DOUBLE AND TRIPLE CHECK YOUR SCENARIOS WITH A FINANCIAL PLANNER WHOSE FIDUCIARY DUTY IS TO YOU!
Option Four – Stay in your home, invest your equity
Reverse Mortgage or
Home Equity Line Of Credit (HELOC)
HELOC rate is 8.0%; this is based on a loan for 80% of the home’s value and is .25% below prime (Source: Countrywide).
Assume that there is one refinance after 10 years.
HELOC mortgage interest deduction is limited to the interest on the first $100,000 of the loan.
Assumes home is sold off to pay the loan; if another mortgage is taken out, transaction costs could be lower.
Allows both couples to live in their home.
Works well when the home continues to appreciate in value.
The HELOC debt is covered by the increase in value.
After paying off the credit line heirs receive substantial legacies
Remember both couples could deduct the mortgage interest by itemizing on Federal taxes attributable to the first $100,000 of the loan.
HELOC transaction costs are also quite low at about 1% of the loan and the credit line offers flexibility in timing any drawdown.
The costs and responsibility of home maintenance.
As cost of living expenses increase both couples may be tempted to spend down more than the initial 80% debt value ceiling.
Or, as their home value increases they may continually ramp up their debt.
Of course, they will need to make regular monthly payments on their HELOC or face the risk of foreclosure.
Reverse Mortgage scenarios:
Assumes that proposed legislation is enacted that would change housing limits to a national limit of $417,000.
Limit increases at 4% annually.
Assume current interest rate of 7% – includes the 6.5% interest rate and the .5% insurance premium.
Monthly servicing fee of $30/month is added annually.
This scenario assumes that interest rates stay fairly constant.
Reverse mortgage interest deduction is limited to the interest on the first $100,000 of the loan; accrued interest is deductible by the heirs in the year that it is paid.
It is assumed that the heirs will be able to deduct the mortgage interest in the year that it is paid, and that the heirs will be able to utilize $100,000 of that interest deduction.
The utility of the deduction will depend on the individual tax situation of the heirs.
Assume home is sold to pay off loan; if another mortgage is taken out, transaction costs could be different.
Enable these couples to receive regular payments (actually loans) secured against the value of their homes and be assured that they can remain in those homes for life.
Homeowners live in their homes and tap into their substantial amount of equity.
Depending on their age.
Prevailing interest rates.
As long as they live in their home, life is good.
No payments need to be made on the reverse mortgage (though they must, of course, cover the home’s routine expenses and maintain it).
Better still, loan payments to the borrower may feel — and function — like ordinary income, but they are not taxable income.
Under current law, payments received by a reverse mortgage borrower don’t count towards Medicaid resource limits provided they are spent each month and not accumulated.
Here’s the bonus while you live in your home.
They don’t count toward the income threshold for determining whether regular Social Security payments are subject to federal income tax.
Also, reverse mortgages do not count toward the $500,000 – $750,000 home equity test for nursing/long-term care assistance under Medicaid.
Here’s the bonus for your kids.
Heirs to a home carrying reverse mortgage debt do sell, they should be able to deduct the mortgage interest (subject to any applicable limitations).
During 2007 Fidelity cautioned.
Because the reverse mortgage market is still emerging, upfront costs are much higher than a HELOC — up to several percent of the loan value.
The product is complex and the amount available for lending is inversely correlated to interest rates — which are difficult to predict and impossible to control.
Are these five options the only scenarios for both couples?
It is possible to combine these strategies in various ways.
Both couples could choose to combine the first scenario,
Sell Home and Buy a Less Expensive Home, with either a HELOC or a Reverse Mortgage on the new home.
Why would this be in their best interests?
They could generate incremental cash flow.
Heirs would benefit from the new home.
Equity could be extracted for their comfort or future investments
But, here’s the kicker.
Time to age 94.
One couple’s planning horizon is 32 years while the other is just 19 years.
You need to take into account the difference in possible home values, cash flows and other variables.
Think of it this way — if these couples chose one of these options in the (year 2016) — the results we project would be realized for the Walkers (by 2035)… the Smiths would not see the results the table suggests until (2048 )— the last year of their 32-year planning horizon.
Since this age and timeframe difference is so substantial, the only meaningful comparisons to make are among each couple’s own options.
Remember, don’t rely solely on your home equity as a significant retirement funding source.
Recurring cyclical downturns in real estate can inflict severe damage.
Investment returns on residential real estate have been lower historically than
on stocks and bonds.
If you pour all your funds into your home you’ll have nothing left to invest for higher marginal returns.
Don’t count out the emotional components of owning a home.
The emotional aspects of homeownership can also present significant barriers to the use of home equity for retirees.
Whatever the financial case, the emotional investment involved can make it hard to sell, rent or float debt on a home after a lifetime of paying off mortgages — even if that strategy makes sense financially.
The comfort of living in a familiar home as one ages or the desire to leave the home’s full value to heirs compound many retirees reluctance to tap their home equity by either sale or leverage.
