A Risk Management Tool for Retirement Distributions
Often reverse mortgages are used as a solution to a financial problem. However, the intended function of reverse mortgages is for long term retirement planning. They can be used as an insurance policy if sorts.
A reverse mortgage provides a significant opportunity to have your home equity contribute to your retirement planning.
Borrowers can keep a reverse mortgage as an option to stabilize their distributions during times when their retirement portfolios are underperforming. As financial planning expert Harold Evensky tells the Journal of Financial Planning in a Q&A:
“When markets recover and get better you pay it off again, so it’s not designed to be a leverage investment strategy; it’s not designed as a credit strategy,” he says in his response. “We see it simply as risk management, “insurance” against a volatile market allowing investors to remain invested through those volatile times”
The article was published in August, 2012 in the Journal of Financial Planning Accounting entitled “Standby Reverse Mortgages: A Risk Management Tool for Retirement Distributions.” The study was conducted by John Salter, Ph.D., CFP®, AIFA®; Shaun Pfeiffer; and Harold Evensky, CFP®, AIF®. The article talks to the value of incorporating a specific type of reverse mortgage – a HECM (Home Equity Conversion Mortgage) Saver — into your financial planning to offset the impact of the future ups and downs in the market on your other retirement assets.
Efficient and Effective
The authors’ state: “Using home equity as a risk management tool in distribution planning may provide retirees with more efficient and effective distribution strategies. As this is a potentially important financial resource that often remains untapped, strategies that incorporate a prudent use of this resource also become important.” Their proposed strategy works by only borrowing from the HECM Saver during bear markets in order to avoid selling assets at depreciated prices, thereby allowing the assets to recover before selling — focusing on the line of credit option of the HECM Saver as a substitute for a source of cash.
Tested in 1,000 simulations
They used their Saver strategy in 1,000 simulations testing its efficacy as a retirement savings strategy, using the credit line against a cash reserve bucket under different withdrawal and debt preference scenarios. “The Saver Reverse Mortgage provides an alternative to refill the cash bucket with no transaction cost, no tax consequences, and possible tax-deductible interest upon repayment. The strategy also allows a reduction in the cash reserve holdings, from as much as 24 months down to 6 months, because of the “standby” source of readily available cash in the reverse mortgage line of credit.”
As the spotlight of the article shines on a specific reverse mortgage product, we should first address its features. The FHA insured HECM (Home Equity Conversion Mortgage) Saver was first made available in October 2010. It is almost identical to a traditional HECM Standard reverse mortgage except for three things: The first is that it has substantially lower up-front costs and secondly it, therefore, provides a lesser percentage of the available equity. The third difference today [as of the writing of the article] is that the HECM Standard is only available in the variable rate option whereas the Saver is currently available in both a variable and fixed rate option — but only the variable rate option provides the benefits that make this a financial planning tool.
Recent changes to the HECM program make it better.
Recently (subsequent to the article referenced) there were significant changes to the HECM program that make it an even better risk management tool. When structured correctly, the upfront costs of the new HECM remain significantly lower than the previous HECM,
HECM updated Benefits
• The HECM variable rate option has some important features: a non-cancelable line of credit, with the borrower in control over when, and if, he or she uses the line of credit. And, very significantly, the line of credit can be paid back at any time without a penalty, or never paid back during their lifetime, as long as they remain in their home as their principal residence. They must, however, maintain the home and pay taxes and insurance.
• The income received from the reverse mortgage is tax-free, and the interest, when paid, may be tax-deductible.
• The FHA-insured HECM 60 is a non-recourse loan—upon sale or death, the repayable debt of the mortgage will not exceed the home value.
• And key to this discussion, and the further expansion, is the fact that the unused line of credit grows in availability to cash over time, independent of the home’s value, at the same effective interest rate that would accrue to an outstanding loan balance.
Why not use a HELOC?
You might be thinking about substituting a Home Equity Line of Credit (HELOC) in this strategy? The authors’ answer was that it didn’t have all the features that made the reverse mortgage so attractive: The HELOC can be frozen and the interest only payment ends in 5 or 10 years, depending on the bank used. Avreverse mortgage is non-cancelable (by always leaving a small amount “owed” in the line); borrower maintains payback control; there is no minimum payment requirement; and once established will not be frozen, reduced or canceled. The HELOC credit amount is established relative to the home’s value and does not automatically increase though the cost of living may increase over time. With the HECM the unused line of credit grows independent of home value, the mortgage may not be cancelled or frozen, and there is the flexibility of payback.
Set up a reverse mortgage and let it grow in cash availability
What about going beyond the concept in this study — imagine broadening this approach beyond a risk management strategy to think of it as the ultimate savings strategy — setting up a reverse mortgage and letting it sit and grow in cash availability over time — until such time as you would want to enhance your cash flow. All the same logic that made this an attractive selection in the research above, are at play in this scenario as well — the difference here is that you are making a decision to use the reverse mortgage as an investment in your future. You might well still select the HECM for all the logic already discussed and simply open your line of credit and sit back and watch it grow.
What would this growth look like? For example, if at age 66 you had a home valued at $1.5 million with no mortgage and simply wanted to establish a line of credit and let it grow for future requirements. Today, the FHA cap on the appraised value of your home is $625,500. Your initial line of credit would be an estimated $325,000 with the HECM . However, at age 71 — without accessing any cash and just letting it grow in availability — it could be an estimated $445,000 – an increase of about 35 percent.*
Building a Future Nest Egg
If you elect to pay your up-front costs out-of-pocket, then zero interest is being accumulated and you are simply building a future nest egg. You might even elect to do this with an existing mortgage — and pay the reverse mortgage at the rate that you were paying down the mortgage — and watching your line of credit grow as the loan balance diminishes.
What might that scenario look like? For example, if at age 66 you had the same home with the FHA appraised value capped at $625,500 but with a $90,000 mortgage and wanted to both establish a line of credit for future requirements and pay down on your existing mortgage with the HECM. At the closing of the HECM, your existing mortgage becomes part of your loan balance and you could simply make payments against it at potentially the same dollar amount you were previously (or another amount of your choosing). Because you have a mortgage balance, your initial line of credit would be an estimated $235,000. In 5 years, with making consistent payments on your loan balance equivalent to your previous payments – and without accessing any cash and just letting the credit line grow in availability – your line of credit could be an estimated $349,000.*
No Payments and Flexible
But, there is no requirement to make loan payments at all as long as you are in compliance with the terms of the reverse mortgage which include payment of your homeowner’s insurance and property taxes during the life of the loan and keeping up with repairs. It can be very flexible to meet your requirements.
These are concepts that deserve your serious consideration
If you are in a home that you see as your primary residence looking out in the future, then these are concepts that deserve your serious consideration. A first step would be a discussion with me to better understand your choices. This is in addition to any other advice you have chosen to seek from your accountant, lawyer, financial planner or children to discuss the reverse mortgage program in general and the concepts suggested in this article.
A reverse mortgage is clearly a significant opportunity to have your home equity contribute to your retirement planning.
This process will assist you in determining if this should be an integral part of your financial plan.
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* The examples of increases in the Line of Credit shown above are in no way a guarantee of performance. They are given only as examples. The performance of any individual Line of Credit is dependent on variables such as the amount of the Line of Credit, the financial market conditions, the individual use of the Line of Credit by the borrower, etc. There is no way to make an accurate prediction about the future available Line of Credit to a borrower.