Should Wealthy Folks Consider Reverse Mortgages?
Should wealthy folks consider a reverse mortgage? Yes!
While reverse mortgages have bad reputations, they are not fundamentally flawed products. Certain academics in Retirement Income Planning actively encourage these products, and interest is growing among financial advisors and the public in general.
For lower or average net worth folks, more often than not a reverse mortgage can be quite useful. After all, do the kids really want your house? Really?
What about for wealthy folks? Should they consider a reverse mortgage preemptively?
And that is the key. Instead of as a backup plan if everything goes wrong, you need to consider your home as an asset and spend down that asset when the time is right!
What are the pros and cons of a proactive reverse mortgage that is part of the overall retirement income strategy?
Let’s look at reverse mortgages and see how they can provide downside protection and risk mitigation even for wealthy folks. AND you may leave your heirs more money with a reverse mortgage than without. Ready?
Questions about Reverse Mortgages for the Wealthy
If you have an existing mortgage headed into retirement, pay it off! In fact, you can use a reverse mortgage to pay it off as well. That’s right, if you are 62 or older and still making mortgage payments, you might consider a reverse mortgage to pay off the debt.
Given low interest rates, more wealthy folks consider keeping their home mortgaged during retirement, but there are other options.
What if you have a goal of leaving a large legacy to your children. If they don’t want the house, what is the effect of a reverse mortgage on your total assets?
Usually when reverse mortgages are considered, they are “a last resort.” Or at least plan B or C.
Are there times where a reverse mortgage can help protect or even grow the nest egg? Are there advantages of opening one early and letting the credit line grow?
Remember, your home is just another asset. When is the ideal time to spend down that asset in your retirement plan?
First, what is a reverse mortgage? Let’s get specific and talk about a HECM.
What is a HECM?
Home Equity Conversion Mortgages (HECMs) are becoming more popular as the stigma from early abuses of reverse mortgages fade.
These are FHA loans (which are, almost without exception, more expensive than non-FHA loans) with mortgage insurance as part of the deal. The loans are non-recourse, which means even if you own more than the value of your home, you are not held responsible for the difference. In addition, you retain the title to the home and homeowners cannot be evicted as long as they keep up the property and pay insurance and taxes.
To quality for a HECM you must be at least 62 and live in the home. You can borrow about 40-60% of the home’s value, up to about $726k. This can be a lump sum (and pay off existing mortgages), monthly, or as a line of credit. The line of credit is of interest in most cases for the wealthy. This line of credit grows larger over time at the same rate as the interest rate on the mortgage. A credit line that grows and may actually, though infrequently, become larger than the asset itself.
Reasons to get a HECM
Access to equity in the home, no need to pay back while mortgage active
Stay in home as long as you want or are able
Flexible, tax-free “payments” (return of equity) which can be lump sum, monthly, or as a line of credit
Line of credit grows over time
Use to pay off traditional mortgage
The older you are, the more you can borrow
The earlier you open, the higher the credit line grows
Any equity left over is yours (or your heirs)
Low interest rate environment makes particularly interesting
As an insurance policy for Sequence of Return Risk, or unexpected cash needs
As an income or longevity play
Tax planning opportunity if you decide to pay back the interest
Drawbacks of a HECM
Closing costs are not inexpensive (FHA loan)
Stigma for use due to past (and occasional current) abuses
Must be over 62, spousal or family issues (though they won’t be evicted if on the mortgage)
Can lose home if you stop paying taxes or insurance, neglect the property, or move out
Complicated, need to complete financial counseling to acquire
Exit strategy for heirs can be complicated (though they may be able to take advantage of accrued interest as a deduction)
What about a HELOC?
Home equity lines of credit (HELOC) can be set up in the years prior to retirement while you still have an income. The nice thing about a HELOC is that there are minimal costs to open. You can establish the line of credit and use it if needed for income. HELOCs, of course, are not intended to be permanent lines of credit and must be paid back. In addition, they often have a variable interest rate rather than fixed, and are cancelable. In 2008, apparently many folks had their lines of credit closed just when they were most needed. HELOCs are an interesting consideration for some wealthy folks who are looking for a Bridge Asset to delay social security claiming but not a definitive solution.
Back to HECMs.
An Example of a Reverse Mortgage for the Wealthy
Let’s now look at a HECM for a 65-year old wealthy couple with a $3M nest egg. They have a mortgage-free $1M home, a $1M brokerage account, and $1M IRA.
They plan to use social security plus a 5% withdrawal rate on their $2M portfolio for income. What happens without a reverse mortgage, and let’s compare that to a reverse mortgage with a line of credit or a monthly income (tenure payment).
The reverse mortgage is simulated here. On their $1M home, they can access $679,650. Closing costs are $22,093 and are financed in the loan.
Their net available credit is just under $275k. They can take this as a $1,466 monthly payment (payout rate is 5.92%) or as a term payment ($99k yearly payout for three years).
Results of the Simulation
In our baseline scenario for 30 years—without a reverse mortgage—the Monte Carlo odds of success are 60%.
Using a HECM for 3 yearly payments of $99k, Monte Carlo odds increase to 77%.
Finally, monthly tenure payments of $1,466 from a reverse mortgage increase the odds to 81%.
This makes sense, as Monte Carlo odds are the chance of success over multiple random market returns. In the baseline case, the home equity is not accessed at all, leading to low odds of success.
Let’s visualize the success of the portfolio in the above circumstance.
