BOSTON (MarketWatch) — Five short years ago, many learned men and women warned Americans against thinking that rising home prices would eliminate or lessen the need for them to save for retirement. Institutions and advisers alike advised people against relying on the equity in their homes to finance part or even all of their consumption needs in retirement.

Read August 2006 column: Will baby boomers tap home equity to survive retirement? Not necessarily.

Today, that’s no longer the case. In fact, we now have almost the opposite situation. With home prices falling for nearly five years, many Americans must consider what to do with their homes should prices continue to collapse and the equity in their homes — if they are still lucky enough to have any — disappears completely.

Should they stay in place and wait it out? Or should they bail out now and downsize? If they stay in place, should they pay down their mortgage, if they have one? And if they have a home-equity loan, should they refinance that or, if possible, accelerate the payments on that debt?

“As always, the answer to such questions is determined by the age, desires, financial situation and other characteristics of the owners,” said Barney Walsh, a pension- and retirement-planning consultant with Morgan & Walsh.

Others agreed. “The answer is [that] it depends on the individual situation,” said Nicholas Paleveda, an adjunct professor at the graduate tax program at Northeastern University. “If you have plenty of assets for retirement, there may be no reason to downsize. If you do not have sufficient assets for retirement, then selling your home to live in a smaller home may be appropriate.”

And Gene Amromin, a senior financial economist in the financial-markets group at the Federal Reserve Bank of Chicago, said, “It’s hard to give general advice. It all depends on the rest of the financial portfolio and family characteristics of an individual.”

So let’s take a closer look at the options.

Aging in place

In years past, Americans planned to age in place and viewed the equity in their home as the break-in-case-of-emergency asset, the one asset they would use to pay for long-term care or nursing homes. Today, however, aging in place isn’t the option it once was, especially given the possibility that the equity in one’s home might be falling in value, while the cost of keeping a home — real estate taxes, property insurance premiums and utilities — is rising.

“The vast majority of people are looking to age in place,” said Kenn Tacchino, a professor at Widener University as well as the director the New York Life Center for Retirement Income at the American College. Unfortunately, keeping a home a person used to raise his or her family “may not be the most cost-effective or accommodating place for retirement living,” he said.

One option to consider if you plan to age in place is something that was commonplace years ago: multigenerational living. AARP and Pew Research Center recently reported that growth of multigenerational households has accelerated during the economic downturn. In fact, the number of households comprising multiple generations jumped to 7.1 million such households, or 6.1% of all U.S. households in 2010, from 6.2 million intergenerational households, or 5.3% of households, in 2008, according to AARP. By contrast, in 2000, there were 5 million households composed of multiple generations, which represented 4.8% of all households.

In essence, a multigenerational household could be one means of aging in place while reducing the cost of maintaining a home.

Pay down the mortgage?

If you plan to age in place, and you have the assets, and your house is not underwater, Tacchino said a good case can be made for paying down one’s mortgage before retirement. “Retirement-income planning requires that a person establish an income stream that can provide for ‘basic expenses’ throughout a person’s lifetime,” he said. “One way to set the base is to minimize or eliminate monthly expenses like the mortgage. The issue then becomes: Is it more cost effective to, for example, pay down the mortgage or buy an annuity or equivalent product?”

Ultimately, the answer depends on the mortgage’s interest rate, annuity costs, liquidity concerns and any other relevant factors, he said.

For his part, Amromin said it is difficult to think of a scenario in which paying down the mortgage would be advantageous. “Assuming refinancing is an option, current low interest rates should allow for a cheap way of financing the remainder of the mortgage, potentially generate tax deductions, and free up money for alternative investments,” Amromin said.

Meanwhile, the Center for Retirement Research at Boston College published a study in 2009 suggesting that all but a small minority of households are better off paying down their mortgages before entering retirement. In 2007, for instance, an increasing proportion of Americans were entering retirement with a mortgage. In fact, 41% of households aged 60 to 69 had a mortgage that year and, at least at the time, 51% had sufficient assets to pay down their mortgage. “These households could, if they wanted, be mortgage-free simply by selling some of their investments and mailing a check to the lender,” Anthony Webb, the study’s author, wrote at the time.

