By John Salter, PhD, CFP®, AIFA®, Associate Professor, Personal Financial Planning, Texas Tech University
Many retirement professionals are concerned about the retirement security of the mid-market. Home equity is the average retiree’s second largest household asset behind their Social Security benefits – not only for the middle mass market, but most of the mass affluent as well – with pension benefits, 401(k)) savings and IRA’s trailing behind.
For the average mid-market American, it’s been long thought that home equity is the last resort, but reverse mortgages may now have a place in mainstream investment and cash management during retirement. As retirement counselors, we need to understand the options for helps retired clients appropriately use their home equity if their economic situation requires it. Please visit the Journal of Financial Planning for a more detailed analysis of this strategy.
This presentation was delivered in live webinar format by John in 2013. John’s comments have been edited for clarity and length. The following is an excerpt from the transcript of the live webinar provided in March, 2013 by John Salter, Ph.D., CFP®, AIFA®, professor at Texas Tech University and Vice President/Wealth Manager for Evensky and Katz Wealth Management in Lubbock, TX.
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The first half of this presentation is about what is a reverse mortgage, what are the benefits, the requirements and so on. Then we will talk about a retirement income strategy we’ve come up with using a reverse mortgage.
What we battle with retirement distributions is making sure retirement funds are going to last a long time. There are a lot of factors that go into evaluating whether that is going to happen or not. Two are most important. First is what is called reverse dollar cost averaging. Probably everybody is familiar with forward dollar cost averaging, meaning if you need to save $1,000 a month, should you save $12,000 at one time or divide it up and save $1,000 a month? There is conflicting research as to whether this works or not, but the consensus is that it doesn’t work in the opposite or when we’re taking retirement distributions.
The other factor is sequence of returns. We think that the recession hurt some people’s ability to meet goals and they will not be able to spend as much going forward. Or is there another way we can get around these problems and improve their chance of meeting goals?
Our general idea was go back to that reverse dollar cost averaging and think of it in terms of shares; it’s easier than in dollars. Assume someone had 1,000 shares of whatever investment, and we have to sell five shares to meet an income goal. If the market drops and the client does not want to decrease the amount of their goal, instead of selling five shares, we might have to sell seven. The problem with that is those two extra shares should have been there 20, 30 years later to fund the overall retirement income goal. We encounter a reverse dollar averaging problem when we’re selling something at a depreciated price and end up having to sell more, because we’re essentially robbing from the future. Is there any way to get around selling when we don’t want to sell?
After we learned about a new reverse mortgage option available is the benefit of using a line of credit. Our idea was rather than sell the portfolio to fund goals, can we not borrow from this line of credit and pay it back when things are “better”?
Reverse Mortgage Defined
What is a reverse mortgage? What probably comes into your mind is A. they’re bad, and B. they’re expensive. That is what I thought too, along with much of the whole financial planning profession. So what changed in October, 2010? The FHA (Federal Housing Authority) came out with a less expensive product called the HECM (Home Equity Conversion Mortgage) Saver program. The original product is the HECM Standard reverse mortgage program. It costs more but you get a higher amount of equity to access. With the newer HECM Saver product, the upfront cost is significantly cheaper in exchange for accessing a smaller benefit. For both products, low interest rates provide a higher benefit.
There are some requirements for being a borrower:
- The youngest borrower on the title has to be 62 or over. There is an issue if you have someone who is 62 and someone who is 58; only one person can be on the title. If something happens to the person on the title, the loan becomes due, meaning it could require you sell the house to pay it off. It is very important you make sure this is thought through if someone is not 62 at the time the reverse mortgage is taken out. The older the youngest borrower is, the higher the benefit.
- You have to continue to pay taxes and insurance over the time. You have to keep up homeowner’s insurance and property taxes or the home loan becomes due.
- You have to maintain the home and maintain its value.
- It is better to have little or no existing mortgage. There are some thoughts I have that don’t require that, but you will see why I say that for this particular research strategy.
- You need to plan to be in the home long-term. I have talked to a few of my planning clients and the conversation about reverse mortgages has gone well. One particular client has a decent chance that they will move in five years. They see the value in having a reverse mortgage, but it might not make sense to incur the cost for them to move in five years.
