Reverse Mortgage Part #3 — Best Use
Posted on July 1, 2016 by bob in MoneyWise
For some, the wise use of a Home Equity Conversion Mortgage (HECM), or FHA-insured reverse mortgage, can provide financial flexibility. In my opinion, an HECM should only be used:
1. when the borrowers are confident the home being mortgaged is the last one they will own;
2. they are not motivated to leave it as a legacy to their heirs.
If those conditions are met, an HECM may permit the borrower to do any or all of the following:
1. eliminate or avoid principal and interest payments on a traditional mortgage;
2. postpone Social Security retirement benefits to age 70, potentially providing a higher lifetime payout;
3. save income taxes by minimizing taxable retirement plan withdrawals;
4. reduce exposure to sequence-of-return risk by minimizing withdrawals from retirement or other investment accounts when the market is down significantly; or
5. create (a) a stream of fixed monthly payments to supplement other sources of cash or (b) an increasing pool of funds that can be tapped if and when it becomes appropriate.
Consider two scenarios based on a home value of $300,000, a “line of credit” type of loan (available only with a variable rate HECM), an initial interest rate of 3.75% per year (which we will assume does not change over the HECM term), a maximum available loan of $150,000, and closing costs, excluding initial FHA Mortgage Insurance Premium (MIP), of $3,000. In both cases we’ll assume that no more than 60% of the maximum available loan is borrowed in year one, which means that the initial MIP will be $1,500 (0.5% x the $300,000 home value), bringing total closing costs to $4,500. The borrowers will owe a 1.25% annual MIP on their outstanding loan balance in addition to the 3.75% interest.
In scenario 1, the borrowers take 60% of the maximum available loan at closing, or $90,000. At closing the borrowers will get $85,500 ($90,000 – $4,500 closing costs). Each year, both the loan balance and the maximum available loan increase by 5%. A year after closing, the borrowers take the remaining available loan, $63,000, taking their net cash received to $148,500. Thereafter they have no additional funds available under the HECM unless they repay part of the existing balance at some point. They will not have to make HECM payments as long as either spouse lives in the home, keeps it insured and maintained, and pays the property taxes. Unless the home appreciates more than 5%/year, the increasing mortgage balance will annually consume an increasing slice of the borrowers’ home equity.
In scenario 2, the borrowers use the HECM to cover total closing costs, but otherwise do not draw on the maximum available loan in year one. Their loan balance and the maximum available loan then increase 5%/year. If the borrowers did not draw on the available loan for 15 years, the maximum available loan would grow to $311,839 and the existing loan balance would reach $9,355, providing access to $302,484 more in loan principal.
If the second couple waited until year 15 before applying for an HECM and the value of their home had appreciated 2%/year, it would be worth $403,761. A new HECM of half that value would provide access to $201,880, almost $110,000 less than the couple could borrow if they had set up the HECM 15 years earlier and the maximum available loan increased 5%/year.
What do these scenarios reveal? That setting up an HECM early on and using it as little as possible during the first several years could provide access to more borrowing power down the road if the home appreciates at a lower rate than the one at which the maximum available loan increases. In such a case, a growing HECM line of credit might serve as a flexible “insurance policy” against a variety of financial challenges.
Alan Wallace
Alan Wallace, CFA, ChFC, CLU, is a Senior Private Wealth Advisor for Ronald Blue & Co.’s Montgomery office, www.ronblue.com/location-al. He can be reached at 334-270-5960, or by e-mail at alan.wallace@ronblue.com.
