January 6, 2019 by HECM Pro
Say what?? Gut an IRA to get a reverse mortgage? Were they nuts?
It might sound completely crazy, but these clients did just that – and they did it happily. I’ll show you why.
First, let’s set the stage. This married couple, who we’ll call Joe and Loretta, were 65 at the time. They really wanted to get retired so they could spend more time with their grandchildren, who were growing up fast.
Here was the problem: they had two mortgages with a total balance of $306,000 and combined principal and interest payments of $1,616. Their only retirement income would be around $2,800 from Social Security. There was no way they could handle the mortgage payments and their other living expenses on a $2,800 monthly income.
Unless they got rid of the mortgage payments, they would likely be working for most of the rest of their lives. They would miss out on precious, irreplaceable time with their young grandchildren.
There had to be a better way!
The various options
Let’s take a closer look at Joe and Loretta’s current financial situation. Figure 1 shows a summary of the two mortgages. As you can see, they have 22 years left on the main mortgage and 14 years left on the home equity line of credit, or HELOC. The way things are going now, it will take until they are both 87 before they can eliminate the mortgage payments entirely.
Joe and Loretta also have total combined retirement assets worth about $230,000 (see Figure 2).
Thanks to a favorable real estate market, their home is currently worth around $590,000, giving them a total net worth in the ballpark of $514,000. That’s a nice number on paper, but a good chunk of their net worth is locked away in the form of home equity, which isn’t liquid.
Joe and Loretta considered working a few more years, paying extra on the mortgage payments, and then refinancing for a lower payment.
But that idea comes with some risk. What if home values fall or their financial situation changes and they can’t refinance? Besides, they want to spend more time with their family now, not a few years from now.
Even if they chose to work a few more years to pay down the mortgages, how much of a dent could they really make in the total balance? Even if they buckled down and paid an extra $500/month for the next three years, they’ll only reduce the combined balance by an extra $20,000 or so.
And what if interest rates increase over the next few years? All those extra principal payments could be for naught. Higher interest rates could offset any payment savings received from refinancing a lower loan balance.
Joe and Loretta like the idea of a HECM reverse mortgage because it could free them of the mortgage payments once and for all today. As long as they continued living in the home and paying the required property charges, they’ll never be asked to make mortgage payments again.
For Joe and Loretta, that is huge. In fact, it almost sounded too good to be true! If the reverse mortgage could get rid of the mortgage payments, they would be able to finally retire and spend more time with family.
Houston, we have a problem
After putting the reverse mortgage calculator to work, we discovered that Joe and Loretta qualified for a principal limit of $246,030 based on age and estimated home value. Uh, oh, that’s a problem. That wasn’t enough to clear both mortgage balances. They needed $78,000 more than what the reverse mortgage offered.
Joe was particularly disappointed, but didn’t miss a beat and offered to bring the shortage to the closing table from his IRA account. Yes, he would be draining a retirement account dry just as he was retiring. Yes, he would get hit with income taxes on the money, too (traditional IRA funds are taxable when withdrawn).
However, when we discussed and broke down the numbers, it became clear that Joe’s plan made perfect sense.
Before we go any further, let me first emphasize a really important point: your lifestyle in retirement is determined by your cash flow. In other words, what’s left over at the end of the month after paying your living expenses determines the fun things you can do. If you want to have more fun, you need to increase your income and/or reduce your expenses so you have more free cash flow at the end of the month.
For Joe and Loretta, the barrier to the retirement lifestyle they wanted was the mortgage payments. To stop working, they needed to either get rid of the mortgage payments or increase their income so they could more easily afford their mortgage payments.
With that in mind, let’s look at the two available options to improve their cash flow situation and get them retired.
Option 1: Supplement income by withdrawing from retirement savings
To cover a combined mortgage payment of $1,616, they would need to withdraw about $2,000 to $2,100 from the retirement accounts every month. Remember, IRA and 401(k) withdrawals are taxable, so they would need to withdraw enough every month to cover the mortgage payments and income taxes.
Now, here’s the kicker: their retirement funds would run out long before the mortgages were paid off. Even if they managed a consistent 8% rate of return on their retirement savings (not likely), the savings would only last around 20 years. If they achieve a 4% rate of return (which is more realistic, according to financial experts), the savings would drain to zero in less than 14 years.
The bottom line is this: if they use retirement savings to supplement income so they can more easily afford their mortgages, they’ll drain their retirement savings dry and still have a mortgage payment. Folks, that’s throwing good money after bad!
Now, let’s take a look at another option.
Option 2: Drain the IRA and get the reverse mortgage
At first glance, this sounds crazy. But hear me out! If Joe and Loretta liquidate their IRA (which has an $80,000 balance), they’ll have enough to pay down their total mortgage balance and get a reverse mortgage. Yes, they’ll be draining a hard-earned retirement account and incurring a tax bill to do it. However, they’ll be eliminating both mortgage payments for good and make it possible to retire.
Joe and Loretta are essentially “investing” the IRA and gaining a monthly cash flow “return” of over $1,600/month by eliminating both mortgage payments. You can look at it from the standpoint of a cash on cash return: setting income taxes aside, if they save $1,600 per month with $80,000 worth of retirement money, they are essentially getting a 24% cash-on-cash return on the money. To achieve a $1,600/month return on the $80,000 IRA in the stock market, they would a consistent return of 24% year after year. We all know that’s not going to happen.
For Joe and Loretta, the reverse mortgage was ultimately a no-brainer. Yes, it was nerve-wracking to drain a hard-earned IRA, but they were able to get rid of the mortgage payments and finally retire from their jobs. They were now able to enjoy priceless time with their beloved children and grandchildren.
For them, it was well worth it.