There’s No Place Like Home: Unlocking the Door to Greater Retirement Income
Initially, two figures must be calculated. First, the annual dollar amount retiring clients require to meet their individual needs and goals. Second, the retirement account’s withdrawal rate that allows it to stretch over the client’s projected lifetime. If these two measures don’t match, difficult choices may need to be made.
Financial professionals often structure their advisory strategy similar to a medical doctor’s. Both collect the relevant data, then run diagnostic tests to determine if there’s a significant concern. If the determination is ‘yes’ responsible counter measures (or treatments) are researched, weighed and presented. Physicians offer their best advice and the patient decides on their course of action.
Clients concerned about not having adequate funds will certainly ask about options to increase their retirement income. One income generation tool which has become increasingly prescribed is The Home Equity Conversion Mortgage (HECM) established and regulated by the U.S Department of Housing and Urban Development (HUD). Some private reverse mortgage loans are offered outside of this standard, but these are jumbo reverse mortgages for high value homes. They are not insured by HUD, have higher interest rates and lower loan-to-value ratios.
Many financial professionals and their clients were initially leery of reverse mortgage loans. However, HECMs have matured and become increasingly valid and useful retirement income tools. After accepting industry input, safeguards were instituted in the Reverse Mortgage Stabilization act of 2013.1Costs were dramatically reduced and borrowers and their surviving spouse could only lose their home under very limited situations. Additionally, repayment protocols for loan recipients and their heirs were outlined firmly and with clarity. Subsequent protections include:
October 2013: HUD limited upfront draws to 60% of qualification or 100% of mandatory financial obligations. Now, borrowers cannot “spend it all” at once, the medication became time released. Also, upfront Mortgage Insurance Premiums were lowered for those who stay under the 60% draw amount.
August 2014: HUD ensured that non-borrowing spouses are granted equal deferral provisions. Now, a qualified, non-borrower surviving spouse cannot lose the right to own and occupy their home.
April 2015: HUD instituted mandatory financial assessment. Now, every HECM borrower must demonstrate the ability to continue paying taxes, insurance and maintenance expenses for their expected lifetimes, so that fewer homes are lost due to tax and insurance default.
To answer what is often a client’s first question, accepting this income stream usually does not affect Social Security or Medicare benefits. The IRS qualifies reverse mortgages as loan advances, not earned income, so the payments received are not taxable nor do they affect a client’s Adjusted Gross Income.
Another important fact. A reverse mortgage is a non-recourse loan. This means that the final repayment amount cannot exceed the value of the house.
Reverse mortgage income strategies were previously used as a passive avenue of last resort. However, opening a line of credit earlier in retirement and delaying its use can be actively advantageous. Accepting an HECM credit line during a low interest rate window is key.2 The size of the allowable line of credit hinges on the interest rate. As interest rates rise, the ceiling cap for the loan amount will drop, sometimes substantially, reducing this prescription’s effectiveness. The objective is to release the maximum liquidity stored within one’s home and preplan the use of that unlocked wealth with more efficiency.
The flexible income stream released by an HECM opens up several new income generation strategies. This is where the knowledge and experience of the financial advisor or CPA becomes invaluable. As in chess, understanding how each piece moves and knowing how to set them in their initial stance is the simple part. The skill comes in recognizing how opposing forces are operating and then determining how to best utilize your tools to orchestrate the proper response.
Superior strategies depend on several circumstances. Optimal timing, for example, can fall along a spectrum. In 2012, Drs. Barry and Stephen Sacks presented detailed case studies on this subject in the Journal of Financial Planning3. To synopsize, sometimes approaches that access the credit line early is best. Taking HECM funds early in retirement allows retirees to wait on receiving IRA and Social Security payouts, potentially increasing how much is received. Withdrawing retirement plan funds at the start of retirement can be detrimental as any future gains will be built off substantially smaller capital. An HECM credit line can buffer the savings account from such compounded loss.
In other cases, delaying home equity use for as long as possible will prove better. A significant health issue or any host of blindsides can unexpectedly reduce a well-structured retirement plan to shambles. Drawing from a pre-established line of credit, which has grown predictably over the years, is preferable to entering into a rushed reverse mortgage when rates may be high and home values low.
Randall Buffam, a 10-year veteran loan officer at Arrowhead Capital Mortgage offers a concrete example: “A 70 year old borrower with a $650,000 home could see their line of credit grow from $358,000 to $701,000 in just ten years. This is like equity insurance,” he adds, “because the growth is not dependent on the value of the home. The growth rate of the line of credit will be the same as the interest rate of the loan as a term of the contract.”
These general scenarios merely represent two ends of the spectrum. Savvy advisors often devise coordinated income strategies. Clients have greater financial flexibility if two or more potential income sources are available.
The Sacks’ report outlines this logic. Each year, the investment performance of the retirement account is determined. If the performance was positive, then the next year’s income is withdrawn from that account. When performance is negative, the next year’s income withdrawal comes from the reverse mortgage credit line. The retirement account is spared any additional drain, resulting from withdrawal, during adverse market conditions. This leaves the account’s assets to recover in subsequent up years. Pursuing such active strategies demonstrates that the ‘doctor is in’.
Before concluding, legacy issues must be addressed. Many clients may want to leave their family home to their heirs and they certainly do not wish to lay a financial burden on them. Once the loan does become due, beneficiaries generally have 12 months to pay off the balance. Options include selling off the home or heirs can access other funds to keep the house, perhaps by seeking a traditional mortgage of their own.
Obtaining life insurance on the borrower could be part of a well-coordinated strategy. HECM’s are available to people after they reach the age of 62. That’s still young enough that, precluding deniable heath conditions, securing a policy is realistically within reach. The insurance proceeds, then, could be used to pay off a portion or all of the mortgage balance.
The fact is many Americans will run out of money during retirement. Even middle or upper-middle class retirees can end up cash strapped and become vulnerable later in life. Unlocking the personal wealth stored in one’s primary residence can be lifesaving. Retirees can tap into this cash flow, remain in their home for life and help ensure that the next generation does not lose ground.
*The views and opinions expressed in this artice are that of the author and do not necessarily reflect the opinion of Ed Slott and Company or its team of experts.