If you’ve planned well and acquired significant equity when reaching retirement age you’ve got multiple options for mobilizing it.
Decisions on precisely how to tap home equity require careful analysis and he financial and emotional trade-offs change as retirees age.
Non-financial personal preferences may quite reasonably trump sheer financial or cash flow benefits.
Peace of mind, convenience, familiarity are all real, if hard-to-quantify values.
Reverse mortgages do offer many advantages for retirees —
… notably, regular cash flows that do not count as taxable income.
But this market needs to mature.
High initial costs of reverse mortgages scare off many retirees.
Many fear losing their homes to the lender, even though there is no such risk.
The reverse mortgage market will likely grow substantially once upfront costs drop, securitization takes hold, and customer awareness of potential advantages grows.
With your financial planner double-check all of the
your spreadsheet calculations.
If the calculated risks are baked in, then go ahead with your eyes wide open.
Like all carpenters know, measure twice and cut one.
Pulling the trigger on any major decision like this one with consequences (intended or unintended) will significantly impact the rest of your life.
An excerpt from Book Four in “The Knowledge Path Series” dedicated to helping you find the place of your dreams in the Rocky Mountain State.
“Buy land, they’re not making it anymore.” — Mark Twain.
Figure out if you should unlock that equity for investments.
Or more specifically, how to tap into your source of capital to fund your retirement.
Part One in a 4-part series weighing the pros and cons of investing in real estate over the course of a life time.
Leaving aside rental and commercial property or other indirect forms of investing in real estate, such as REITs, a more common scenario involves typical homeowners.
Those who bought years ago, paid off their mortgage or will have shortly and despite the negative impact of The Great Recession managed to build a decent amount of equity.
Don’t take what follows as financial advice.
If you haven’t consulted professionals, well, what are you waiting for?
Do so at once!
Back in February of 2007 I read a FidelityReport published by Fidelity Research Institute that compared unlocking equity for investments to risks and relative returns of stocks, bonds and cash.
Fidelity emphasized how much a home, and therefore it’s equity, is subject to market cycles.
Previous generations of Americans treated home equity as an illiquid asset being built up almost invisibly as mortgages were paid down.
They considered this growing equity either as an “asset of last resort” or as a source of bequests to heirs.
And, of course, back then those homes cost what a luxury car today goes for today.
So, it’s no surprise that future generations are on track to carry much larger mortgages.
And, they will continue to do so into their late middle age and even deep into their retirement years
… perhaps on the assumption that these larger debts will be compensated for by a continued rise in home values.
By 2007, more than 80% of all Americans over age 65 owned homes.
The median price of new homes in the United States has averaged an annual appreciation rate of 5.9% since 1963.
Fidelity cautioned, even before the more recent Great Recession
… historical experience suggests that real estate investments can suffer serious and sometimes prolonged downturns.
Sometimes it can be across the board.
But, baring a prolonged deflationary slump teetering on an economic depression, it is certainly true for local regions struck by extended economic decline.
Local real estate prices and your return on investment rise and fall with economic factors
… such as interest rates, per capita income, building costs and unemployment rates.
Shifts in your mortgage loan market can reduce your monthly payments.
Those innovations make housing more accessible.
Like variable rate and interest only loans.
But, they don’t come without their own set of risks.
Beyond the loan market, don’t forget to monitor important variables expanding or constricting the local supply of real estate properties.
General availability of land.
Land use restrictions.
Tough zoning rules.
Slow administrative procedures.
And, of course shifts in demographic trends
Average household size.
Household formation age (individuals in their thirties).
Fidelity said American real estate values endured three sharp “corrections” during ten-year intervals.
From the early 1970’s to the early 1980’s.
During the early 1990’s.
And, during The Great Recession at the end of the 2000’s to mid 2010’s
With the severity and duration of the downturn that occurred in 2006 still uncertain (published in 2007).
Fidelity tracked investment performance back to before you were born.
How did they say real estate investments held up?
Returns on a dollar invested in residential real estate in 1963 have been only lightly better than returns on low-risk Treasury Bills.
What about compared to stocks, then?
Over this more than forty-year time period, real compound returns to stocks outpaced realty, averaging 5.95% versus returns of just 1.35% to real estate after adjusting for inflation.
So, if you took a dollar and invested it in the 1963 stock market it would have “compounded to $12.36 by 2006.”
But, the same dollar invested in real estate would have grown to just $1.79.
What about those higher appreciation regions on the coast?
Even the highest appreciating regions of the country, the Northeast and West Coast, only realized real returns of 2.35% and 2.49%, respectfully, and underperformed the returns on bonds at 2.74%.
Don’t they say past performance isn’t a guarantee of future performance?
Still data are data.
Home values have underperformed stocks and bonds in terms of average annual returns over every five- and ten-year period from 1963 to 2005, but have only been slightly above the returns on treasury bills.