By Robert Klein, CPA
Housing wealth, although it represents about one-half of an average household’s net worth, is often ignored as a retirement income planning tool. There are numerous strategies that can be used to provide readily available tax-free liquidity to pay for planned and unforeseen expenses throughout retirement by monetizing a portion of the equity in one’s home.
Several of the strategies are offered by home equity conversion mortgages, or HECMs, which is the most popular reverse mortgage program and is offered and insured by the Federal Housing Administration (FHA). You can qualify for a HECM beginning at age 62.
If you aren’t familiar with HECMs or simply need a refresher, I recommend that you read my Retirement Daily article from June 2020, Not Your Father’s Reverse Mortgage. The biggest change since I wrote the article is an increase in FHA’s HECM lending limit from $765,600 in 2020 to $822,375 in 2021.
Home Equity Conversion Mortgages Unlock Home Equity Without the Downsides of a Line of Credit
A HECM is designed to unlock home equity for homeowners as needed through a readily available credit line without the downsides of a home equity line of credit, or HELOC. These include access for a specified number of years, typically 10 required minimum monthly payments. The lender can freeze or cancel the loan, and the home is subject to foreclosure if minimum payments aren’t paid. There is also a requirement to repay the loan in full even if the borrower owes more than the home is worth. Perhaps most importantly, you may not qualify for a HELOC when you’re retired if your sources of income for repayment are limited.
All homeowners with or without a mortgage should evaluate a potential HECM beginning at the eligible age, 62 years old. An evaluation should be done whenever contemplating refinancing, purchasing a new home, or planning for other major financial changes. Whatever the situation, a HECM can increase cash flow, reduce expenses, and increase retirement savings.
The HECM Pentathlon
There are five key financial metrics that should be analyzed individually and collectively when considering a HECM. Just like a track and field pentathlon, you don’t need to score high in every event to win the gold medal. You may bask in glory after finishing low in the shot put, excelling in the 800 meters and 60-meter hurdles, and performing in the 75th percentile in the high jump and long jump.
Side-by-side projections of existing or potential refinancing of forward, or traditional mortgages with one or more HECM scenarios applying each of the five metrics for the next 20 years should be prepared. This will enable you to evaluate the pros and cons of a HECM in your situation.
Three hypothetical scenarios to illustrate each of the five financial metrics. Please refer to Hypothetical Scenario List of Assumptions for a list of assumptions used in the various scenarios.
Please keep in mind that the “Mortgage” scenario in each illustration refers to a forward, or traditional mortgage. Please also note that the assumed increasing interest rates that are used to calculate accrued interest on projected HECM loan and credit line balances are greater than FHA’s “expected,” or initial, interest rate that’s required to be illustrated for the life of a loan on a projected amortization schedule when applying for a HECM.
Metric #1: Projected Mortgage Balance
Most people entering retirement who own a home still have a mortgage, home equity loan, or outstanding HELOC balance. Many of these won’t be paid off for 10 to 20 years. Even if you have a minimal or no mortgage balance, you should consider a HECM if access to tax-free liquidity is or will be important to you during retirement.
There are two primary advantages of a HECM over a forward, or traditional, mortgage:
- No required loan payments
- Ongoing access to a tax-free line of credit that increases by the loan interest rate and elective payments.
- Traditional mortgage balance of $300,572, with assumed monthly payments of $1,600, is paid down over 20 years, with a projected balance of $21,985 at age 82.
- HECM #1 balance of $325,572, which assumes no payments, increases to a projected balance of $807,340 at age 82.
- HECM #2 balance of $325,572, with assumed monthly payments of $1,600, is paid down over 20 years, with a projected balance of $124,749 at age 82.
Winner: Traditional mortgage by approximately $103,000 over HECM #2 and $785,000 over HECM #1.
Metric #2: Projected Savings
Whenever you’re making mortgage payments, whether it’s on a traditional mortgage or electively on a HECM, you’re decreasing the amount that you could otherwise be saving. Likewise, when you don’t make payments on a HECM, which is what most people do, you have the opportunity to save money that would otherwise be used to make mortgage payments.
- Required traditional mortgage monthly payments of $1,600 reduces savings by $19,200 a year, or a total of $384,000 over 20 years.
