In this hypothetical example the Graves household was able to stay invested and watch their $240,000 grow to $769,000. Again, this is an “apple to oranges” comparison because the HECM will accrue interest and reduce housing equity. The portfolio grew but debt on the house grew as well. What is that cost?
All HECM lenders can produce an amortization schedule predicting what the cost of the HECM reverse mortgage would be over the same term (Chart 10.2).Whether or not it makes sense to use a HECM to allow a borrower to retain his portfolio longer includes assessing the cost of depleting home equity to do so. For those with a bequest motive, it is important to ask whether or not the heirs would prefer inheriting a house, or an investment portfolio. The answer to this may depend on how unified the heirs are on selling the house and dividing those proceeds.
Dr. Gerald Wagner, a Harvard Ph.D. and an expert in both reverse mortgages and portfolio theory, published a paper in the Journal of Financial Planning, December, 2013, investigating how tenure payment supplements can provide greater spending success, particularly in higher tax rate locales. For a 63-year-old borrower living in a $450,000 home and having an $800,000 retirement portfolio, if the first year’s withdrawal need is 6.0 %, the amount withdrawn is $48,000, i.e., $4,000 a month. His analysis showed:
“After paying federal and California taxes, this leaves the homeowner with $2,583 to spend. If the client chooses a HECM tenure payment, there is $1,328 tax-free each month from the HECM. On a tax equivalent basis, that is $2,057, so to meet the desired portfolio withdrawal of $4,000, only $1,943 needs to be withdrawn from the portfolio each month during the first year. Because the HECM tenure advance is fixed, the monthly portfolio withdrawal in the second year will be $2,043. The $100 increase over the first year accounts for the 2.5 % expected annual inflation.”
“Depending on the relative values of the home and portfolio, withdrawal rates of 5.0 % to 6.0 % can be achieved with over a 90 % chance of success over 30 years.”
For retirees unable to budget at an initial withdrawal rate of 4% (or less), supplementing with a reverse mortgage may provide enough additional income so that their spending needs are met and their portfolio is sufficiently protected to survive for 30 years or more.
Line of Credit: A Back Up Plan in Retirement
When a homeowner establishes a HECM as a Line of Credit (LOC), he is gaining access to his housing wealth to be available at any time in the future. (Drawing all the funds before the Day 366 will cause a higher MIP assessment.) This LOC has a truly unusual and remarkable feature: The amount available to be borrowed (to the extent not yet borrowed) grows each month. The rate at which the amount of the LOC not yet borrowed grows is equal to the sum of the monthly interest rate charged on any loan balance outstanding (most servicers require a minimum loan balance of $50) PLUS 1/12 of the ongoing MIP rate (now 1.25%, or .104 a month). This feature cannot be canceled; it is a contractual obligation made by the lender to the borrower, and insured by the FHA.
As explained by Dr. Wagner in his December, 2013 Journal of Financial Planning article, “The growing line-of-credit feature maintains the borrowing capacity regardless of when the mortgage is accessed.
“For example, with a note rate of 2.50 percent and an ongoing MIP of 1.25 percent per annum, a loan’s effect rate would be 3.75 Percent. Imagine two borrowers , each with an initial $100,000 line of credit. One draws his entire line of credit at the end of the first year; after one year the capacity would have grown [with monthly compounding]to $103,815. The other borrower lets her line of credit capacity grow untouched for five years. After five years, the first borrower would owe $120,588. That is $103,815 in principal and $16,773 in accrued interest and MIP. The second borrower could owe nothing and have a line-of-credit capacity of $120,588. If she then withdrew her whole line of credit, both borrowers would have exactly the same outstanding loan balance.”18
The growing HECM LOC impressed Dr. John Salter and Harold Evensky, CFPÂ®, of Texas Tech University, for these reasons:
The HECM LOC cannot be canceled
The HECM LOC cannot be frozen
The HECM LOC cannot be reduced
The HECM LOC will grow in value even if the housing value drops
Dr. Salter, and Harold Evensky, known as the “Dean of Financial Planning,” along with Dr. Shaun Pfeiffer, began a series of studies on how the HECM LOC could function as a Standby LOC to meet volatility challenges throughout retirement. All lenders are equipped to provide amortization schedules illustrating anticipated LOC growth. These schedules, however, cannot provide a totally accurate prediction of LOC growth because it is not possible to predict what interest rates will be in the future. Because HECMs with the LOC feature use adjustable rates, from month to month, or year to year, the loan balance will be charged a varying rate. Interested borrowers may wish to request multiple amortization schedules over a range of potential future interest rates. The borrower can choose either yearly adjusting rates or monthly adjusting rates.