I was riding the Philly commuter train the other day with my friend Anna, age 65. I knew from previous conversations that Anna had purchased a house on the Jersey shore last year and was about to initiate some major renovations.
“You must be so excited to start,” I commented.
“Well, actually, I am nervous.”
She proceeded to explain that the funds required for renovation were increasing quickly. The renovation, which had not yet started, was already more than what she had envisioned when she bought the property.
“What’s the plan?” I asked.
“I have no plan, just a due date for the first large chunk of cash that will be required for the renovation. I have a mortgage on the house at the shore and am thinking of using my investment account to fund the renovation. I was going to have the trades done today to create the cash. What do you think of this idea?”
To my follow-up question, “What else did you consider?” she responded, “I didn’t really think of anything else.”
Options and Opportunities
Many of us have found ourselves needing a significant amount of cash for something. If you have found yourself in this situation, take a step back and consider the options. Start with an overview of your assets and the opportunities to leverage them. For Anna, the options included:
- Whole life insurance: A whole life policy is an insurance policy that you own. It is an asset that you can borrow against. It has a cash value. The money you take out is deducted from the death benefit. There is an interest expense charged on the amount of the loan. Either you pay it out of pocket or it gets added to the amount you borrowed (yes, this means that you are paying an interest on interest).
- Primary residence: Familiar to many, home equity lines of credit (HELOCs) can be taken out against the equity in your home. In today’s low-interest-rate environment, the rate on a HELOC can be under 3%. You can add a HELOC in addition to your current mortgage on the same property or use the HELOC to pay off the first mortgage with money left for renovations on a second home. Lots of options here. Interest expense is tax deductible if you itemize.
- Investment accounts: No paperwork required here. You need only to pick up the phone and authorize the sale of securities. Which ones first? Choose those with the greatest cost and the lowest unrealized gain in order to minimize your capital gains taxes. Capital gains taxes can be 0%, 15% or 20% of the gain on the sale depending on your marginal income tax rate. If you buy for $10,000 and sell for $15,000 two years later, your gain is $5,000. Assuming you are in the top income tax bracket, your taxes on the gain could be $1,000. Add that to the cost of financing the renovation. There is also an opportunity cost: The investments that were sold no longer “work” for you. They are out of your portfolio and can’t earn a rate of return.
Don’t want to sell your investments? You can also take a margin loan on your portfolio, depending on the type of securities and other factors. You can often borrow up to 50% of the value of your stocks, bonds and mutual funds. You do pay an interest expense, which can be deductible in some instances but not all and is likely not in the case of using the proceeds to buy a second home.
- 401(k) account: Always tempting to raid the 401(k). Many 401(k) plans allow for a hardship withdrawal if you meet certain requirements. You will be subject to the 10% penalty if under age 59 ½ and income taxes on the amount withdrawn. You can also take out a loan of up to 50% of the value of the 401(k). You are basically lending yourself money with funds you contributed with an interest expense payable to yourself. If you leave the employer, the loan often becomes immediately due.
The problem with both the loan and the withdrawal is that you are robbing yourself of the earnings and appreciation that the account might have experienced down the road.
In talking through the various options, Anna quickly decided that using her primary home (with no mortgage on it) as collateral for a loan made the most sense. She exited the train and bounded up the stairs to her local bank for a HELOC application.
