In challenging times, homeowners should look at their options to supplement their retirement cash flow needs. Reverse mortgages are offering outside-the-box cash flow options for people that are 62 and older.
Generating retirement cash flow has rarely been as challenging as it is right now, thanks to a combination of market volatility, low-interest rates, disappearing pensions, and an uncertain future for Social Security. You may not be able to rely on conventional retirement funding options.
Despite the popularity of 401(k)s and IRAs, it can be risky to save almost exclusively in tax-deferred retirement accounts. The strategy of putting off paying taxes as long as possible, which seems so appealing in one’s working years, can result in a significant tax burden for retirees, or for the beneficiaries who inherit those accounts.
On the other hand, tools that may have developed a bad reputation in the past, such as reverse mortgages, may deserve a second look. While their history of misuse is well documented, the industry has repositioned itself so that today’s reverse mortgages might be considered an important and sophisticated financial tool for some. The intelligent use of a reverse mortgage, particularly a federally insured home equity conversion mortgage (HECM) line of credit, could extend an individual’s or couple’s retirement resources in a way that more traditional strategies cannot.
What is a Home Equity Conversion Mortgage?
A HECM is a way for homeowners 62 and older to turn a portion of their home’s equity into cash. Borrowers can eliminate their monthly mortgage payments while also gaining access to any additional eligible equity.
Unlike a traditional home mortgage or home equity line of credit, paying off this type of loan while you’re alive is optional. Still, borrowers must continue paying property taxes, along with maintenance, mortgage insurance premiums, and homeowner’s insurance.
The proceeds from a reverse mortgage can be used to pay for unexpected costs in retirement, including the kinds of long-term health care expenses that can cripple a financial plan. But strategic use of a HECM can help with other retirement outcomes, as well.
Using a HECM as a Tool to Help Preserve Residual Net Worth
If you’re nearing retirement, hopefully, your financial adviser has spoken to you about “sequence of returns risk.” It was already a legitimate concern before the coronavirus pandemic and recent market volatility. Now, it is even more important. When the market experiences a downturn early in your retirement, when you’re no longer contributing to your retirement accounts, and you’ve begun to take withdrawals, it can be tough to recover from a major loss. A HECM line of credit can be used as a buffer to help protect against adverse portfolio returns because retirees can carefully coordinate distributions from their portfolio and their HECM line of credit based on their needs and current market conditions.
According to research by Barry and Stephen Sacks published in the Journal of Financial Planning, using home equity to supplement retirement cash flow can have a dramatic impact on a retiree’s residual net worth (defined as the value of the retiree’s portfolio plus the equity in his or her home at the end of a designated period of time). Their research suggested that investors who use an active strategy with a HECM line of credit during the stock market down years could be up to twice as likely to have a higher residual net worth after 30 years.
Using a HECM to Pay for Unexpected Expenses
The use of a HECM line of credit for unexpected (or even planned) purchases or shortfalls in cash flow can be extremely beneficial in retirement — and not just because it can provide much-needed funds. A HECM also can protect against the raiding of other retirement resources when those costs come up.
Another bonus: An HECM line of credit has a clear-cut advantage over the use of a traditional credit line in that it has a guaranteed growth option (the growth applies to unused funds) and a “non-recourse” feature. Unlike traditional home equity loans or lines of credit, a HECM line of credit can never be prematurely closed and collected.
The costs associated with the HECM include mortgage insurance premiums, an origination fee, servicing fees, and third-party charges for items such as appraisals, title checks, and more. In many cases, these fees can be deducted from the proceeds of the HECM loan, reducing the amount of cash available to you. While the cost of setting up a HECM line of credit can be somewhat higher than more traditional tools, for some people, the advantages can outweigh the costs. That’s because unused funds are guaranteed to grow regardless of fluctuations in the economy, mortgage interest rates, or the appreciation/depreciation in an investor’s home value. The earlier homeowners set up a HECM line of credit, the more growth they can expect. Depending on local real estate market appreciation rates, it is possible that growth can outpace the value of the home.
A version of this article can be found on Kiplinger