Caution HECM Reverse Mortgage Sequence Risk

The Lurking Danger That Can Swamp Even a Solid Retirement Plan (and How You Can Avoid It)

If you’re not familiar with the term sequence risk, you definitely should be. It’s a potentially devastating lurking danger that can completely swamp an otherwise solid retirement plan. Brian Davis wrote a great article over at Bigger Pockets on this topic a while back and I’d like to build on what he wrote. If you haven’t read his article yet, you may want to now. I’ll hang tight until you get back :).

As Brian defined it, sequence risk is “the risk that the market (usually the stock market, but technically any market you’re invested in) will crash within the first few years of your retirement”. This is a big danger because it can mean burning through your savings much faster than expected.

To illustrate this risk, let’s assume you recently retired and need $1,000/month in income from your Roth IRA. Let’s also assume you’re 100% invested in a balanced ETF that is trading at $50/share. To meet your income needs, you need to sell 20 shares every month, right?

But what if the market crashes by 50% in the near future? You now need to sell forty shares to meet your income needs. You’re draining your shares twice as fast, which means you risk running out of money much earlier than planned.

The old adage “buy low, sell high” is highly applicable here. You want to be a seller when the market is up, not down. This is especially true if you have a limited capacity to generate income, which is typically the case in retirement.

Defending against sequence risk

The whims of the financial markets are beyond our control, so the best defense against sequence risk is to have multiple financial options. You want to have multiple income sources so you aren’t forced to draw draw down an asset when market conditions are unfavorable. Brian highlighted a few possibilities, including real estate and cash savings, but I’d like to offer another option you’ve probably never thought of: home equity.

The equity in your home can be an important defense against sequence risk. If the stock market is bad, you can rely on home equity to fund your lifestyle instead of selling shares in a bad market. When the stock market recovers, you can leave your home equity alone and once again live off your investments.

Diversifying your income sources enables you to draw on an asset only when conditions are favorable. When they’re not, you can rely on another asset (such as home equity) for your income. The end result is that you can more easily preserve both your lifestyle and your money for far longer.

Two ways to tap home equity (one good, one bad)

Let’s address two different ways retirees often tap into home equity to fund their retirement: one good, one bad. I’ll cover the bad one first.

One of the most common ways to tap into home equity in retirement is the HELOC, or home equity line of credit. I’ll be honest with you: I cringe when I meet seniors who have HELOCs because I know the kinds of financial headaches HELOCs can create.

Now don’t get me wrong, I have nothing against HELOCS. A HELOC is a great product, but only when it’s used for the correct purpose. Unfortunately, many seniors use them for the wrong purpose (often at the recommendation of well-meaning advisors) and end up getting into trouble.

HELOCs are designed for short-term cash needs where the homeowner borrows and repays on a relatively short-term basis. HELOCs become risky when a large balance is carried long term.

Unfortunately, many seniors tend to use HELOCs as a long-term cash source and carry large (and often growing) balances for many years. This can be highly risky for several reasons:

