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Guiding borrowers to the right decisions Protecting borrowers from mortgage predators |
Seniors who accumulate a nest-egg during their working years
which they then use to maintain their lifestyle during
retirement, risk running out of money if they live too long.
With life spans growing at an increasing rate, that quandary
is increasingly being labelled a “retirement funds crisis”.
Seniors who own homes, however, have a valuable option. They
can use a reverse mortgage to reduce the risk of outliving
their money. The proviso is that they need to unlearn what
they thought they knew about shopping for a mortgage.
John retires at 65 with $2 million of financial assets that,
along with social security, must support him for the rest of
his life. Whether it does or not depends mainly on the rate
of return earned on his assets, on the rate at which John
withdraws money from the fund, and on how long he lives. If
the fund earns a constant 6% a year and John withdraws a
monthly stipend equal to 4% of the $2 million divided by 12,
rising by 2% each year as an inflation offset, he will
succeed. He will draw $6667 a month to start, and because
this is less than the growth rate of his wealth, his wealth
will gradually rise,
reaching $4 million when he celebrates his 108th
birthday.
These numbers come from a spreadsheet developed with my
colleague Allan Redstone, which will shortly be freely
available on my web site. The spreadsheet makes it easy to
model many different combinations of the factors affecting
how long a retiree’s wealth will last.
For example, considering how highly priced common stocks are
today, and how low interest rates are, a 6% rate of return
on John’s wealth appears unduly optimistic. If we reduce the
assumed rate of return to 4.5% while retaining the
withdrawal rate as it was, John’s wealth will gradually
decline, hitting zero when John reaches 103. A further
reduction in rate of return to 3.5%, which is probably more
realistic, results in John running out of wealth when he
hits age 96. For most retirees, that risk would be
unacceptable.
The standard remedy is to reduce the withdrawal rate by an
amount that pushes the asset depletion point far enough out
that John is comfortable with the risk. If the withdrawal
rate is reduced from 4% to 3.15%, John’s wealth will last
until he reaches age 107. John may be comfortable with this
risk, but it involves a reduction in the initial monthly
stipend from $6667 to $5250, which may require a significant
scale-down in living style. If John is a homeowner, however,
there is another option.
The option is for John to take a reverse mortgage line of
credit, and let it sit unused until it is needed. While his
financial assets are gradually being depleted, his credit
line is getting larger. He draws on the line only if he is
still alive when his assets are fully depleted, otherwise
the equity in his house will pass to his estate.
If John’s house is worth $400,000, he can command a credit
line of $210,519, which will grow at a rate equal to the
interest rate on the adjustable rate reverse mortgage that
John selects. Assuming a rate of 6%, the line will reach
$1,351,000 when John runs out of money at age 96, extending
the monthly draws until he reaches 108. If the rate is only
3.5%, the line grows to $624,000, and it extends the draw
period only until John reaches 100.
If John dies before his wealth is fully depleted, the
reverse mortgage credit line may never be used. The cost in
that case is the initial settlement costs of $6282 if paid
in cash at the outset. If John finances the settlement
costs, as most seniors do, the cost is the future value when
the reverse mortgage is paid off, which will be considerably
higher -- yet tiny compared to the available draw amounts.
The HECM credit line is cheap insurance against running out
of money.
Retirees who select a credit line to hold unused as their
sole reverse mortgage option should view themselves as
investors rather than borrowers. When market interest rates
rise, investors benefit while borrowers lose. The
distinction is critical to the retiree’s decision process.
For example, using the same adjustable-rate HECM, John takes
a $100,000 unused credit line while Jane draws $100,000 in
cash. In year 2, both John’s line and Jane’s debt grow at
the prevailing interest rate. A higher rate that makes Jane
worse off makes John better off.
This should affect John’s shopping strategy in two ways.
First, in selecting between alternative combinations of
interest rate and origination fee, John should select the
highest rate/lowest fee combination. Second, in selecting
between ARMs with a 5% rate increase cap and those with a
10% cap, they should choose the second. Note that these
selections are the opposite of those that should be made by
Jane.
That seniors with different objectives should select reverse
mortgages with different features points up the need for
lenders to offer the different options, and also to provide
the expert advice that many seniors need. Not all lenders
offer both the options and the expertise -- if yours
doesn’t, let me know and I’ll send you the names of some
that do.