Wednesday, September 4, 2013

9 Ways to Use Reverse Mortgages in Retirement Planning

Reverse mortgages may help seniors manage debt, but they can also help advisors manage risk. As a tax-free source of income, advisors can use these loans as a way to replace cash, defer drawdown of retirement assets, reduce tax liabilities, and more.
By Amy E. Buttell

For years, reverse mortgages have had an iffy reputation with advisors. ...

REVERSE MORTGAGES? You know times aren't like ...
REVERSE MORTGAGES? You know times aren't like they were when Fred has to obtain a reverse mortgage... (Photo credit: roberthuffstutter)
However, the attitude surrounding reverse mortgages is undergoing a shift. In light of changing options for payouts, advisors are finding that reverse mortgages can help with cash, risk, and investment management. Harold Evensky, CFP, AIF, president of Evensky & Katz Wealth Management in Coral Gables, Fla., is at the forefront of creative thinking for wealth managers using reverse mortgages. 

Evensky sees specific types of reverse mortgages that offer a line-of-credit-type payout as a significant source of cash for retirees in the event of a market reversal. Previously the firm would recommend that these types of clients hold a two-year cash reserve to ride out a market downturn. Now, with a reverse mortgage line of credit, that amount of cash can be cut down because clients can draw on the line of credit connected to their home equity in the event of a prolonged market downturn. 

... "Reverse mortgages can be used as an alternative source for retirement income, especially in a low-interest-rate environment," says Robert Margetic, ChFC, CLU, and president of Redwood Financial Advisors. "In retirement, this can be a source of tax-free income that allows clients to continue to defer drawing down IRA and 401(k) funds, get large sums of tax-free money to purchase a car, or cover an unexpectedly large expense." 

Advisors need to overcome their bias against reverse mortgages, which have been viewed as shoddy and expensive products, Evensky says. "Practitioners need to overcome these psychological barriers and see that reverse mortgages are not a debt strategy but a risk management strategy," he adds. "By framing the issue in that context, it can be seen as a very useful tool in a variety of situations." 

ABCs of reverse mortgages and payouts 

United States Department of Housing and Urban ...
United States Department of Housing and Urban Development Seal (Photo credit: Wikipedia)
There are several different types of reverse mortgages. Federally insured reverse mortgages offer the best terms. These are known as home equity conversion mortgages (HECMs) and are backed by the U.S. Department of Housing and Urban Development (HUD). Reverse mortgages can be used for any purpose, and their proceeds are not subject to taxation because they are a return of principal to the homeowner. ... Here is a low-down on borrower requirements:
  • Borrower requirements. Borrowers must be 62 years old or older, own their own property or have a mortgage or home equity line of credit with a small balance, occupy the property and use it as their principal residence, have no federal debt delinquencies, and participate in mandatory counseling by an approved instructor.
  • Property requirements. Single-family or two- to four-person unit with one unit occupied by the owner-borrower or a HUD-approved condominium or a manufactured home that meets FHA requirements.
  • Financial requirements. No regular repayments; no minimum income requirement; closing costs can be financed into the loan amount; may require escrow account; limited withdrawals on initial approval, financial assessment required.
  • Mortgage amount basis. Age of the youngest borrower, current interest rate, and the lesser of the appraised value of the home or applicable FHA HECM limit, currently $625,500.
Once a borrower meets the above requirements and is qualified for the federal HECM, there are four payout options, which include:

  • Term option. A fixed monthly cash advance for a specific term.
  • Tenure option. A fixed monthly cash advance for as long as the borrowers live in the home.
  • Line of credit. A line of credit that can be drawn on in any amount until the line is exhausted.
  • Combination. A combination of monthly payments and a line of credit.
Using reverse mortgages in planning 