  1. Interest-only payments. Most HELOCs have low minimum payments that only cover the interest. Unless you intentionally make extra payments, the debt isn’t paid down over time.
  2. The more you borrow, the bigger the payment. This can become a real financial headache if you use a HELOC to cover big expenses such as medical bills, car repairs, or home maintenance. The more you borrow, the bigger the payment gets.
  3. Adjustable rates. Though some HELOCs have fixed rates, most come with adjustable interest rates. If rates rise, the payment will as well, which further exacerbates problem #2 above.
  4. HELOCs can be revoked, chopped, or frozen with little notice. This can be bad news if you plan to use the HELOC as a long-term financial safety net. If home values fall or credit conditions deteriorate, banks will reduce their risk exposure. It’s entirely possible your HELOC will be revoked, chopped, or frozen when you need it most.
  5. HELOCs are typically full recourse loans. If home values fall and you owe more than the home is worth, the bank will come after you for the shortage if you try to sell your home. You will either have to come up with a lot of cash at closing or negotiate a short sale to get your home sold. And if you can’t keep up with the payments, you may face foreclosure and a deficiency judgment for the unpaid loan balance.
  6. The recast. This is probably one of the most devastating problems with HELOCs. Unfortunately, most borrowers only find out about this potential financial iceberg when they’re about to crash full-on into it. Most HELOCs allow you to withdraw funds for up to the first ten years of the loan. At the ten-year mark, the bank recasts the loan into a full principal and interest payment that pays back the entire balance over a relatively short time period. If your balance is large, this can mean your payment increases by hundreds of dollars or more. I can think of one particular client a few years ago who had this happen to her. She’d had her HELOC for 10 years and the payment recast from a manageable $150 to over $700. Since she was on a fixed income, she struggled to make the payment and was at risk of losing her home.Ten years might seem like a long time in the future, but those years pass quickly. This is not a situation you want to be in if you’re in your late 70s or 80s and perhaps not in the best of health.

In short, the HELOC is not designed to be a source of income (or emergency funds) in retirement. They’re just too risky.

So, what’s a far better solution? The HECM line of credit.

The convenience of the HELOC, but without the risk

A HECM, or home equity conversion mortgage, is a federally-insured home loan that enables homeowners 62 or older to convert a large portion of their home’s value into tax-free cash without giving up ownership of the home or taking on a mortgage payment. As long as at least one borrower is living in the home and paying the required property charges (property taxes, homeowners insurance, etc.), no mortgage payments are required.

HECM proceeds can be received as a lump sum, monthly term or tenure payment, or line of credit.

It’s the line of credit that I would like to focus on here because it can serve as a fantastic defense against sequence risk.

The beauty of the HECM line of credit is that it has the flexibility and convenience of a HELOC, but without the payment risk. Again, as long as a least one borrower is living in the home and paying the required property charges, no payments are required.

The best part is that the unused credit line grows and gives you access to more of your equity over time automatically based on a guaranteed growth rate. A HELOC definitely doesn’t do that!

To see how the growth works, let’s take a look at an example.

HECM Line of Credit Scenario 1Let’s assume the initial credit line is $75,000 and the annual growth rate is 5%, which is very reasonable for today’s market. As you can see in the table, after just 5 years, the line of credit will have grown to over $95,000. After ten years, it will have grown to more than $122,000!

Because the growth rate applies to the available line of credit, growth compounds on growth. This means that the available credit in absolute dollar terms can really pile up over time – especially if you get it set up early in retirement.

Even better, the growth rate is designed to keep up with prevailing interest rates. If rates rise in the future, the growth rate will rise as well, which means the line of credit will grow even faster.

Because there’s no limit on the size of the line of credit, it could even outgrow the value of the home at some point. If that happens, you’ve beat the system! Remember, the HECM is a non-recourse loan, which means the most that has to be paid back is the value of the home. FHA will cover any shortage out of it’s insurance fund.

The HECM line of credit can be a fantastic tool to reduce sequence risk. Many retirees already have a lots of home equity, so why not put it to work to increase the longevity of other assets?

The HECM line of credit essentially turns a large chunk of your home’s equity into a liquid and tax-free retirement “account” that grows.

More options equals more financial security

I think it is absolutely essential to have as many financial options in retirement as possible. People are living longer, the cost of living is rising, and there’s a lot of economic uncertainty out there. And when you’re retired, you simply don’t have the capacity to earn an income the way you did in your younger years.

It’s essential that you protect and preserve your assets against the whims of the economy and financial markets. Just as it’s prudent to diversify your investments, it’s also prudent to diversify your income sources to protect your lifestyle and savings from sequence risk.

The HECM line of credit can be a fantastic additional option to an already solid financial plan for retirement. When the financial markets are down, you can live on home equity. Once markets recover, you can leave your home equity alone, let the line of credit grow, and once again tap into retirement accounts.

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