Retirees must fund an enjoyable lifestyle without working, which is no small feat. With fewer pensions, lackluster Social Security benefits, low interest rates and significant market volatility, hard earned retirement savings may not last until age 90 or later.
Retirement is generally considered sustainable if total portfolio withdrawals during the first year of retirement are no higher than 4% of portfolio value (the so-called 4% rule). But it turns out even 4% could be too much if retirees suffer a market downturn in early retirement. Or any number of other things can go wrong. (For more, see: Why Early Retirees Should Reconsider the 4% Rule.)
So, what can retirees do to enhance their retirement chances without working longer, spending less or taking on additional market risk? It could be done with the recently revamped reverse mortgage. This financial tool allows retirees to access their home equity and, more importantly, enhance their retirement cash flow.
Let’s look at a hypothetical retirement projection to show how a reverse mortgage could help.
Conventional Retirement Planning: A Hypothetical Scenario
Here are the basic planning assumptions: Retirement will last 23 years for a couple that retires at age 67 and until age 90. We’ll also assume annual post-tax expenses are $75,000 growing at 3% annually for inflation. Lastly, we will also assume that the couple achieves 5% average annual growth on their investment accounts, after fees and taxes.
Here are the sources of income and assets:
- Social Security: Combined $3,600 per month at full retirement age, ($43,200 total in year one), increasing at 1.5% annually;
- Pension: $10,000 per year with zero growth
- Savings: $600,000 total in retirement and investment accounts
- Other non-liquid assets (if necessary): Home equity of $350,000 (primary residence worth $500,000 with a remaining mortgage balance of $150,000). The monthly mortgage payment is roughly $1,800, or $21,600 annually, for the next 15 years.
They might make it. The plan for this scenario calls for a withdrawal rate of 3.6% ($21,800 in year one). Using a basic analysis, these retirees will need roughly $450,000 to reach age 90 without running out of money. But keep in mind this analysis doesn’t account for things like market downturns or health issues, either of which could derail retirement plans much earlier. (For more, see: How Reverse Mortgages Work.)
Any good retirement planner would see the red flags here and understand that these retirees are very susceptible to the “retirement boogie men” of market downturns or costly health issues. No potential retiree wants to stop working with this level of risk. Traditionally, advisors have encouraged working longer, spending less or investing more aggressively. None of these are great solutions.
There’s nothing worse than telling someone that they can’t retire after years of hard work and saving but in this case, there’s no other option. Or is there?
The New Reverse Mortgage
The reverse mortgage has a bad reputation due to versions that existed prior to a recent regulatory overhaul. In 2012 the federal government rewrote the reverse mortgage regulations. Now, a reverse mortgage could be a lifeline of tax-free cash flow to individuals who might otherwise not be able to retire.
A reverse mortgage is a line of credit against the equity in a homeowner’s primary residence. But unlike traditional home loans, there are no monthly payments required. Instead the lender (usually a bank), is repaid with interest upon the sale of the primary residence or death of the borrower.
Our retirees in the above example had about $350,000 in home equity. If they applied for a reverse mortgage, they might have an available line of credit up to $268,000 (based on certain guidelines). Upon opening the reverse mortgage, the current mortgage (and any ongoing payment) would go away. This amounts to an immediate annual savings of $21,600 for our hypothetical retirees. (For more, see: The Reverse Mortgage: A Retirement Tool.)
Of the total $268,000 line of credit, a significant portion is taken away at closing to pay off the existing mortgage and cover closing costs. Here, $150,000 would go to the first mortgage and about $22,000 to closing costs, leaving roughly $96,000 for the retirees to cover living expenses, etc.
But here is the real planning piece. After paying off the original mortgage, living expenses in the first year of retirement are now only $200, rather than $21,600 before, which could be funded with savings, or through their line of credit. This allows our retirees to let their retirement savings grow, virtually untouched, for years.
Here’s a side by side comparison of the original scenario versus using the reverse mortgage:
You can see the variance begins immediately. The reverse mortgage allows this couple to thrive in retirement. I should mention that, while the couple incurred debt, they continued their same living arrangements and likely died with equity in their home. But keep in mind that even if their home went under water, it’s of no concern to them (unless they wanted to leave their house to heirs), which leads us to the question...
What’s the Downside?
This planning strategy seems great, but almost too good to be true. There’s something that seems wrong with essentially, taking on additional debt to fund retirement. Many would-be retirees have one simple question. What happens if the property depreciates below the value of the outstanding mortgage?
Who holds the bag? The answer: The federal government
And this is exactly what makes a reverse mortgage so attractive. Let’s assume in our above example that one day after the couple closes on their reverse mortgage, and a significant amount has been drawn from their credit line, the real estate market tumbles and the value of their home falls by 40%.
This has little, if any, effect on our retirees. They still have access to the same amount of credit. If they must move or they pass away and sell the home into a buyer’s market at an amount significantly less than what they owe, they have no obligation. They’re in no worse of a position than if they hadn’t taken out the reverse mortgage. (For more, see: Turn Retirement Cash Flow Into Your Own Paycheck.)
Let’s assume that upon opening the loan, the value of the home drops from $500,000 to $300,000 (about 40%). Without the reverse mortgage line of credit, this would be troubling to our retirees. Although not under water, they’ll have to continue making mortgage payments but their net worth just got reduced by $200,000 - a hit to the cash flow and the balance sheet.
With a reverse mortgage, the retirees aren’t necessarily concerned with the “paper” value of their home. Their new asset is the line of credit, which grows at a specific rate per month irrespective of property values. In above situations, with the house depreciating, the retirees would still have: a) no monthly mortgage payment and, b) access to $90,000 of tax-free cash. If the property went under water with an outstanding loan of say, $250,000 and a fair market value of $200,000, the loss of $50,000 would be absorbed by the federal government.
Reverse Mortgages Aren’t for Everyone
A reverse mortgage may not be for you if your goal is to leave the family home to your children or if you otherwise wish to have some legacy assets upon death. Although there is a chance that the real estate will appreciate higher than the rate of the mortgage, some can’t take the risk of not passing on a cherished family asset (the home) to their heirs. (For more, see: 4 Keys to a Satisfying Retirement.)
Also, people should solidify their living arrangements prior to taking out a reverse mortgage. That is, don’t open a reverse mortgage if you plan to downsize in a few years as the closings costs may be prohibitive.
The benefits outlined above apply to a very basic retirement problem – how can I make my money last through retirement? The reverse mortgage can help solve that issue, but it can also do more:
- Enhance Social Security. In our scenario, we assumed that the retirees started taking Social Security at their full retirement age of 67. But if they defer to age 70, their benefit would be 32% higher. Why not use the line of credit to supplement income for three years and then take the higher benefit at age 70?
- Contingency Planning. Long-term care insurance is the major contingency risk for retirees. In the event that a retiree loses the ability to carry out activities of daily living, they may require permanent care from a professional either at home or in a facility. This care can be prohibitively expensive without insurance in place. A reverse mortgage might provide the funds to buy a safety net.
A reverse mortgage is a financial tool that can significantly increase the chances of a successful retirement, when used properly. Anyone with significant equity in their homes should consider this option as a means of reaching basic retirement goals, providing funds for contingency planning or even creating a line of credit that grows tax-free without a very clear downside. (For more, see: What to Do to Prepare for Retirement.)
Claro Advisors, LLC ("Claro") is a registered investment advisor with the U.S. Securities and Exchange Commission ("SEC"). Information contained in this post is for educational purposes only and is not to be considered investment advice. Claro provides individualized advice only.