Most people think a reverse mortgage is designed only for low income seniors… people who need money to support their lives during their retirement years. They’re wrong about that.
In fact, even if you have $1 million or more in your retirement account, using a reverse mortgage in some situations could save you hundreds of thousands of dollars… and I’m about to describe a real life situation where that’s exactly what happened.
First let’s define what we’re talking about…
Today’s reverse mortgages are more accurately referred to as Home Equity Conversion Mortgages and they’re known by the acronym: HECM. A HECM is basically an FHA insured mortgage that’s only available to homeowners over 62 years of age with significant equity in their homes.
What makes the HECM unique is that it doesn’t require the homeowner to make any payments on the loan until the home is either sold by the homeowner… or when it’s sold or refinanced by their heirs. Homeowners can choose to make interest only payments, if they want to… or they can choose to make principal and interest payments… or they can make no payments at all until they die or sell the home.
When you have a HECM, you still own your home… just like with any other mortgage. You still have to pay your property taxes, insurance and normal maintenance, but you don’t have to make any payments on the loan if you don’t want to.
A better source of capital…
If you think about it, a HECM is simply a source of capital that homeowners with equity can access after age 62. And in many cases, it’s a better source of capital than the alternatives because it doesn’t have to be repaid on any certain schedule, it’s available at a relatively low interest rate… and it’s tax free.
Some homeowners need the funds available from a HECM to supplement their income during their retirement years, but that’s only one of the reasons to use the HECM as a source of capital… there are many others and now I’m going to show you how a homeowner recently saved something like $300,000 by using a HECM instead of pulling the cash out of their retirement accounts.
What you’re about to read is 100% true… it really happened over this past summer… but because telling the story would involve disclosing the homeowner’s personal financial information, I’ve changed the names and a few of the details to protect their privacy.
We’ll call our couple Mr. & Mrs. Smith…
Mr. Smith is 64, Mrs. Smith is 62. Their Southern California home appraised for a little over $800,000… and the couple paid off their mortgage a few years back. Mrs. Smith retired some years ago, but Mr. Smith plans to continue working for another six years, which is when he’ll turn 70.
Mr. Smith is a senior partner at an architectural design firm… his annual income is $250,000. He has a little over $1 million in his 401(k) plan account and Mrs. Smith has another $150,000 in her retirement plan account… the couple doesn’t have any debt of which to speak.
You don’t need to be any sort of financial expert to see that the Smiths are among the relative few in this country who are on track to save enough money to maintain a comfortable lifestyle in their retirement years… and with no significant debt, they certainly saw no need to borrow money from anywhere.
Late last April, we met Mr. Smith. He had read an article of mine and was calling to ask questions about the HECM. He explained that he and his wife were planning to retire in Arizona… that they hadn’t yet purchased a home there, but that they were planning to do so in the next couple of years.
Mr. Smith wanted to know how the HECM would apply in his situation and we arranged to meet at his home after dinner a few days later. I told him that my wife and I would bring cheesecake for desert and he promised to have good coffee brewing when we arrived.
We crunched the numbers and compared different alternatives in order to create a proposal for the Smiths… and after Mr. Smith spent at least an hour reviewing the documents and searching for any sort of “catch,” they both had to admit that not only did it seem the best way to go, but it also would allow them to buy their Arizona home now, as opposed to waiting six years until Mr. Smith retired.
Over the next week, we would also present our proposal to the couple’s accountant… then to their attorney… and finally to their financial planner… and everyone agreed that the HECM was ideal for what the couple wanted to do. A month later, the Smiths were making an offer on their retirement dream home in Arizona.
Why the HECM was clearly the best way to go…
To understand why the HECM was by far the best way for the Smiths to purchase their retirement home you first need to understand the nature of qualified retirement plans, like the 401(k) or the IRA.
The money you contribute to a 401(k), for example, is “tax-deferred,” which means that you don’t pay taxes on the funds until you withdraw them. That means that if you get a $10,000 bonus at work, you can deposit the whole $10,000 into your 401(k) account, instead of the $6,000, give or take, that you’d have left after paying taxes on that money.
Over time the benefits of pre-tax contributions add up. However, when you withdraw funds from the account, the withdrawals are considered “ordinary income,” and they are therefore subject to both state and federal income tax.
Assuming a combined state and federal tax rate of 40 percent, that means that if you need $150,000, and want to withdraw it from your 401(k) account, you’d need to withdraw at least $210,000.
The other thing you need to understand about saving for retirement in a qualified retirement plan is that during the last five years of your working life, it’s highly likely that you’ll earn the most on your investments simply because during those years you have the most money invested.
