By PETE WOODRING, RIA, Founding Partner | Cypress Partners
Until recently, the subject of reverse mortgages rarely ever came up in my consultations with clients. When it was discussed, it was the client who brought it up. I’d easily dismiss the idea of a reverse mortgage because it was an expensive form of borrowing and posed unnecessary risk when there were other sources of income. Besides, tapping home equity through a reverse mortgage was always viewed as source of last resort for retirees who had insufficient capital to meet their income needs.
I’ve since reconsidered my bias against reverse mortgages and now view them as a viable tool in the context of a holistic retirement income plan in certain situations. Here’s why:
First, recent rule changes by the Federal Housing Administration (FHA) have reduced borrowing costs and lowered the risk to borrowers. It is still a more expensive form of borrowing, but not prohibitively so.
Second, considering the risks facing all retirees who rely on their own capital as a source of lifetime income—sequence of returns, longevity, inflation—it would be foolish not to consider one of their largest stores of wealth, their home, as part of their retirement income plan, even if it was never needed.
Finally, a significant body of research now shows that responsible use of a reverse mortgage can increase both the sustainable withdrawal rate and the net legacy available for heirs.
Reviewing the Basics
The basic structure of a reverse mortgage allows homeowners over the age of 62 to borrow the equity from their home up to a certain limit based on the borrower’s age, the interest rate and the amount of equity in the home. The amount borrowed, either through a lump sum or monthly payments, is paid back to the lender when the youngest homeowner sells, dies or leaves the property permanently for any reason. The money received is tax-free, and the accrued interest is tax-deductible (up to applicable deduction limit) upon repayment.
The Reverse Mortgage LOC as a Planning Tool
Another way to access the equity is through a reverse mortgage line-of-credit (LOC). As with any LOC, it can be established and accessed anytime funds are needed. Unlike a traditional LOC, the credit limit of a reverse mortgage LOC actually increases each year. The longer it is not used, the more cash becomes available. Adjustable rate mortgage (ARM) loans can be drawn and repaid indefinitely, and any funds repaid can be used in the future and will again have the growth factor applied. For fixed-rate loans, they can be repaid, but no additional funds will be available (closed-end loan). It’s these unique properties of the reverse mortgage LOC that offer retirees more planning options that can help protect their assets and improve their quality of life.
Avoid Sequence of Returns Risk
One of the biggest risks retirees face when converting their capital into income is the sequence of returns. If there is an expectation that a retiree can withdraw a certain percentage of their capital each year without the risk of outliving their income, a prolonged stock market decline early in retirement could require that percentage to be reduced or selling stocks at a loss to make up the difference. With a reverse mortgage LOC, retirees can tap their equity at a cost of 3% to 5% interest, rather than selling stocks at 10% to 30% loss. When stock prices recover, some can be sold to repay the LOC. In this way, a reverse mortgage LOC can be the best tool to use to ensure the sustainability of a retirement portfolio.
Delay Social Security Benefits
For some retirees, delaying Social Security benefits to age 70 is the recommended course if they want to maximize their benefits. Each year benefits are deferred past age 65, the benefit increases 8%. However, if income is needed before age 70, retirees can use their reverse mortgage LOC, which charges a rate of 4% to 5% (and doesn’t have to be repaid), to meet their income needs. If there is money available when Social Security benefits commence, it can be used to replenish the LOC.
Convert to a Roth IRA
For many retirees, receiving taxable income from a 401(k) or a traditional IRA can present problems when it lifts them into a higher tax bracket and subjects a larger portion of their Social Security benefits to taxation. These plans also create potential issues because they are subject to required minimum distributions (RMD) starting at age 70½.
A reverse mortgage can help address both problems. Retirees can use their home equity to convert their 401(k) and traditional IRA plans into a Roth IRA.
When converting to a Roth, the distributions from a 401(k) or traditional IRA become taxable, which must be paid at the time of conversion. The home equity can be used to pay the tax, and from that point forward, any distributions from the Roth are tax-free. In addition, income from a Roth IRA is not included in the Social Security tax calculation. The reverse mortgage LOC would be the preferred option because it can be used only as needed and replenished with any excess cash flow.
Paying for Long Term Care Costs
Long-term care insurance is a great way for retirees to shift risk for potential care costs and preserve assets for heirs, but many shy away because the premiums can be high and increase in the future. The reverse mortgage LOC can be a resourceful way to help pay long-term-care insurance premiums without impacting retirement cash flow. Since the credit line is guaranteed to grow over time, it can offset LTC insurance premiums if they rise. For retirees that choose not to insure or don’t qualify for insurance, the reverse mortgage LOC can be used to directly cover the costs of home care or a spouse’s facility care.
When considered in the context of a holistic retirement income plan, it should be considered with the guidance of an independent financial adviser specializing in retirement income planning.
Woodring is founding partner of San Francisco Bay area Cypress Partners, a fee-only wealth consulting practice that provides personalized, comprehensive services that help retirees and busy professionals to enjoy life free of financial concern.
Craig Slayen, a new partner with Cypress Partners, contributed to this article.
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