Reverse mortgages are a growing but still lesser known way to supplement your retirement income. Conventional wisdom regarding retirement is to first spend down your invested portfolio assets such as a 401(k) or IRA before borrowing against your home equity as a way to make financial ends meet. Reverse mortgages are therefore usually seen as the account of last resort and only used after your other securities portfolios have been exhausted. But there may be a smarter way to use reverse mortgages.
A Smarter Way to Use Reverse Mortgages
Based on research from a recent Financial Planning Association (FPA) webinar featuring Barry H. Sacks, a practicing tax attorney in San Francisco, there's an alternative way to utilize reverse mortgages that could actually generate more supplemental retirement income and over a longer period. Also known as a Home Equity Conversion Mortgage (HECM), a reverse mortgage loan borrows against the existing equity you have in your home, withdrawing it as a cash loan. The loan is due when the borrower moves, sells the home, or passes. If the borrower dies, heirs to the estate must pay off the home by getting a loan themselves and refinancing the reverse mortgage under their own name, or selling the home.
In Sacks' report published February 2012 by the Journal of Financial Planning, Sacks suggests to flip the traditional retirement plan entirely around, and to borrow against your home equity earlier in your retirement instead of later. He states that our perceptions of using reverse mortgages is anchored on the idea that once we pay off our home mortgage, it should be an untouched asset and not be subject to debt again. Sacks argues this is the wrong idea and this type of thinking works in contrary to the way sequence of returns risk can be overcome.
Instead of the usual passive approach of making allocated withdrawals from your portfolio, and potentially exhausting your retirement accounts, Sacks recommends a more active and calculated "wait and see approach," making small draws from a reverse mortgage credit line at specific times based on your portfolio returns. This can potentially extend both your retirement income, and leave a larger investment to your heirs once you pass.
The rationale behind this approach is the fact that your retirement portfolio is generally an appreciating asset, still gaining net returns throughout the time of your retirement. And likely larger returns than say, your home's value, depending on market conditions and the amount of invested assets you have towards retirement. The more you have invested and remaining in the portfolio, the larger earnings growth you will see. By withdrawing from the portfolio, you are losing not only the amount you withdraw, but the potential future returns that withdrawal would yield compounded over time.
A Real-Life Example
Based on an example from the webinar, two people, John and Jim, aged 65, each start off in Year-1 with a $500,000 retirement portfolio and no mortgage debt. Both have the same exact investment performance over the course of a 30-year retirement.
John follows the traditional route of taking out a reverse mortgage once his portfolio is fully exhausted at Year-24. Jim instead gets a reverse mortgage line of credit in Year-2 when he's 66, and uses a coordinated strategy, withdrawing only from this standby line of credit in specific years following negative returns on his retirement portfolio, in years 2, 3, 6, and 23, and taking no withdrawals from his portfolio during those specific years.
At the end of a 30-year retirement, Jim as borrowed $295,000 from his reverse mortgage credit line, and owes $692,000 after interest. But his investment portfolio is now worth $1,086,000 due to compounded growth on his remaining portfolio assets, leaving a residual net worth of $394,000.
John, who ran out of money in Year-24, has no investment portfolio, and owes $447,955 on his reverse mortgage loan, which must be paid back through the selling of his asset, his home, or paid back by his heirs.
This example, of course, is determined by a few factors such as specific portfolio return rates, the initial investment portfolio value and withdrawal rate over time. If considering this strategy, be sure to consider your own portfolio value, mix and projected returns. Consider the interest rates of reverse mortgages before you take one out as that has a substantial impact on the sustainability of your cash flow and the residual net worth you have at the end of your retirement. Take into account these variables, but as you can see, an active retirement strategy can lead to significant reduction in the risk of running out of money in later years.