- It must be a primary home and currently lived in, so it can’t be a vacation home. There are some restrictions; you can be out of the house for no more than a year. It can be a single family property, a HUD approved condo or up to a four unit home.
- There is no credit check required.
- It is the only financial product where it’s mandated that you have to go through counseling in order to close on the reverse mortgage.
- There are different types of benefits, which is intriguing in finding ways to use home equity. There are ten year payments and those that are annuitized for life of the home equity. There are term payments; you can specify, “I want this much,” or “Can I get payments for five years?”
- There is a line of credit, which is what we will talk about in this research strategy later, that basically sets up a line of credit you can use or not use. There is a modified ten year payment which is a combination of ten year payments and modified term.
- There is a value cap of the home, which is $625,500. You can do a reverse mortgage on a million dollar home, but the highest amount you can use in the calculation is $625,500.
- Part of what makes reverse mortgages expensive upfront is that they require the same fees as a traditional mortgage. Appraisal fees, attorney fees, all that good stuff plus an insurance premium that goes through the Federal Housing Authority (FHA). FHA insurance really covers a lot of the benefits of a reverse mortgage. The big cost that went away with the new HECM Saver program is that the standard reverse mortgage has an upfront premium to FHA, and the SAVER program does not.
Benefits of Reverse Mortgages
What are some good things about reverse mortgages? I will lay the groundwork for our Standby Strategy.
- There are no monthly payments required. If times are bad, you don’t have to repay it and there is no repercussion other than accruing an interest debt.
- The proceeds are tax free, much like any other loan.
- The interest is deductible when paid and when itemizing, just like a forward mortgage. The interest paid back is front loaded.
- The benefit type can be changed. I found this interesting. You can start off with a line of credit and keep it for five years, and then decide to switch to a modified tenure. I’ve been told it’s only a $25 administrative fee and you can change the benefit you receive.
- The FHA insured reverse mortgage is federally insured. There are private, reverse mortgages that are not insured, so this is specifically talking about the FHA insured mortgage. It is a non-recourse loan, meaning the homeowner will never own more than the house is worth.
- It cannot be called or cancelled. That’s important because we’re using this product for risk management. During the Great Recession the home equity line of credit for some of our clients was cancelled either from non-use or because home prices had dropped 50 percent. People had to re-qualify on the lower value of the home.
- The unused line of credit grows over time. If you have a $200,000 line of credit and a $100,000 balance, the line of credit actually increases each month as the borrower gets older.
- You can also refinance any terms or product changes or anything else, but like refinancing a house, you incur those costs again.
The Downside of Reverse Mortgages
I had a student help me out search the web for any stories on reverse mortgages; of course there are a lot of negative stories. Many were about either misuse or ill-advised use.
The New York Times had an article about a woman who was going to lose her home because of a reverse mortgage. The problem was that her name had not been put on the title when the reverse mortgage was taken out. I have been told from people in the industry that she would have had three opportunities to know this was a problem. When her husband passed away, there was a $260,000 loan due. The only way she could pay it off was to sell the house and pay off the debt. This had nothing to do with the reverse mortgage; it has to do with ill-advised use of it
Also, there is a stigma of using the home value. People are debt averse; they don’t want to create debt. There are misconceptions that people can lose their home. As in the situation above, the bank is not taking the home; it’s a requirement to sell the house in order to pay that debt off.
Some common issues are:
- Potentially unhappy heirs, meaning children, grandchildren. They might think they’re their inheritance is being robbed.
- Spending control. I was once asked, “How do I keep my client from showing up in a new Mercedes?” That’s a good question, and something you need to understand about you client’s propensity to spend. This is intended to be a risk management tool.
- Full cash out. You can take all the money up front and do what you want with it.
So why not use a home equity line of credit instead of a reverse mortgage?
- A home equity line doesn’t grow in a value. Although it’s not one of the biggest benefits to reverse mortgage, our needs grow over time. If we have goals we want to meet during retirement, inflation causes them to increase and this helps us cover that.
