The financial planning community is finally catching on to the potential offered by the reverse mortgage known as the Home Equity Conversion Mortgage (HECM). The HECM is a product insured by the Federal Housing Administration available to households where at least one owner is 62 or older.
Harold Evensky and John Salter, principles of the nationally known financial planning firm of Evensky and Katz in Coral Gables, Fla., and faculty members at Texas Tech University, recently published an article in the Journal of Financial Planning suggesting how what they refer to as the “Standby Reverse Mortgage” can increase the probability that retirees will be able to meet their retirement income goals. Readers can find the full article at www.fpanet.org/journal/StandbyReverseMortgages.
The principal issue the Evensky plan addresses is something he calls “volatility drain.” Most planners advocate a total return approach (maximizing the combination of income and appreciation) for generating income. Total return investing is typically quite successful when accumulating assets, but when it comes to generating cash flow from one’s investment portfolio, the approach can create serious problems in periods of market downturns. The retiree must then sell assets at depressed prices to meet living expenses.
Two buckets. To avoid volatility drain, Evensky’s firm has long advocated what it calls a “two-bucket approach.” The retiree sets aside two years’ worth of living expenses in cash, while the remainder goes into a total return investment portfolio. Cash generated by the total return portfolio flows into the expense reserve bucket. Only if and when the expense reserve is drawn down to two months remaining, part of the total return portfolio is sold to replenish the reserve. Since most market downturns last well less than two years, volatility drain can be avoided much of the time. However, in the current low interest rate environment engineered by the Federal Reserve, the retiree must accept that the two-year expense reserve is earning essentially nothing.
HECM Saver. Evensky’s enthusiasm for reverse mortgages was sparked by a modification to the HECM program implemented in October 2010 called the “HECM Saver.” Its upfront expenses, always a stumbling block for borrowers, are considerably lower than in the standard program. In exchange for lower upfront costs, the retiree gets access to a smaller portion of his or her home equity. I’ll compare the two programs a bit further on in this column.
The reason Evensky calls the plan a Standby Reverse Mortgage is that the retiree actually draws on the home equity as little as possible at the outset. This means that the plan works only for those with no (or a low) existing conventional mortgage.
Three buckets. Under the Evensky plan, the Standby Reverse Mortgage is added as a third bucket. Now if the expense reserve is used up and the investment portfolio is suffering from a market downturn, the retiree draws on the reverse mortgage to meet living expenses. When the markets recover, the retiree can then sell assets to replenish the expense reserve and to pay down the balance on the reverse mortgage. By having a third alternative source of cash, the expense reserve can be much smaller—say, six months—lessening the portion of the retiree’s assets generating no return.
Benefits of the HECM. Let’s review the benefits of the HECM Saver that Evensky finds so attractive and that I’ve written about in Wealth Wise before:
• The retiree controls when or if he or she uses the line of credit;
• The money borrowed can be repaid at any time without penalty;
• Advances against the reverse mortgage aren’t income, meaning they’re taxed neither as ordinary income nor as capital gains;
• The unborrowed portion of the line of credit grows at an interest rate that’s the same as what’s being charged on the borrowed portion, currently about 4.5 percent;
• The FHA insurance guarantees that the retiree can withdraw up to the full available principal of the HECM at any time even if the lender goes belly up or if the value of the home falls below the amount borrowed; and
• HECM loans are non-recourse, meaning the lender must satisfy itself out of the value of the home. If that turns out to be less than the amount owed, the lender cannot sue the retiree (including his or her estate or heirs) for the deficiency.
Saver vs. standard. Before the saver program was announced, I thought that the HECM standard program was an option worth exploring despite its significant upfront costs. Let’s look at how the two options might work in the real world. Assume a single borrower age 66, with a free and clear home worth $625,000, the maximum allowable value under the HECM program. Under the saver option, the initial principal limit is $336,500, or 54 percent of value, reduced by $5,150 of upfront costs, making the net line of credit available $331,350. For the standard option, the initial principal limit is $405,300, or 65 percent of value, reduced by $20,600 of upfront costs, generating an initial available principal of $384,700.
In short, for $15,450 in upfront costs for the standard option, the retiree increases the amount of equity available by $68,800. Let’s say that some years hence, the retiree must move to assisted living that costs $200 per day. The standard option would cover almost a year of additional care. Of course, the retiree might sell the home and receive net proceeds greater than the remaining available HECM loan principal. But if there’s another major downdraft in home prices, the retiree knows that he or she can draw the full line of credit and let the lender worry about selling the home.
Where the retiree wishes to leave a legacy for children or others, the saver option is likely to be preferable. For the childless retiree simply trying to make sure he or she doesn’t run out of money, the standard option is better because he or she will never pay the higher upfront costs—they simply increase the loan balance.
