Financial Advisors

The Cost of Ignoring Home Equity in Retirement Planning

All good retirement planning weighs the costs and fees associated with any product used for investment purposes.  Of course, this is critical as the retiree can only use the money that was not spent on fees. There has always been plenty of discussion and analysis around fees and the long term effect on investment value and real income in retirement.

Sometimes life insurance and annuities are criticized because of their fees but the opposite sides argue the guarantees that make the costs worth it. Reverse Mortgages which are offered to homeowners only over 62 as a retirement tool have long been criticized for having expensive fees.  The truth is that the main difference in the cost of a reverse mortgage as compared to a traditional forward mortgage is the 2% FHA Mortgage Insurance Premium (MIP).

The MIP is a fee that goes to the FHA to insure that no payment is ever required and that any deficiency at the end will be paid by the FHA MIP fund and not the heirs or the remaining estate.  It is a substantial guarantee stretching 20-30 years into the future that most consider to be well worth the cost to mitigate a risk for the borrower and family members.  

Maybe it is a good idea to remember Warren Buffett's famous quote:  "Price is what you pay. Value is what you get.”

Too often—all of us— focus on the price— the cost— instead of the value.  For a retirement plan, as in any endeavor, it is important to assess what the goal is— not just small pieces of the effort. Very few people have the goal of dying with the most equity in their home, but most advisors and their clients make decisions that reach that goal by default.  In reality it doesn’t make sense to put hundreds of thousands of dollars into an illiquid asset during our retirement years — but our culture is very used to doing just that.

Recently at a presentation to dozens of experienced financial advisors I asked why they typically did not recommend a reverse mortgage, except as a loan of last resort.  Several cited the high fees.

Then I asked if any of them had done an analysis for any of their clients as to the real cost of not doing a reverse mortgage and leaving hundreds of thousands of dollars in that illiquid asset called home equity.  Not one hand went up. That is interesting because there is $7.5 trillion parked in this one asset class owned by baby boomers over the age of 62.

Maybe it is a really good idea to investigate the opportunity cost of leaving such a huge part of a portfolio into this very low performing asset.  The main reason someone wants to pay off a mortgage is obviously to get rid of the payment.  But, with the advent of the reverse mortgage in 1988, after achieving about 50% equity in a home, the payment becomes optional.  If the payment requirement goes away with 50% equity— is there a better place for that cash flow to go after a borrower reaches their 62nd birthday?

After all, the only thing that is gained by making a mortgage payment is the 2.5 to 3.5% interest that is saved. It really makes sense to pay for that interest with the equity in the home that typically is increasing anyway, with a non recourse guarantee from FHA that you will not be liable for a deficiency. That is usually a better alternative than using up cash from other buckets of investments. 

There are two major uses of a reverse mortgage.  The first is to pay off an existing traditional forward mortgage that requires payments which results in optional payments for the rest for the rest of the time you live in the home.

The second is to create a liquid, non recourse, growing line of credit with no required payments when a house is paid off.

Most reverse mortgages are a combination of both of these methods depending on the remaining mortgage balance at 62 years old. So what is the cost of not using this safe retirement tool? 

It turns out it is expensive to not use the reverse mortgage in almost every scenario.

Opportunity cost is number one— where else can that cash flow be deployed instead of simply paying down a 3-4% loan? Assets under management typically return double what the mortgage interest rates are.  And solid research from Dr. Wade Pfau shows that reverse mortgages can be used as a buffer asset to mitigate sequence of returns risk in volatile markets.

What about the valuable legacy of life insurance or the power of protecting other assets with long term care insurance? Since all reverse mortgage cash flow has no income tax liability— and the fact that it can be used to pay taxes on Roth conversions—how much tax savings will there be to dramatically offset any closing costs? But maybe the biggest advantages of having a reverse mortgage in the 4th quarter of life is not able to be measured.  The ability to enjoy more income, spend more time with grandchildren, do more bucket list items, own 2nd homes, take more vacations, have more fun and have less anxiety— things that don’t have a price tag but are incredibly valuable.

And since most people plan to give their home to their children or a charity anyway after death—what is the value of giving some of your home equity while you are alive with a warm hand as compared to a cold hand? 

Grandma always told us not to put all your eggs in one basket. One of the most expensive things to do in retirement is storing too much wealth in an illiquid home equity basket. Is it time to rethink the purpose of home equity?

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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