity in real estate AND that real estate is not generating positive cash flow, then your balance sheet might be a paper tiger. No liquidity, no cash.

Liquidity gives you flexibility. It allows you to withstand unforeseen financial circumstances, capitalize on opportunity, and live a life with less financial stress because you have access to money. The risks associated with low liquidity become amplified in retirement because both income and risk tolerance typically decrease.

Today, over half of Baby Boomers have over half of their net worth stored in equity in their primary residence. Most of them are understandably proud to call their home an asset because it is likely worth hundreds of thousands of dollars. But if they have no access to that money, low liquidity is a serious risk they will face in retirement.

In the interest of academic integrity, I believe you must either proactively account for the use of home equity in retirement OR plan as though the money stored in your primary residence does not exist. I want seniors in this country to retire with dignity. In part, that means having freedom of opportunity and choice – a difficult task with limited cash.

If we erase home equity from your balance sheet, what happens to your net worth? Did it drop by 30 percent? 40 percent? If your net worth is less than $10 million, it probably went down by at least a quarter. For most Americans, it would be cut in half! Can you comfortably sustain a retirement for 25 – 35 years with this new number as your starting point?

If you are interested in learning more about why incorporating home equity into retirement planning is so important, read this article for more information. Here are a few highlights:

• Dollars are a standard unit of measure, so it is not logical to value home equity dollars more than dollars in other accounts.
• Having access to equity does not require you spend the money; it just gives you the ability to spend the money if necessary or prudent.
• It is a strategic error for most Americans to neglect their largest bucket of money when entering the uncertainty of retirement.

So, how do we mitigate low liquidity? There are only two ways to convert equity into cash: a cash-out refinance or selling the home. From my experience, there are three primary reasons seniors in retirement are hesitant to utilize a cash out refinance.

1. Most people believe a mortgage on their home means the bank owns the property (which is not the case).
2. Cash out refinances typically incur a monthly mortgage payment.
3. Many retirees want to maximize their legacy to their children, and view spending equity as detrimental to that goal.

Enter the Home Equity Conversion Mortgage (HECM). The HECM is a special type of cash out refinance, insured by the Federal Housing Administration (FHA), designed for Americans 62 or older. Its most common form is a line of credit which simply gives you access to your money stored in your home. The line of credit is insured so it cannot be canceled at the whims of the bank, and it grows overtime, giving you access to more money as you age.

As for the three objections, the HECM has an answer for each.

1. The HECM is simply a lien against the property – you never lose ownership of the home. You are not selling the house to the bank, and you are still able to pass the house on to your heirs if desired.
2. This product does not have a required principal and interest payment. Managing cash flow is one of the most important aspects of retirement planning, so having the ability to access cash without incurring a large payment is extremely valuable.
3. A HECM cannot be analyzed in a vacuum. Yes, if a draw is made, equity is being spent. However, there are numerous academic studies which demonstrate that appropriate use of a HECM line of credit frequently allows for a larger inheritance because it is used to manage cash flow, preserve other retirement accounts, and pay less taxes. Additionally, you can make optional payments anytime to restore the line of credit and over time, the home also continues to appreciate in value. Typically, home appreciation far outpaces the interest accrual for several years, if not the entire lifespan of the loan.

A retiree who has most of their net worth stored in equity can use a HECM to mitigate the risk of having minimal assets in retirement.

A retiree who has a solid plan but would like more margin against risk can utilize a HECM as an emergency fund. If there is never an emergency, then they spend no equity.

A very affluent retiree can use a HECM for more advanced applications such as Roth conversions, mitigating sequence of returns risk, or paying for home improvements to acquire acquisition indebtedness (a potential tax write-off).

Regardless of the situation, it is highly probable a Home Equity Conversion Mortgage will help you have a more successful retirement because people with more options outperform people with less options. Increasing liquidity makes your retirement plan much more formidable.

Tens of thousands of retirees every year are grasping the benefits of this product and are now choosing to utilize all their assets. Those who do not, are neglecting one of the most powerful retirement tools available to them. Which one will you be? Don’t be a paper tiger.