Tap Home Equity When Markets Drop

EDITOR'S NOTE: This article was originally published in the November 2012 issue of Kiplinger's Retirement Report. To subscribe, click here.

Seniors in their seventies and eighties who are in a financial bind are traditional borrowers of reverse mortgages. But new research shows that a younger retiree can stretch a nest egg by using a reverse mortgage as a source of retirement income during bear markets.

In a recent study, researchers found that a retiree could benefit by using a reverse mortgage line of credit to replenish cash reserves during market downturns. Because the investor would not need to sell stocks at depreciated prices, the portfolio would have a much greater chance of lasting the retiree's lifetime. "From a financial planning perspective, the line of credit is very powerful," says John Salter, co-author of the study and an assistant professor of personal financial planning at Texas Tech University.

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A reverse mortgage allows a homeowner who is 62 or older to tap home equity with a line of credit, monthly draws or a lump sum. The loan must be repaid when the homeowner dies, sells the house or moves out for 12 months. Nearly all reverse mortgages are Home Equity Conversion Mortgages, or HECMs, which are backed by the federal government.

The introduction in 2010 of a new HECM product, called the Saver, opened new opportunities for borrowers. Its upfront fees are much lower than those of the traditional Standard product, although its loan amount also is lower. The Saver offers the same payout options as the Standard; the line of credit option has an adjustable rate, generally capped at 10%.

The lower costs of the Saver make it attractive for retirement-income planning. Salter and his colleagues looked at a hypothetical 62-year-old retiree with a portfolio worth $500,000 and a home value of $250,000. They set up three retirement-income "buckets": One held cash in short-term investments for up to two years' worth of expenses, the second held a long-term portfolio with stocks and bonds, and the third held an $82,500 reverse mortgage line of credit. A line of credit only accrues interest on the tapped amount; money left in the credit line grows at the same interest rate that is charged on the loan.

When the cash reserves dwindled to two months' worth of expenses, the "retiree" replenished part of that bucket, usually by selling assets from the long-term bucket. But when the long-term bucket dropped during periods of market volatility, the retiree used the line of credit to come up with cash. This helped the retiree to avoid locking in losses. When the market and the portfolio recovered, the retiree paid off the line of credit with the long-term assets. Such a strategy "gives advisers control over when to sell assets," says Salter, a certified financial planner who is also a consultant in the Lubbock, Tex., office of Evensky & Katz Wealth Management.

In numerous computer simulations using historic returns and various portfolio withdrawal rates, the researchers found that the portfolio using the "standby reverse mortgage" strategy had a 78% chance of lasting 30 years. That compared with a 52% chance for the portfolio that used only cash and long-term investment buckets.

Managing the Volatility Risk

Certain features of a reverse mortgage work well with this strategy. Brad Baumann, a certified financial planner with Critical Capital Management, in Calabasas, Cal., says an advantage that a reverse mortgage line of credit has over a home equity line of credit is that the reverse mortgage line can't be frozen, reduced or canceled. During the financial crisis, many banks cut HELOCs. "There are a lot of situations that will close that line when a retiree needs it most," he says. Also, unlike a reverse mortgage, HELOCs require regular payments.

But loan fees must be low, Salter says. "If the cost goes up, we'd be more cautious" about using a reverse mortgage, he says. Also, the loan should be in the form of a line of credit, which provides flexibility. With a lump sum, interest payments begin immediately because you get all the loan proceeds at once.

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