- HECM #1, which assumes no payments over the first 20 years, results in annual savings of $19,200, or a total of $384,000 over 20 years.
- Elective HECM #2 monthly payments of $1,600 produces the same result as a traditional mortgage, i.e., annual savings reduction of $19,200, with a total of $384,000 over 20 years.
Winner: HECM #1 by $768,000 over traditional mortgage and HECM #2
Metric #3: Projected Net Worth
Projected net worth as it relates to the evaluation of a HECM is equal to the total of the projected mortgage or HECM balance, projected savings balance, and projected home value each year. The projected mortgage or HECM balance needs to be shown as a negative amount since loans reduce net worth.
- Traditional mortgage projected net worth increases from $599,428 to $1,566,026 at the end of 20 years.
- HECM #1 projected net worth, which assumes no payments, increases from $574,428 to $1,548,671 after 20 years.
- HECM #2, projected net worth, which assumes monthly payments of $1,600 totaling $384,000, increases from $574,428 to $1,463,262 after 20 years.
Winner: Traditional mortgage by approximately $17,000 over HECM #1 and $103,000 over HECM #2
Metric #4: Projected Line of Credit
As previously stated, one of the primary advantages of a HECM over a forward, or traditional mortgage is ongoing access to a tax-free line of credit. Once again, the line of credit increases by the loan interest rate and elective payments.
As discussed in the “Reverse Mortgages No Longer a Program of Last Resort” section in my Not Your Father’s Reverse Mortgage article, research by Wade Pfau, a professor of retirement income at The American College of Financial Services, has shown that applying for a HECM earlier and using the HECM line of credit strategically throughout retirement can potentially increase retirement spending and provide for a larger legacy.
Both HECMs in the hypothetical scenario are illustrated with no credit line advances for the first 20 years to keep the illustrations simple. This results in a projected increasing line of credit for the duration of the illustration. Any advances from the credit line would reduce the projected line of credit balance.
- Traditional mortgage has no line of credit.
- HECM #1 projected line of credit, which assumes no payments, grows by the assumed interest rate, which begins at 2% and increases gradually to 5.5% in years 17 to 20, causing it to grow from $86,188 to $213,725 at the end of 20 years.
- HECM #2 projected line of credit, in addition to growing by the assumed interest rate, also increases by the monthly payments of $1,600, resulting in a tenfold increase from $86,188 to $895,316 after 20 years.
Winner: HECM #2 by approximately $681,000 over HECM #1 and $895,000 over the traditional mortgage
Metric #5: Projected Liquidity
Metrics #4 – projected line of credit and #5 – projected liquidity, when evaluated together, are the most compelling criterion favoring the use of a HECM as a retirement income planning tool for prolonging the longevity of retirement assets.
Projected liquidity is equal to the total of projected savings (metric #2) plus the projected line of credit (metric #4). The ability to readily access funds from savings as a result of not making mortgage payments and/or from a readily available tax-free credit line during one’s retirement years, especially when alternative sources of income may be scarce or nonexistent, distinguishes HECMs as a unique planning solution.
- Since there is no credit line available with a traditional mortgage, projected liquidity decreases by the amount of projected savings which is -$19,200 per year, or -$384,000 after 20 years.
- HECM #1 savings is projected to increase by $19,200 per year as a result of no credit line payments, or a total of $384,000 after 20 years. The credit line is projected to increase from $86,188 to $213,725 during the same period. Combining the two results in projected liquidity of $597,725 at the end of year 20.
- HECM #2’s monthly payments of $1,600, or $19,200 a year reduce projected savings by $384,000 after 20 years. The credit line, however, is projected to increase from $86,188 to $895,316 during the same period, resulting in projected liquidity of $511,316 at the end of year 20.
Winner: HECM #1 by approximately $87,000 over HECM #2 and $982,000 over the traditional mortgage
Illustration HECM Pentathlon Overall Winner
As stated in the beginning of the “HECM Pentathlon” section, there are five key financial metrics that should be analyzed individually and collectively when considering a HECM. Just like a track and field pentathlon, the overall winner is determined by the highest total score for all five events.
