In the past, reverse mortgages were often considered loans of last resort, only to be used after a homeowner has exhausted all other financial assets. Today, a national discussion has sprung up discussing how reverse mortgages can be effective when used as part of a coordinated retirement planning strategy. Why now? These loans underwent several major changes for the better, which led the financial planning community to take note.
A reverse mortgage credit line can exceed your home’s value if you get it early enough.
The basics
A reverse mortgage is a loan that allows homeowners to tap into their home equity during retirement. By borrowing against your home equity, you are able to convert your home’s value into tax-free proceeds which you can elect to receive in lump sum upfront, monthly, line of credit, term or tenure payments, or a combination of these payment options. The amount of proceeds a borrower may receive depends on their age, home value and interest rates.
To be eligible you must be at least 62 years old, own your home outright (or have a mortgage balance that can be paid down at closing), and undergo a financial assessment to ensure you have the resources to maintain the terms of the loan.
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“If used efficiently, the strategic use of a reverse mortgage can improve the overall success rate of a retiree’s portfolio.”
Reverse mortgages need only be paid off when the borrower decides to relocate or otherwise vacates the home for an extended period of time, or if he or she passes away. While borrowers don’t make monthly payments to a lender as they would with a traditional mortgage, reverse mortgage borrowers are required to pay property taxes and homeowner’s insurance associated with their property. Failure to do so triggers the loan to become due and payable.
If used efficiently, the strategic use of a reverse mortgage can improve the overall success rate of a retiree’s portfolio over the course of a lengthy retirement, according to a research paper published by Wade D. Pfau, a financial planner and director of retirement research at McLean Asset Management in McLean, Virginia, and professor of retirement income at The American College in Bryn Mawr, Pennsylvania.
Pfau’s research demonstrates that retirees can leverage reverse mortgages to successfully use home equity in a retirement income planning strategy. He published a paper detailing the various ways reverse mortgages can improve the spending power of a retiree’s securities portfolio, when used as part of a coordinated strategy with assets like an IRA or 401(k) plan.
“Even for wealthier clients, home equity…should not automatically be lumped into a limiting category of last resort options once all else has failed.”
“For most Americans, home equity and Social Security benefits represent the two biggest assets on the household balance sheet, frequently dwarfing the available amount of financial assets,” writes Pfau in his paper. “Even for wealthier clients, home equity is still a significant asset which should not automatically be lumped into a limiting category of last resort options once all else has failed.”
In fact, using a reverse mortgage earlier in retirement has been proven to significantly improve the success rate of a person’s retirement portfolio. And more financial planners have taken notice of this particular strategy, which can be used to buffer assets when the investment portfolio suffers negative returns.
A buffer for bad investment returns
The line of credit feature payment option a reverse mortgage offers presents a unique strategy for retirement income planning. With a reverse mortgage line of credit, you can choose not to spend home equity initially, instead allowing the credit line to grow over time, which you can then tap as needed.
“A number of strategies involve opening a line of credit and then leaving it to grow at a variable interest rate as an available asset from which to draw to cover a variety of contingencies later in retirement,” Pfau finds.
When used in retirement income planning, research has shown how a reverse mortgage line of credit can serve as a “buffer asset” to mitigate down years where your investment portfolio suffers negative returns. This is also known to financial planners as “buffering against sequence of returns risk.”
In situations where a portfolio experiences negative returns, rather than simply having to decrease spending as a way to insure against the losses, a reverse mortgage credit line can provide an additional source of much-needed funding.
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“Overall spending does not necessarily have to decrease if part of the spending goal can instead be covered through an alternative buffer asset,” Pfau writes. “This is where the reverse mortgage fits into the puzzle. Reducing portfolio draws when markets are down by sourcing that spending from elsewhere is another effective method for mitigating sequence risk.”
Taking a reverse mortgage at the beginning of retirement and letting the line of credit grow, untouched, tapping it only after the investment portfolio has been depleted, drastically improves the chances of not completely running out of money during retirement. This is true even if a person’s retirement were to last a lengthy 40 years.
Improving portfolio success by acting now rather than later
A popular theory in retirement planning is known as ‘The 4% Rule’, which determines the spending success of a person’s investment portfolio over the course of a 30-year retirement. In other words, you withdraw 4% of your assets the first year and an inflation-adjusted amount every year after that. By doing so, a retirement portfolio that is 50-75% stocks could be sustained for 30 years.
But let’s say, for example, a person has a portfolio that’s an even-split asset allocation of 50% stocks and 50% bonds. That same person has a home worth $500,000 and their investment portfolio is valued at $1 million. Let’s also assume a 25% marginal tax rate.
Abiding by the 4% Rule, that portfolio has a whopping 100% chance of success to sustain the retiree over a 20 year retirement if the retiree had taken out a reverse mortgage credit line at the start of retirement and only tapped into it once the portfolio was depleted, this according to Pfau’s research modelling.
If retirement stretches to 30 years, the portfolio’s chances of success are still high at 90%; at 35 years, 80%. Even at 40 years, the probability of success is still relatively high at 75%.
“Especially when interest rates are low, the line of credit will almost always be larger by the time it is needed when it is opened early and allowed to grow…”
Given these high success rates, it becomes clear that taking a proactive approach getting a reverse mortgage at the onset of retirement is critical, rather than relying on past conventional wisdom that you should get a reverse mortgage later and only after you’ve run out of other options.
“The strategy which uses home equity as a last resort, but which opens a line of credit at the start of retirement in order to let the line of credit grow before being tapped, provides the highest increase in success rates,” Pfau writes. “Especially when interest rates are low, the line of credit will almost always be larger by the time it is needed when it is opened early and allowed to grow, than when it is opened later.”
Reverse mortgages are non-recourse loans. This means that neither you nor your heirs will be responsible for paying more than the value of your home at the time you or your heirs pay off the reverse mortgage. This is true even if the loan balance grows over time and were to exceed your home’s value.
Of real interest, this non-recourse provision can benefit retirees who opt for the line of credit feature, because the credit line grows over time and can potentially surpass the home’s value before it is even accessed.
“This strategy allows the line of credit to grow longer, perhaps surpassing the home’s value before it is used, which provides a bigger base to continue retirement spending after the portfolio is depleted,” Pfau writes. “Frequently, this line of credit growth opportunity serves a stronger role than the benefits from mitigating sequence risk through the use of coordinated strategies.”
If you think getting a reverse mortgage sooner rather than later might benefit you, or you would like to know more about other reverse mortgages strategies, let us connect you with a reverse mortgage professional today.
