Using home equity to generate cash flow - Akler Browning LLP

For the past two years, Canadians have had to continually adjust their household budgets to accommodate price increases for nearly all goods and services. The impact of rising prices is felt most by those who are living on a fixed income and who, of necessity, spend a larger than average share of their income on non-discretionary expenditures like housing and food. And, while such individuals and families can be found in all age groups, retirees make up the largest Canadian demographic who live on such fixed incomes.

For many Canadian retirees, benefits received from the Canada Pension Plan (CPP) and Old Age Security (OAS) make up a significant portion of their annual income. And while such benefit amounts are indexed to inflation, those inflationary increases in benefits are tied to the overall rate of inflation. For the past two years, however, the cost of non-discretionary goods and services – especially housing and food – has risen much faster than the general rate of inflation. Consequently, such increases have outstripped the amount by which CPP and OAS benefits have been increased to account for inflation. Price increases in the cost of food purchased from stores were, in fact, higher than the overall rate of inflation in every month between December 2021 and November 2023 – in some months, nearly three times the overall inflation rate.

It must seem to Canadian retirees that there just aren’t many good options when it comes to generating the cash flow needed to cover ever-increasing costs for non-discretionary expenditures. Fortunately, however, the roughly 75% of Canadians over the age of 60 who own their own homes (based on Statistics Canada’s figures for 2021) do have options. Canadians who are now of retirement age and own their homes most likely purchased those homes many years, or even decades, ago and have, consequently, built up significant equity. In the current economic circumstances, that equity has made them house-rich and cash-poor. And that equity can now provide an ongoing source of retirement income – through a home equity line of credit or a reverse mortgage.

The home equity line of credit (or HELOC), as the name implies, is a line of credit which permits the homeowner to borrow up to a pre-set limit based on the current market value of their home. Such borrowings can be in any amount (up to, of course, the limit on the HELOC) and can be made at any time and for any purpose. Typically, the interest rate charged on a HELOC is a variable rate – usually one half or one per cent more than the prime rate used by the lender. There is, however, a significant feature of the HELOC of which potential borrowers must be aware. While there is generally no obligation to repay amounts borrowed from a HELOC until either the death of the homeowner or until the house is sold, borrowers are required to pay interest each month on the total amount borrowed.

Take, for example, a couple who own a house currently valued at $750,000. Assume that the couple obtain a HELOC based on that home value and borrow $1,000 each month ($12,000 annually) from the HELOC to help meet current cash flow shortfalls. At an interest rate of 8.70%, they will be obliged to make an interest payment of approximately $87 per month on that $12,000 borrowing. As the amount of HELOC indebtedness increases over time, or the interest rate charged goes up, the amount of those required monthly interest payment obligations will, of course, also increase.

The other option open to homeowners to provide cash flow is a reverse mortgage. Like the HELOC, a reverse mortgage allows homeowners to borrow based on the market value of their property. A reverse mortgage is also similar to a HELOC in that borrowers can borrow a lump sum amount, or can opt to structure the reverse mortgage as a series of payments which will provide a regular income stream, or some combination of the two. And, as with a HELOC, no repayment of the funds advanced under a reverse mortgage is required until the death of the homeowner, or until they leave or sell the home.

The basic advantage of a reverse mortgage over a HELOC is that no payments of interest are required under a reverse mortgage. However, homeowners need to consider the impact that advantage can have over time. Once the reverse mortgage is taken out, interest will, of course, be levied on all amounts provided, and will accumulate from the time the funds are first advanced. Total interest costs can add up very quickly and reach significant amounts by the time the debt is eventually to be repaid, usually out of the proceeds from the sale of the house. And, of course, every dollar of funds advanced and interest levied eats away at the amount of equity which the homeowner has built up, on a dollar-for-dollar basis. By contrast, with a HELOC, where accrued interest charges must be paid monthly, the amount of debt (and consequent reduction in equity) will never be greater than the principal amount borrowed. Finally, under the terms of many reverse mortgages, a prepayment penalty is levied where the homeowner moves or sells the house within a few years of obtaining the reverse mortgage – the exact time frame will depend on terms provided by the particular lender. With a HELOC, however, repayment of the outstanding balance can be made in part or in full at any time, without penalty.

As is almost always the case with financial issues, there is no one right answer or even a one-size-fits-all answer, as the “correct” answer is always based on the particular financial and life circumstances of the individuals involved. Some help with making a decision on whether a HELOC or a reverse mortgage makes sense in one’s circumstances can be found on the website of the Financial Consumer Agency of Canada at https://www.canada.ca/en/financial-consumer-agency/services/mortgages/borrow-home-equity.html, where the benefits and downsides of each option are outlined in detail.