- Reverse mortgages can’t be cancelled. It’s going to be there when we need it and we know it’s going to be there.
- Reverse mortgages don’t require repayment.
The Standby Reverse Mortgage Strategy
Harold Evensky developed an approach 20 years ago that’s basically a two-bucket strategy. We set up a completely separate account that holds cash and funds client’s income needs for two years. Let’s assume that we have a $500,000 portfolio and our client wants to spend $25,000 a year out of that. Fifty thousand dollars would be put into the cash account, and now the investment portfolio is worth $450,000.
We refill the cash account at opportune times when we rebalance the portfolios. If the stock market goes up a lot and we have a targeted 50 percent bond, 50 percent stock portfolio, we are going to sell what did well and buy what is cheap. Rather than just selling what did well and taking all that money to buy what didn’t do well, we will take some of that money and refill that cash account. Also, if we make any other investment changes, we will refill the cash account. The point of this is to bypass transaction charges.
There comes a point in time where the cash account might go to zero because we haven’t rebalanced or made any investment changes. Now we have to sell the portfolio and are faced with the reverse cost dollar averaging problem I mentioned earlier, where we might not want to sell the portfolio.
After learning about the new, cheaper reverse mortgage product, we added in a reverse mortgage line of credit as a third bucket. The only time we borrow from that is the one instance when the cash account goes to zero.
A problem I mentioned earlier is that that we wanted to reduce the missed opportunity cost. Rather than having two years of cash in the cash account, we sought to drop that to six months. The reason for that is we have a liquid, readily available source of cash within that line of credit.
Now we had to define when we wanted to borrow and when we wanted to pay back. We started with returns. If we had loss this year we would borrow. If values went up next year, we would pay it back.
Assume our client is 62 years old; they want to withdraw 5 percent of their portfolio and increase the dollar value by inflation every year. We have a home value of $250,000, a portfolio value of $500,000, a two asset portfolio (60% stocks, 40% bonds) and a Principal Limit Factor (PLF). The PLF is the loan to value ratio that you can get of the line of credit to the home value, but capped at the $625,500. We built and ran a Monte Carlo analysis and we simulated a thousand possible scenarios with either a 13% PLF or a 53% PLF, so 33 percent was the median.
How well does this strategy work? There are three lines on the graph in Figure 1 below, with years of retirement on the horizontal axis and the percent of plans that are able to fund goals on the vertical axis. The strategy was successful for 4, 5, and 6% withdrawal rates, and for multiple home-to-portfolio value combinations. We analyzed combinations of $250k and $500k home with $500k and $1,000k portfolios (see Figures 1 and 2 below).
In sum, the higher the PLF, the higher the available LOC, and the higher the success rates are (see Figure 2). Same relationship applies to home value relative to portfolio size.
A reverse mortgage should absolutely be a tool in our toolbox once we evaluate a situation and determine it is right for you or your client. Here are top tips:
- Make sure you understand everything about the reverse mortgage. It goes back to the story about someone not being on the title; take the time to understand what is going on.
- One of the most powerful things here is having the line of credit as a rainy day fund that can’t be taken away. It’s risk management. Even though it costs money to set up, it opens up a resource or protects against possible risks moving forward.
- Annuitizing the equity in the form of ten year payments is something to really look into; we’re going to do some research on this as well. I am not referring to the benefit compared to immediate annuity. If I turn $100,000 over to an insurance company and my client dies after the first payment, the rest of the money is gone. In the home, if we take $100,000 and annuitize it and the client dies after one payment, they only owe one payment, and the rest of the equity is still there.
- Don’t cash out the money and try to invest it.
- Don’t use it if a short duration is expected in the home.
About the author:
John Salter, PhD, CFP®, AIFA®, is an Associate Professor of personal financial planning at Texas Tech University.
John Salter primarily teaches in the areas of retirement planning and portfolio management and his research interest is in the area of retirement planning and income management.
He is also a vice president and wealth manager at Evensky and Katz Wealth Management in Lubbock, TX.
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©2013, John Salter, PhD, CFP®, AIFA®. All rights reserved. Used with permission.