Home equity loan when retired?

Q - Being retired and finally paying off our house, we now need a new $15,000 roof. I'm hesitant to use our home equity line of credit, but I'm not sure I want to take another $15,000 out of my 401(k). What's the best approach to pay for the roof?

A - First, you started with the right action, thinking about options. But what are the options?  Well, there's emergency savings, non-retirement investments, retirement savings (IRA, 401(k), Roth, etc.), credit card, installment loan by contractor (90 days Same as Cash or 6-mo No Interest), and home equity line of credit. Some options may be easier for you than others based on balances or credit limits, but there is one impact retirees need to consider: taxes.

If you have a retirement budget, you have either already planned for major house maintenance, forgotten to include that, or had something happen that was unexpected, maybe storm damage not covered by insurance. For this question, I'll assume it was an unplanned expense, and you now have to find a way to pay for the roof. As you consider each option, think about the opportunity cost. For example, $15,000 taken from your non-retirement investments results in an opportunity cost of $750 per year in lost interest or dividends, assuming a 5% yield. If you replenish the account over three years, maybe the total is essentially a $1,500 loss of the interest you would have received. Now consider the home equity loan. Assuming the interest rate today is 7.5%, if you borrow $15,000, then make payments of $500 a month, you'll pay the loan off in 3 years, for a total interest cost of $1,842. So, it's only a few hundred dollars more to use a home equity line of credit vs. depleting savings. Of course, you now have to come up with $500 a month.

Next, consider the option of taking the $15,000 out of a tax-deferred retirement account. If you're in the 24% tax bracket and subject to a few percent of state income tax, it might cost you $4,500 in taxes. Plus, the loss of the re-invested "income" of $750 per year, thus it turns out that this option is even more expensive than using a credit card! Now you can see why what appears to be a reasonable financial decision - taking money out of retirement savings vs. borrowing it - can actually be the worst option.

I believe the more ideal option is to combine pre-allocated savings with the home equity loan, if possible. What do I mean by "pre-allocated"? You should already have a line in your retirement budget for home maintenance, say $300 per month. If there's no maintenance, then it's saved, not spent. In the future, when presented with the bill for the $15,000 roof, you would then pay for one-quarter to one-half from that savings, the rest from the home equity loan @7.5%. Next, instead of saving $300 per month for maintenance, you drop it to $150 a month, using the other $150 to increase the home equity payment to $300 a month, paying it off in 3 to 4 years. Of course, you can adjust the numbers and percentages to what makes sense but the idea is to (a) not withdraw more from retirement savings and increase taxes, (b) utilize prior savings earmarked for home maintenance, and (c) use the lowest interest loan, which is likely the home equity loan. Finally, as I always do, consider the risk with your decision. Yes, the home equity loan is reducing your equity, but that equity is just sitting there, not being productive. Reducing your savings by a lot increases risk when the next unplanned expense comes along, because you have less cushion, limiting your options.

Note that I didn't consider emergency savings in the options for the roof. Of course, if you had $100,000 in emergency savings, sure, use those funds, but replenish as noted. But many people have much smaller emergency savings, and home maintenance should be saved for separately, leaving the emergency savings alone. In summary, consider options, evaluate cost and risk, and if not already budgeting for maintenance, make sure enough is going into savings once retired to pay for the inevitable.