Following are some examples of how advisors can use reverse mortgages in different planning scenarios.
  • Replace cash reserves. Evensky believes the line of credit option offers a significant benefit for retirees because it can replace much of the cash reserves that the firm previously recommended that retirees have. "We tested scenarios in different market environments, and it was not very often that the six-month reserve would be exhausted," he said. "If it is, the funds in a HECM Saver could be used at a very modest carry cost. Then, when the market recovered, those funds could be put back into the line of credit."
  • Delay Social Security and pension payouts. Postponing Social Security benefits can be enormously advantageous to clients, Evensky says. Delaying claiming benefits to age 70 can mean a difference of thousands of dollars in income per year. It also delays paying taxes on that income, including pension payouts. "Maybe you have money in a pension account and you don't want to draw it down as soon as you retire," he says. "You can use an HECM home equity line and then pay it back later."
  • Draw on tax-free vs. taxable funds. By using proceeds from a reverse mortgage in whatever payout form that works for the homeowner, clients can avoid drawing down on taxable funds from retirement accounts, thus reducing their tax liabilities, says Josh Stephens, president of Reverse Mortgage Direct, a reverse mortgage brokerage firm located in Kirkland, Wash.
  • Capitalize on lower interest rates. With interest rates low today, it makes sense for any client who might potentially need the money from a reverse mortgage to apply now if they qualify, says Stuart MacMillian, a reverse mortgage loan originator with Reverse Mortgage Direct. "Because interest rates are so low now, borrowers will get more money now than if you wait and rates rise," he says. "Once the loan is originated in a low-rate environment, the proceeds are available—the client can get a line of credit and not have to tap it."
  • Postpone drawing down retirement assets. Just like Social Security and pension payouts, a reverse mortgage can allow clients to postpone drawing down 401(k) assets and IRAs. "By drawing on a reverse mortgage, assets held within retirement accounts have more time to grow, which means they can last longer through retirement," says Stephens.
  • Cover large expenses. Rather than draw down taxable retirement assets, clients can take funds from a reverse mortgage to make large purchases. "In retirement, a reverse mortgage can be a source of tax-free income to purchase a car, cover a large medical bill, or manage other unexpected expenses," says Margetic.
  • Provide for mortgage-free retirement. For clients who still have mortgages, a reverse mortgage can be used to pay off the existing mortgage or line of credit, says David M. Williams, CFP and founding director of Business Enhancement Associates in Cordova, Tenn. Of course, clients must have sufficient equity in their primary residence to qualify for a reverse mortgage to make this workable.
  • Finance a new residence. Clients who are considering relocating can use proceeds from a reverse mortgage to buy a new home, then pay off the proceeds when the current home is sold, says Williams. "The proceeds of the present home sale in excess of the down payment can be invested with other retirement assets," he says. "Additionally, there is no mortgage payment for the rest of their lives."
  • Receive payouts in excess of the value of the home. For retirees who secure a reverse mortgage early in their retirement and choose a monthly payout, those payouts last as long as the youngest borrower lives if the tenure option is selected. So, potentially the borrower who takes out a loan at age 62 and lives for 25 or 30 years would likely receive monthly payouts in excess of the value of the home.
Disadvantages of reverse mortgages 

While there are many pros to reverse mortgages, there are also cons. Like any mortgage, reverse mortgages carry interest. Of course in today's low-interest-rate environment, the costs are not as high as they could be, but that could change if interest rates spike. In addition, a reverse mortgage means that there is less equity in a house for heirs or other purposes. 

At some point, as a liability, reverse mortgages are subject to repayment. This typically happens when the youngest borrower leaves the home permanently (to go in a nursing home, for example) or dies. The heirs or homeowner will be faced then with having to sell the property quickly, which may not work well if the local real estate market is distressed. 

Bottom line 

Advisors have multiple options when employing reverse mortgages as a planning tool for clients. And because virtually anyone who is 62 or older with a significant amount of equity in their home can obtain a reverse mortgage, it's a tool that can potentially support a client's retirement portfolio by helping them better manage cash, risk, and investments.
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