Assuming that a score of 5 points is assigned for 1st place, 3 points for 2nd, and 1 point for 3rd, the overall winner of the Illustration HECM Pentathlon with a total score of 17 points is HECM #1. (The crowd goes wild!) Traditional mortgage and HECM #2 tie for 2nd place with a total score of 13 points each.
Illustration HECM Pentathlon 1st Place – HECM #1 demonstrates the importance of analyzing all five metrics together. If you focus only on the mortgage balance, which is projected to increase from $326,000 to $807,000 in 20 years, you would never choose HECM #1. When you factor in projected savings and liquidity, both of which finished in 1st place, together with projected net worth and credit line, with both finishing in 2nd place, you have your HECM pentathlon overall winner.
Caution: It isn’t prudent to select a winner based on score alone in the HECM Pentathlon. This is a starting point and may not be the best option for you. If, for example, your priority is to have the highest line of credit with a large amount of liquidity 20 years from now to pay for potential long-term care expenses using tax-free funds, HECM #2 would be your clear choice provided that you’re comfortable with continuing to pay $1,600 per month for 20 years despite the fact that there’s no payment requirement with a HECM.
Per Illustration HECM Pentathlon 2nd Place – HECM #2, by continuing to pay $1,600 per month, or a total of $384,000 over 20 years, HECM #2 credit line balance is projected to be $895,000 in 20 years, or $681,000 greater than projected HECM #1 balance of $214,000. Projected HECM #2 liquidity is projected to be $511,000, or only $87,000 less than HECM #1 projected liquidity of $598,000. HECM #2 net worth is projected to be $1.463 million, or only $86,000 less than HECM #1 projected net worth of $1.549 million.
The fact that HECM #2 mortgage balance is projected to be $125,000, or $103,000 greater than the projected balance of $22,000 of your current traditional mortgage should be less of a concern, especially when you consider the fact that there’s no line of credit and your liquidity is projected to be -$384,000 in 20 years if you keep your current mortgage.
A HECM Isn’t for Everyone
Despite the fact that a HECM is a wonderful tool for unlocking home equity, it isn’t a good solution in every situation. One example would be if you’re planning on selling your home in the next five years. The initial costs associated with a HECM would generally not be justified in this case. You could, however, potentially use a HECM for purchase strategy when you sell your home if you buy a replacement home if that makes financial sense.
Also, individuals who are focused only on paying off their traditional mortgage, have already paid off their mortgage and are unwilling to borrow against their home, or are unable to justify the value of having ready access to an increasing tax-free credit line during their retirement years relative to the initial costs aren’t good candidates for a HECM reverse mortgage.
A HECM can furnish you with a one-of-a-kind tool to unlock illiquid home equity, providing unfettered access to tax-free funds when you’re likely to need them the most, i.e., in your retirement years, without the downsides associated with a HELOC. The combination of no required loan payments and ongoing access to a tax-free line of credit that increases by the loan interest rate and elective payments are unique.
This article introduces a process for analyzing a potential HECM in any situation. The process includes five financial metrics that can, and should be, used individually and collectively to analyze the pros and cons of unlocking home equity. The inclusion of projected credit line advances to pay for one or more strategic outlays, e.g., projected long-term care expenses, would complete the analysis.
When the value of a HECM as a retirement income planning solution is understood, implemented early in retirement, and used strategically to unlock illiquid home equity, a HECM reverse mortgage can be used to increase after-tax cash flow at opportune times throughout retirement while providing peace of mind.
Disclosure: Robert Klein isn’t licensed to sell HECM and other reverse mortgage products. Klien and Retirement Income Center receive no fees, commissions, or other forms of compensation from any reverse mortgage providers or other third parties in connection with sales of reverse mortgage products to Klein and Retirement Income Center’s clients or for referral of individual clients.
About the Author – Robert Klein
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the writer and publisher of Retirement Income Visions™, a blog featuring innovative strategies for creating and optimizing retirement income that Bob created in 2009.
Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies, including fixed income annuities, Roth IRA conversions, HECM reverse mortgages, and charitable remainder trusts, to optimize the projected longevity of his clients’ after-tax retirement income and assets. Bob does this as an independent financial advisor using customized holistic planning solutions determined by each client’s needs. Retirement Income Center has established relationships with various highly respected professional organizations and platforms to provide the firm’s clients with its comprehensive array of fee-based planning, management, and protection services.