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Use Real Estate Equity To Generate Reliable Income For You, Not The Securities Salesman
Key Ideas
- How leveraging equity near retirement is a gain for the salesman and a risk for you.
- Why it doesn't make sense to increase your risk profile at an older age.
A reader asks, “I'm 61 nearing retirement and a lot of financial gurus say I should leverage my rental property equity to buy stocks, real estate, etc., for retirement. Is it a good idea?”
There are two answers to that question – the scientific answer and the realistic answer…
The scientific answer is that you should do whatever provides the highest after tax return net of all fees and expenses.
Science says that if leveraging up provides a higher return then it's theoretically a better choice; however, THERE IS A HUGE DIFFERENCE BETWEEN SCIENTIFIC THEORY AND ACTUAL PRACTICE.
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I'm not a big fan of anyone nearing retirement re-leveraging equity to be reinvested in volatile assets (like stocks) for the following reasons…
- Financial leverage is the only form of leverage that cuts both ways. It makes the good times great, and the bad times unbearable.
- Re-leveraging real estate equity will incur lots of fees and expenses creating an immediate loss. This might be good for the salesman in search of commissions pitching the idea, but it all comes out of your pocket, creating a net negative investment return before you ever get out of the starting gate.
- Increased leverage raises your interest carrying costs and debt to equity ration thus increasing your risk of financial failure because you have less room for error. Your additional investments must provide a compounded (not average) return in excess of interest costs and expenses before ever adding a dime to your pocket. Most people lack the investment skill to reliably achieve that goal.
Actual practice shows there are historical time periods where a high leverage strategy would have worked out well, but there are historical time periods where it would have been a miserable failure.
Whether it works to your advantage or not is completely dependent on future asset returns, which is unknowable.
Related: Why you need a wealth plan, not a financial plan.
The only thing you know for sure is your risk profile and expenses will increase, but you can't know if your future returns will increase as well (no matter how much the salesman pitches you with historical return evidence to support his ideas).
The whole problem with this strategy is two pronged: future returns are unknowable but your interest costs will absolutely increase.
Unless you can forecast expected returns to exceed interest costs reliably and with a strong degree of confidence, then you have no basis for increasing your risk through leverage.
In fact, I'm hard pressed to think of a circ*mstance where I would implement such a strategy in my own portfolio.
It generally doesn't make sense to re-leverage your rental real estate equity and increase your risk profile as you near retirement.
Your retirement objective should be sustainable cash flow in excess of expenses that adjusts for inflation – not maximum wealth. Real estate equity provides the former and leverage is targeted for the latter.
The pitch to apply high leverage strategies primarily exist because salesman are highly motivated to earn double commissions both on the mortgage refinance, and on the reinvestment of the proceeds from the refinance into other assets.
It's a double-down for the salesman… but a high risk play for the retiree.
Others may disagree, but that's my two cents worth.
What do you think? Tell us in the comments section below…
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FAQs
It generally doesn't make sense to re-leverage your rental real estate equity and increase your risk profile as you near retirement. Your retirement objective should be sustainable cash flow in excess of expenses that adjusts for inflation – not maximum wealth.
Should I use home equity in retirement? ›
Home equity can be a significant source of wealth for retirees, often representing a large portion of their net worth. It can be used to supplement retirement income, fund long-term care, or pass wealth to heirs. Retirement planning can be complex, but your home equity shouldn't be overlooked.
Is real estate a good investment for retirement? ›
Rental real estate can be a good source of retirement income. The relative inefficiency of the real estate market can produce bargains that offer strong returns. Do so before you retire if you have to borrow to buy a rental property. Choosing a good location is more important than finding the cheapest property.
Should you use leverage in real estate? ›
While the potential for a good return is possible—like when real estate prices rise—using leverage can be a double-edged sword. That's because it can also lead to losses if the investment moves in the opposite direction.
What are the risks of leverage in real estate? ›
Interest Rate Risk: Most real estate leverage involves borrowing money, often through a mortgage. If interest rates rise, your mortgage payments could increase, impacting your cash flow and potentially making it more difficult to repay the loan.
What is the disadvantage of using home equity? ›
Home Equity Loan Disadvantages
Higher Interest Rate Than a HELOC: Home equity loans tend to have a higher interest rate than home equity lines of credit, so you may pay more interest over the life of the loan. Your Home Will Be Used As Collateral: Failure to make on-time monthly payments will hurt your credit score.
Does real estate equity count as retirement savings? ›
After all, you'll need somewhere to live in retirement. And your family may be depending on you to keep the house. Financial advisors typically don't count house value as part of retirement income.
What is the 4 rule retirement real estate? ›
The 4% rule says people should withdraw 4% of their retirement funds in the first year after retiring and take that dollar amount, adjusted for inflation, every year after. The rule seeks to establish a steady and safe income stream that will meet a retiree's current and future financial needs.
What is the 2% rule in real estate? ›
The 2% rule is a rule of thumb that determines how much rental income a property should theoretically be able to generate. Following the 2% rule, an investor can expect to realize a positive cash flow from a rental property if the monthly rent is at least 2% of the purchase price.
Why you should avoid leverage? ›
Using leverage can result in much higher downside risk, sometimes resulting in losses greater than your initial capital investment. On top of that, brokers and contract traders often charge fees, premiums, and margin rates and require you to maintain a margin account with a specific balance.
The rewards of leverage
Leverage increases the return on equity, improving investors' return on capital invested; investors have fewer funds at risk and their ownership percentages do not get diluted (debt financing does not reduce their control of the entity or profit allocation).
What is the average real estate leverage? ›
Between 70% and 80% of your equity is considered safe leverage. For example, between $70,000 and $80,000 of $100,000 in equity is considered safe to leverage. This is because your property could potentially depreciate and harm your equity.
What is bad about leverage? ›
Key Takeaways
Companies take on debt, known as leverage, in order to fund operations and growth as part of their capital structure. Debt is often favorable to issuing equity capital, but too much debt can increase the risk of default or even bankruptcy.
What is the major disadvantage of leverage? ›
One major disadvantage of leverage is the potential for significant losses. As leverage amplifies the size of a position, even a small decline in the value of an asset can result in substantial losses.
Is there a potential danger of using financial leverage? ›
Risks of leverage
Investing comes with risks, and with leverage, you have to account for paying back borrowed funds. For investors, if you're unable to repay debt or cover losses in the event of a decline in stock prices, you may have to sell securities.
Is a home equity loan a good idea for seniors? ›
Reasons to use home equity in retirement
Tapping your home equity can be a convenient, low-cost way to borrow large sums at favorable interest rates. From medical expenses to tuition bills, there are many reasons that you might decide to use your equity in retirement.
Is it better to retire with or without a mortgage? ›
There may be good reasons to pay off your mortgage. It can save you thousands of dollars in interest, depending on the current size of your debt, and give you peace of mind that no matter what happens in the future, you own your home outright.
When should you take advantage of home equity? ›
Some of the most common (and best) reasons for using home equity include paying for home renovations, consolidating debt and covering emergency or medical bills. Although allowable, it's best to avoid using home equity for discretionary purchases and expenses.
Is it better to pay off house or put money in retirement? ›
A paid-for house provides stability.
It'll help keep your finances steady, no matter how stormy the stock market or economy might be during your retirement. When you pay off your mortgage early, you won't have to spend your retirement worrying about fluctuating interest rates or what the housing market is doing.