It’s a bit of an oversimplification, but just consider that if you were five years away from retirement, your account balance was $1 million, and you were earning 10 percent annually, you’d be looking at earning $100,000+ each year, or $500,000+ over those critical last five years on the job.
It might have taken you 30 years to save the first $1 million, but during the last five years at work, you’re portfolio could grow by 50 percent.
However, if you withdrew $500,000 from your account at age 60, then over the next five years you’d only earn returns based on a $500,000 account balance, which again assuming annual returns of 10 percent, would mean earning only $250,000 during those last five years at work… half as much as you would have earned had you kept the entire $1 million invested.
In that example, therefore, withdrawing $500,000 from your 401(k) at age 60 and retiring at age 65, not only means having to pay $200,000 in taxes (assuming a 40 percent rate), but it would also cost you $250,000 in lost investment returns over your last five years at work.
The moral of the story…
Obviously, the moral of the story is that you want to leave the money in your qualified retirement plan for as long as possible… and that withdrawals during your last five years at work are clearly to be avoided if at all possible because such withdrawals are the most costly.
Mr. and Mrs. Smith already understood this math. In fact, it’s precisely why they hadn’t yet purchased their retirement home in Arizona, even though they had found a home there that they loved for $350,000.
They had inquired about financing the home in Arizona and were told that because it would be a second home, they’d need 30 percent down, or about $140,000, plus they figured they’d need $20,000 for furnishings and miscellaneous expenses, so the couple figured they’d need to withdraw $225,000 from their retirement accounts to net enough to purchase the home.
The couple then also realized that withdrawing $225,000 from Mr. Smith’s 401(k) account would also mean not earning returns on that $225,000 for the next six years until Mr. Smith retired.
Mr. Smith told us that on average he’d been earning about 10 percent annually over the last 10 years on the investments held in his 401(k) account, so withdrawing $225,000 now would mean not making almost $25,000+ a year for the next six years.
So, withdrawing that amount now would cost the couple $125,000 in lost investment returns over the next six years… plus the taxes of over $60,000 that would need to be paid on the $225,000 withdrawal from Mr. Smith’s 401(k) account.
All told, and in round numbers, getting the $160,000 they needed to buy the Arizona home now would end up costing the Smiths $225,000 if withdrawn from Mr. Smith’s 401(k).
A better way to go…
We presented another way to go… using the HECM as the source of funds instead of Mr. Smith’s 401(k) account.
To begin with, the HECM would easily provide the couple with the $160,000 they needed, but since funds from a HECM are TAX FREE, the couple wouldn’t have to pay the $60,000 in income taxes that would result from withdrawing the funds from their retirement account(s).
In addition, because getting the funds from the HECM meant not having to withdraw $225,000 from Mr. Smith’s 401(k), he would still be able to earn returns on those funds as they would remain invested until he retired at age 70.
Also, since the HECM doesn’t require the borrower to make monthly payments, the Smiths could use the HECM to get the money they needed to buy their retirement home now, but they would’t have to make any payments on the loan until they sold their primary residence, which they planned to do in roughly six years.
Assuming their home, which you might remember appraised for $800,000, were to appreciate by just two percent a year, it would increase in value by a little more than $16,000 a year… so over six years, that appreciation would mean adding something like $100,000 to the home’s value.
Of course, there’s also the interest on the HECM to consider, which in the Smith’s case was about four percent. A loan balance of $225,000, and a four percent interest rate, means roughly $9,000 in interest accruing annually. That’s a lot less than the $16,000 in appreciation that would accrue assuming their home were to increase in value by only two percent a year.
However, the Smiths decided to make interest only payments on the HECM, because as mortgage interest, those payments are deductible… and they could use the deduction.
So, now let’s take a look at where we are…
Before we presented the HECM as applied to the Smiths situation and goals for retirement, the couple was looking at having to withdraw $225,000 from Mr.s Smith’s 401(k) in order to get the $160,000 needed to purchase their retirement home in Arizona.
That would have not only meant having to pay $60,000 in income taxes, it would also mean reducing that account’s balance by $225,000, which would mean not earning an estimated $25,000 in investment returns every year for the next six years… or $125,000.
That means that about HALF the cost of the Arizona home would be covered just by leaving the funds in Mr. Smith’s 401(k) account for the next six years, as opposed to withdrawing funds now to purchase their Arizona home. And who knows how much more the Arizona home would cost six years from now, as compared with buying it today.
In addition, by making interest only payments on the HECM, the couple would be able to deduct mortgage interest of approximately $9,000 a year, and in six years, when Mr. Smith retires, they’ll simply sell their current home and pay off the $160,000 they received from the HECM.
Of course, selling their home is also a taxable event, but it means paying long-term capital gains tax, which is a MUCH lower rate than the ordinary income tax that would need to be paid on withdrawals from Mr. Smith’s 401(k) account.