Why pay down the mortgage? Webb, in his study, suggested that it was unlikely that many retired households would be able to earn a return on risk-free investments such as bank certificates of deposit, Treasury bills and Treasury bonds that would exceed the cost of their mortgage. “Liquidity considerations aside, households holding such assets will generally be better off using them to pay down their mortgage,” he said in the study.

All that said, Webb noted this week that, ultimately, it’s unwise to be dogmatic about paying off the mortgage. “People shouldn’t do this at the cost of forgoing a 401(k) match,” he said. “And they should think about the tax consequences if paying off the mortgage requires them to withdraw money from IRAs and 401(k)s.”

“The truth is that for many people the problem is that they are spending too much, and that the solution is to cut back on consumption so that they can both pay off the mortgage and make adequate 401(k) contributions,” he said. “But people don’t like being told that.”

Now, much has changed since Webb published his study in 2009, which we should note was based on 2007 data. For instance, it’s possible those older Americans with a mortgage no longer have the assets to pay down that loan, or they might not have the income to pay down the mortgage, or their mortgage might be greater than the value of their house.

And that raises this question: Should you be paying down a mortgage on a house that’s underwater, and you’re not sure whether you’ll ever get back to even? “Households have an additional option,” said Webb. “Namely, to mail the keys to the lender.”

What’s the advantage of doing this? According to Webb, the household’s net worth increases if it turns in those keys. But remember this strategy is not cost-free. “In some states, the lender can pursue the former owner, and the household will take a serious hit to its credit score,” said Webb.

If a person chooses not to do this, he or she may still find the options constrained. “Downsizing will require the household to clear part of the mortgage by selling financial assets,” said Webb.

And so the optimal strategy, according to Webb, may well be to attempt to reduce gradually the mortgage balance until the house is no longer underwater, “at which point the household can reconsider its options.”

Downsizing

Aging in place doesn’t have to mean aging in the same house where you raised your children. It could mean — assuming that your house isn’t underwater — selling your home and moving to a smaller home or apartment or condominium unit in the very same community in which you already live.

“Downsizing at the outset of retirement can be a good idea if a person is so inclined,” said Tacchino.

Others agree. “Downsizing should definitely be on the table if the alternative is an unacceptably large drop in nonhousing consumption, or if current spending results in an unacceptably large risk of outliving your wealth,” said Webb.

Downsizing may be an appealing option depending on relative supply conditions, said Amromin. “If the relative decline in prices was greater in the condo market, which is what I am assuming to be the downsized housing option, then selling one’s house at the bottom of the market may be more than offset by the ability to buy a smaller dwelling at a deeper discount,” said Amromin. “This may be particularly true if the retirement destination happens to be in some of the areas with greatest price declines and greatest overbuilding of retirement-type housing — such as Florida or Arizona. This argument would apply whether or not the current house is underwater, only in the latter case the cost of paying off the mortgage should be effectively added to the purchase price of a condo in making a decision.”

For his part, Paleveda noted that the market for homes and condo units can vary quite a bit. “It is clear it is the time to buy in Florida, Arizona and Las Vegas, where home prices are depressed,” he said. “In some markets, such as the state of Washington, prices have fallen but very few bargains are available. Many states, like Ohio, are also depressed, but the ability to bounce back in a Rust Belt [location] must be examined before a purchase is made.”

Yes, downsizing could be an especially good idea if you’re in danger of your house going underwater. In some parts of the country, especially retirement communities that are run as associations, the danger lurks that residents will vote against capital expenditures required for upkeep and the like. A community such as that could face falling home values independent of the local real-estate market.

Still, the question of when to downsize goes beyond timing the market, said Tacchino. “Some believe today’s housing market may be ripe for buying a second or vacation home that will mesh well with retirement needs and then selling the [main] residence when the market recovers.”