Portfolio Value and Success Rates
Figure 2 shows confidence levels of assets lasting 30 years with our baseline scenario on top, and monthly income from a HECM on the bottom. As you can see, as expected, accessing the home for income improves median and confidence level rates.
Specifically, looking at the 5th percentile, you run out of money on the top at 84 but not until 89 on the bottom. Similarly, with the 25th percentile, you run out of money at 90 on the top but at 96 on the bottom.
Thus, accessing the equity in a home can improve the portfolio survival over time compared to leaving it as a last resort.
Let’s look at the ability of a HECM to mitigate Sequence of Return Risk.
How does a Reverse Mortgage work as a Buffer Asset to Prevent Sequence of Returns Risk?
Now things get interesting. For this scenario, actual market returns from 2000-2010 are used to model Sequence of Return Risk.
On top, we see the baseline scenario with sequence of return risk. You can see the portfolio balance starts at $2M and is down to $1.5M after taking a beating the first decade. The assets expire at age 91 (27 years after retirement). Of course, there is still the value of the home at that point.
In the middle, we take $99,000 from the home during the first three bad years of sequence risk. After the first decade here, we are left with $1.9M and the portfolio ends with $800k.
On the bottom- the income stream from a reverse mortgage. It does not survive sequence risk quite as well, but actually has the highest portfolio balance in the end. This is due in part to low expected returns assumed in this scenario.
What is the bottom line at the end of the three plans? How much money are you left with?
Other considerations for HECMs
Paying Long-Term Care Insurance or Life Insurance Premiums
This can be considered another emergency use of home liquidity. Say one spouse has a high risk of catastrophic Long-Term Care needs, you can use the equity in your home to continue premium payments to make sure the policy doesn’t lapse prior to use. In addition, say there is a poorly put together permanent life insurance policy with a great death benefit (remind anyone of a VUL??). One may be better off funding this policy with home equity to keep the death benefit active rather than letting it lapse altogether.
Tax Bracket Considerations
401k Millionaires who don’t have an opportunity to do Roth conversions may need to access large amounts of tax-deferred assets to keep income up. Doing so, however, exposes you to increasing tax rates. If your heir is in a low tax bracket, you may be better off taking a reverse mortgage rather than accessing IRAs. This means they will get less “tax-free” house (due to the step up in basis at death) but more taxable IRA. This is a win-win if you are going to be forced into a high tax bracket but they are in a low one and can stretch out the IRA and pay minimal taxes.
As an Alternative to Annuities
An income annuity (such as a Single Premium Immediate Annuity—SPIA) may pay poorly for females, couples, or during times of low interest rates. Although you don’t get mortality credits with HECM’s, you can use monthly income from your home which actually is higher during periods of low interest rates. In addition, instead of longevity insurance (such as a Deferred Income Annuity—DIA), you can open up a line of credit on your home and let it grow over time. Use this credit to buy a SPIA if interest rates improve or turn on income from you home. Again, there are no mortality credits, but as this is a non-recourse loan it is good longevity insurance.
Tax Implications of HECMs
Interest on the reverse mortgage accrues over time, but is not tax-deductible until actually paid. This deduction can be lost if the home is sold by someone who doesn’t have the income for the deduction to offset. For instance, if the heirs sell the property but don’t have a lot of income the year of the sale, the deduction is lost. Or if the home passes in trust and the trust doesn’t have income, the deduction is lost.
However, if the heirs also inherit Income in Respect to the Decedent (such as an IRA), they can take a distribution from the IRA and offset the taxable income by the deduction from the mortgage interest.
If the mortgage originator sells the reverse mortgage and has an IRA, they should also take a distribution large enough to match the deduction. Or do Roth conversions to increase income that can be deducted.
A more complicated tax planning opportunity is to pay off the interest in bunches during retirement. If you chose to pay off part of your reverse mortgage, your first dollars go towards paying off the accrued interest. You can let the mortgage interest accrue for a few years. Then, pay it off in the same year you, say, fund your donor advised fund (DAF). This “bunching” of deductions allows you to take charitable deductions the same year you get a 1098 deduction on your schedule A for the mortgage interest deduction. This can allow you to get income out of your IRA or do Roth conversions with less tax implications.
The topic of taxes is, as always, complicated. Read more about it in Kitces here and here. For the wonkiest tax fanatics, the sentinel article is “Recovering a Lost Deduction.” This article also points out times when a HECM is beneficial to your net worth at the end of your life.
Jumbo Reverse Mortgages for the Wealthy
Instead of being backed by FHA, Jumbo reverse mortgages for the wealthy are backed by individual lenders. With a Jumbo Reverse Mortgage, you can get a much larger mortgage than you can with a HECM.
Conclusion of HECMs for the Wealthy
If I plan to stay in my house forever, I see little downside for wealthy folks to open up a HECM proactively as part of a comprehensive retirement income strategy.
The evident downside is cost. Obviously, in this case $22k origination fee is nothing to sneeze at, but one may consider it like insurance for sequence of return risk or irregular income needs.
Think of the potential upsides for the costs: access to income-tax free income if it ever benefits you (say to avoid IRMAA or prevent Widow/Widower Tax Penalty), with the ability to pay back accrued interest with beneficial tax implications.
When used appropriately, a reverse mortgage can be net worth neutral or even advantageous for your Heirs.
Open it early to let it grow. As aBuffer Asset, a source of tax-free “income,” or just an insurance policy on future income needs, it is hard to beat a reverse mortgage.