Home equity loans for early retirees

[sol]

If you follow the general advice presented on this forum, one of the biggest obstacles to your early retirement is going to be accumulating enough money in taxable accounts to live off for the first five years after you retire, while your Roth IRA conversion pipeline "seasons" until it can be withdrawn without taxes or penalties.

For most people, that five year span will be covered by some combination of Roth IRA principal contributions, which can be withdrawn without penalty at any time, and savings in a taxable investment account.  But I've been thinking about alternative means of funding your expenses for those five years.  Like taking out a home equity loan or line of credit.

Stay with me here, because I know it sounds crazy. 

If you expect to need $40k/year and you have $1million saved up split between $900k in your 401k and $100k in your taxable account, then your taxable account will only cover 2.5 years of your first five years (because 100k/40k is 2.5).  But if you also have 50% equity in a home worth $400k, you could potentially tap that home equity to help pay for the other 2.5 years. 

In this example, you could borrow down to 80% combined LTV, or another $120k out of your $200k of equity, at rates comparable to a 30 year mortgage.  When your first Roth pipeline payments comes in five years later, you could start paying off the loan, effectively using your 401k to also cover those first five years of expenses (plus the accumulated interest).

Whether or not this idea makes sense for you would depend on the interest rate you can get, how the HELOC is amortized, how much you would need to borrow, and what you think the stock market is going to do over the next five years.  It really only makes sense if the market does better than your HELOC interest rate over a five year time period, which means you can potentially get royally hosed if the market tanks.

I'd be interested to hear the opinions of some of our more math savvy members (looking at you, madfientist and friends) on this idea.  For example, I don't know if a HELOC counts as income for ACA or EITC reasons, or if interest is also tax deductible, potentially lowering the tax rate on your Roth conversions now and thus letting you convert more in the lowest brackets to help cover the eventual loan repayment. 

Generally speaking, the math usually favors investing over prepaying your mortgage and this just seems like a natural extension of that idea, that also happens to help out an early retiree with a five year gap problem.

[Cheddar Stacker]

Cash from a HELOC is not income and should not effect ACA or EIC.

Interest paid on a HELOC is tax deductible(ish). There are limits. Off the top, $100k in home equity is the max deductible.

[arebelspy]

Having it available in case of a market crash would be an awesome way to temper the sequence of return risk.

Pay 5% or so on the money, rather than sell at a loss of 20-50%.

Might be a way to go even more aggressive with your investments (a higher stock percentage).

Assuming it's stable and you can rely on it. Though even in a worst case, you sell what you would have anyways.

Interest paid for living expenses would not be deductible, I believe.  Only if it's used in certain ways (to buy another home, for example, or repair yours).

[brooklynguy]

The reason the math often favors investing over prepaying your mortgage is a unique combination of attributes of typical mortgages in the US:  (i) they have low interest rates; (ii) they have fixed interest rates; and (ii) they have a long weighted average life to maturity.  The closer the loan gets to matching these characteristics, the better your plan will be (and you are more likely to do it with a home equity loan than with a HELOC).

If the success of the plan is contingent on the stock market's performance over a five year period, I don't think it's a good plan.  If the plan only requires the market to outperform the loan over a 15+ year period, though, is a very different story.

[benjenn]

Someone suggested to us recently that we should get a Home equity line of credit (HELOC) prior to leaving our high-paying jobs just to know we have a large amount available should we find we need it.  We plan to have our condo paid off in July 2015 and retire the end of 2015.  Even now we have over $250K in equity.  Makes sense to me... and I'll just hope we never have to use it.

[DoubleDown]

Having it available in case of a market crash would be an awesome way to temper the sequence of return risk.

That's how I see it too. I'd be concerned about funding 2.5 years of living expenses from a HELOC as a planned, long term withdrawal strategy, because then you'd lose that potential safety margin if the sh*t hits the fan. And of course you'd have to make minimum payments the whole time while accruing interest. Five years of withdrawals would result in a large balance with hefty interest.

I'd definitely aim instead for directing more investments towards taxable accounts pre-retirement, or starting Roth conversions now (and paying taxes on it). Even if you had to do it at the expense of (sub-optimally) contributing less to tax-advantaged accounts, I think it's pretty important to have enough cash buffer to cover those gap years. And that would be worst-case because, come on, this is MMM -- you can max out 401k/IRAs and invest in taxable accounts.

Personally, my limit would be maybe one year living off a HELOC as a planned strategy, and that would be the max. As Arebelspy would say, YMMV.