Since it’s very likely that both their home’s value and the balance in the 401(k) account will have increased by then, a significant portion of the HECM loan will be repaid by that future appreciation… instead of from their pockets in today’s after tax dollars.
So, what’s on the scoreboard?
It should be easy to now see that using the HECM as a source of funds instead of withdrawing from their retirement account saved the Smiths at least something in the neighborhood of $200,000 and who knows, when all is said and done, maybe even more.
However, the reality is that the Smiths already understood how costly it would be to use retirement plan funds to buy their Arizona home and that’s why they hadn’t bought it already.
So, were it not for the HECM, they would have likely waited until Mr. Smith retired to buy the home, which means that not only did the HECM save them money, but it also made it possible for the couple to get their dream home six years sooner than they thought would be the case.
The couple was positively elated over the prospect of being able to buy the home in Arizona now, as opposed to having to wait for six years. In fact, we closed their HECM just 25 days later and the couple flew to Arizona the day after they signed their HECM loan docs to make an offer on the property.
What did their HECM cost?
If you’ve been following the numbers involved in the Smith’s story, you should see that the HECM was by far the better source of funds in their situation. And you wouldn’t be alone in that view, because the couple’s accountant, their financial planner and their attorney all agreed. Interestingly, those three trusted experts also admitted they hadn’t previously known that the HECM could be used as we were proposing the Smiths use it.
The costs of the Smith’s HECM were only a few thousand dollars, and the Smith’s three advisors were shocked that the costs of the HECM were so low. They had all heard that reverse mortgages were “expensive,” and even though they had never seen HECM costs up close, they had all come to believe the rumors.
The bottom-line is that the Smith’s three expert advisors, after reviewing the Smith’s loan documents, learned that they had been wrong about today’s HECM reverse mortgages. They learned that they had been wrong not to consider the HECM as a potential source of capital for what the Smith’s wanted to do, and they learned that they were wrong to think that the HECM’s costs would make it too expensive.
It’s SCARY out there…
Consider the significance of what I just said… that the Smith’s accountant, attorney and financial advisor all believed that the HECM reverse mortgage would be too “expensive,” to the point of being cost prohibitive. And none of the three had recommended that the couple look into the HECM before seeing our proposal.
The fact is that were it not for my Reverse Mortgage Intelligence Team, those three licensed and experienced professionals would have advised the couple against the the HECM… but for no real reason… just because they had come to believe things about the HECM that simply weren’t true.
I would think that for a lawyer, accountant or financial advisor to tell someone not to use the HECM based on incorrect assumptions is something to be avoided. If that were to happen to me and I found out that my lawyer or accountant had been wrong… I’d never rely on advice from the same advisor(s) again.
I’ve never seen anything so poorly understood as today’s HECM reverse mortgages. The industry has done a horrible job of communicating the applications for the HECM. The mainstream media has been even worse.
Consider this… the HECM is so poorly understood that today almost everyone believes that reverse mortgages are designed only for low income seniors.
However, as everyone should now clearly see, one of the biggest advantages of the HECM is that it’s a source of capital that’s available TAX FREE. But, since low income seniors don’t pay taxes, nor do they have 401(k) accounts with hundreds of thousands of dollars in them, they can’t take advantage of the HECM being tax free.
Do you see how distorted this subject has become?
Reverse mortgages are for people over age 62 with equity in their homes… period. They are not just for people who have no other money on which to retire, in fact, those with significant assets can often benefit from the HECM even more than those for whom money is an issue, because the biggest advantage of the HECM can be that it’s a tax free source of funds.
The HECM is a tool, but like most tools, it can be used for more than one purpose. I can use a screwdriver to open a can of paint and even stir that paint… but it’s also really good at screwing in screws, among other things.
Many experts also tell people that using a HECM reverse mortgage means that they will leave their heirs less money when they die. Really? How so?
Would someone please show me how the Smith’s use of the HECM could possibly result in the couple leaving their heirs less than planned? I’m not sure how you could possibly link the two things together, the HECM with the future value of the couple’s estate, but it would seem to me that the Smith’s use of the HECM can only increase the value of their estate, right?
I’ve also read some financial advisors referring to the HECM as “a loan of last resort,” which I suppose means that they don’t think homeowners should use a HECM unless all the alternatives have been exhausted.
That’s not only WRONG… it’s also terrible advice.
In my opinion, waiting until you’re in financial straights to look into how a HECM might help is why some people get taken advantage of by unethical mortgage lenders or brokers because that’s when people are under pressure and not thinking clearly.
In addition, because of the new financial assessment rules that apply to being approved for a HECM loan, if you wait until you desperately need funds, it’s quite possible that you won’t be able to qualify for the HECM.