How Tenure Payments Trump the Reverse Mortgage LOC in Retirement Planning

There have been several studies showing how a reverse mortgage line of credit, when used as part of a coordinated retirement planning strategy, can add value to a retiree’s investment portfolio. But while the line of credit option has garnered considerable attention in financial planning discussions, in certain situations reverse mortgage tenure payments can significantly improve a portfolio’s success rate even further, according to a recent study.

Reverse mortgage tenure payments can be especially beneficial for retirees who are looking to replace their traditional mortgage with a reverse mortgage, according to a study published this month in The Journal of Retirement by Tom Davison, a reverse mortgage blogger and financial planning partner emeritus at Summit Financial Strategies, Inc., and Keith Turner, a reverse mortgage advisor with Retirement Funding Solutions.

The study analyzes previous research from financial professionals and academics that has shown the effectiveness of reverse mortgages when used as part of a retirement income planning strategy. Taken as whole, the research is meant to inform financial planners of the various strategies in which a reverse mortgage can enhance the well-being of their clients who may have an interest in these products.

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Past research has demonstrated how a reverse mortgage line of credit, when used as a “standby” strategy, can help a retiree reduce portfolio withdraws in the event of market downturns, giving them another funding source to draw upon after experiencing negative returns.

But for retired homeowners who carry sizeable mortgage debt, replacing their traditional mortgage with a reverse mortgage and accessing their home equity via monthly tenure payments can be viable solution that could also improve the chances that the individual’s portfolio will be able to sustain them during retirement.

To demonstrate this, The Journal of Retirement study offers a case study involving a retired client who says her cash flow is too tight. Her assets include Social Security income and an $800,000 IRA. She also has a 30-year life expectancy and recently bought a $600,000 house with a $200,000 traditional 30-year mortgage. Her planned monthly expenses are $4,650, plus federal and state taxes.

A Monte Carlo analysis of her situation reveals a success rate of only 49%, with her IRA depleted at some point before 30 years have passed. First, the woman’s financial advisor recommends trimming her spending, however, the client rejects the 15% cut needed to achieve the targeted 90% success rate.

The advisor then suggests she consider paying off the current mortgage balance of $200,000 with an IRA withdrawal. Doing so, however, causes her success rate to drop to 33%, an indication that the portfolio needs the leverage from the traditional mortgage, the researchers note.

The advisor then informs the client that she is eligible for a reverse mortgage large enough to retire the traditional mortgage and have enough capacity left for either a $137,000 line of credit, or $823 monthly tenure payments.

Using the line of credit strategy as an emergency fund that grows but is never tapped, the woman’s success rate jumps from 49% to 89%. And in her later plan years, her required minimum distributions force IRA withdrawals larger than what is needed for her expenses, and so the extra cash is invested in a side taxable account.

If the woman opts for the tenure payment strategy, adding monthly tenure payments to her cash flow instead of holding the unused line of credit, researchers indicate that her Monte Carlo success rate rises to 100%, and the taxable side account builds up earlier and quickly. As a result, her spending is fully funded every year of the simulated lifetimes and there is a cushion for emergencies, should they arise.

“Electing reverse mortgage tenure monthly payments created the highest final net worth, with the untapped [Reverse Mortgage Line of Credit] RMLOC a close second,” wrote Davison and Turner. “Either method provided significant improvements to both her lifetime spending and her estate if she lives into the second half of the plan.”

The impact of the reverse mortgage stems from various factors, researchers noted, including reducing the client’s initial withdrawal rate from 7.3% to 5.4% by refinancing the traditional mortgage.

“The reverse mortgage eliminated $323,310 of fixed mortgage payments in the 30-year plan (plus extra taxes attributed to withdrawing mortgage and tax payments from the IRA),” researchers wrote. “The reverse mortgage also provided increasing leverage for the portfolio throughout the plan, rather than decreasing leverage from her traditional amortizing mortgage.”

Additionally, smaller early withdrawals reduced sequence of return effects, whereas adding monthly income from the reverse mortgage via tenure payments helped further reduced the withdrawal rate.

“The client’s cash flow and net worth in later years were higher with the reverse mortgage than the traditional mortgage,” wrote Davison and Turner. “This happened despite the reverse mortgage having higher monthly finance charges than her traditional mortgage. Her home equity was consumed by the reverse mortgage, but her investment assets more than offset the home’s value.”

This example, researchers said, clearly illustrates the need to look beyond the home’s decreased value to the entire balance sheet to understand a reverse mortgage’s impact on well-funded or constrained clients with assets beyond their house.

Written by Jason Oliva

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  • The author unwittingly relegates the Standby Adjustable Rate HECM Strategy to a portfolio strategy. It is far more useful than that. It is a shame to see this kind of strategy limited to some specific type of asset application, especially by a financial planner.

    Mr. Oliva did a great job summing up the case study above but its has significant flaws. First, neither the age of the borrower nor the expected interest rate are provided. Second, no upfront cost amount is presented. Third, the borrower is said to have a thirty year life expectancy at closing. Since a borrower must be at least 62 years old at closing, how is that even possible? Perhaps Dr. Davison intended on describing the 30 year period as the period under examination or as some kind of hypothetical period. Fourth, not all IRAs are fully taxable. Many are partially taxable and some are not taxable at all since they are Roth IRAs. If IRA distributions are substantially or fully non-taxable, it could be paying off the existing mortgage with IRA distributions would produce a better result depending upon the average effective earnings rate on IRA assets and the margin on the adjustable rate HECM note interest rate.

    Having said all of that, the borrower would have to be at least 68 years old at closing to have $200,000 of the principal limit utilized in paying off the existing mortgage and a line of credit of $137,000 left over at closing and the expected interest rate would have to have been 5.06% or less if the borrower were 68 years old at closing. Of course that also assumes there is little upfront cost. (The older the youngest borrower is, the more suspect the 30 year life expectancy becomes.)

    Looking at the 60% first year disbursements limitation, with the mortgage payout, that mandatory obligation payout alone is 59.35% of the principal limit if there are no other mandatory obligations (including upfront costs). Yet if tenure payouts are to be taken at $823 per month, that would mean that the additional 10% payout election would have been made increasing the upfront MIP to 2.5% or $12,000 more in upfront MIP costs since the MCA is $600,000.

    The trouble is the alleged HECM is just too flawed to put much stock in and at least to some degree causes the case study to looked at as invalid. It may take some work to salvage the HECM example but with a few stated assumptions and a little better math, it could easily be used to make the conclusion the author makes. Yet another problem with the study is relegating the Standby Adjustable Rate HECM Strategy to a portfolio solution. It is a shame that it is not illustrated in other asset (and some liability) applications.

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