With retirement, it is important to consider how declining cognitive skills associated with aging will make it increasingly difficult to self-manage your investment and withdrawal decisions. For households where one person handles money matters, surviving household members will be especially vulnerable to making mistakes when they outlive the family financial manager. Developing a strong relationship with a trusted financial planner can help with both of these matters.
In a sign that the time had finally come for the idea of coordinated spending from a reverse mortgage, Harold Evensky, Shaun Pfeiffer, and John Salter of Texas Tech University published two articles—beginning with the August 2012 issue of the Journal of Financial Planning—investigating the role of a standby line of credit. They developed conclusions quite similar to the Sacks brothers without knowing of their work.
Maintaining higher fixed costs in retirement increases exposure to sequence risk by requiring a higher withdrawal rate from remaining assets. Drawing from a reverse mortgage has the potential to mitigate this aspect of sequence risk by reducing the need for portfolio withdrawals at inopportune times.
An HECM line of credit provides a tool that can be used to mitigate the impacts of sequence of returns risk. Since 2012, this has been the focus of a series of research articles highlighting how the strategic use of a reverse mortgage can either preserve greater overall legacy wealth for a given spending goal, or can otherwise sustain a higher spending amount for longer in retirement.
I have created a calculator that allows users to get a sense of the principal limit available with an HECM reverse mortgage on their home using the most popular one-month variable rate option. The calculator asks for eight boxed inputs, and uses these inputs to calculate the net principal limit. It also provides the amount of income that could be received as a tenure payment for those seeking this option. An optional ninth input also allows for a term payment amount to be calculated. I will describe tenure and term payments in detail later, but the calculator provides sufficient definitions for now.
One option in the broader category of using reverse mortgages for debt coordination for housing is the HECM for Purchase program, which was started in 2009 as a way to use a reverse mortgage to purchase a new home. The government saw enough people using a more costly and complicated two-step process—first obtaining a traditional mortgage to purchase the home and then using a reverse mortgage to pay off that mortgage—and sought to simplify the process and costs.
After my recent overview of potential uses for a reverse mortgage, I want to go deeper on each item. The first set of options for a reverse mortgage uses the available credit more quickly, either to pay off an existing mortgage or to purchase a new home. With these strategies, it is possible to look at using outside resources to avoid borrowing more than 60% of the initial principal limit during the first year of the loan. Using outside sources could mean the difference between paying a 0.5% initial mortgage insurance premium, and a 2.5% premium. For a $500,000 home, that difference means $10,000 of additional costs for exceeding the limit.
Now that we understand how reverse mortgages work, we can go into greater depth on the potential ways an HECM reverse mortgage can be used within a retirement income plan. For now, I want to focus on the big picture categories.
Repayment of a home equity loan balance may be deferred until the last borrower or non-borrowing spouse has died, moved, or sold the home. Prior to that time, repayments can be made voluntarily at any point to help reduce future interest due and to allow for a larger line of credit to grow for subsequent use. There is no penalty for early repayment.
The discussion of reverse mortgage costs has several moving parts. Which type of cost combination to choose depends on how you plan to use the line of credit during retirement. Let me reveal the punchline for the following discussion: Those seeking to spend the credit quickly will benefit more from a cost package with higher upfront costs and a lower lender’s margin rate. Meanwhile, those seeking to open a line of credit that may go unused for many years could find better opportunities with a package of costs that trades lower upfront costs for a higher lender’s margin rate.
At its most basic, a reverse mortgage is pretty much what it sounds like – the opposite of a traditional mortgage. Instead of turning your money into home equity, you’re turning your home equity into money you can use.