Why a Stand By Reverse Mortgage Line of Credit Can Be a Much Better Option Than a HELOC

In the epic battle of reverse mortgage vs HELOC. The reverse mortgage is the better choice the majority of the time.

A standby reverse mortage line of credit is there and available for when the stuff hits the fan. It is a backup source of income-tax free cash that you can tap when you want. It’s an insurance policy against spending shocks, failed retirement plans and loss of income. It is the knight in shining armor when you are in financial distress or need to access income tax free cash.

I am going to focus on those that own a home free and clear and why the reverse mortgage is better than a HECLOC. However, if you still have a mortgage on your home, the strategy of  Making the Switch, can accomplish the same things you will see here.

Home equity lines of credit or HELOC’s are often recommended by advisors as a source of back up funds for when things go bad. This advice makes sense. Especially when you consider what can happen to a retirement portfolio if there are large and unexpected draws from it during retirement. However, a standard HELOC may not be the best option.

Before we get too far into this, we need to address the differences between the line of credit option with a reverse mortgage and a HELOC. They are very similar and work in many of the same ways. However, there are some serious downsides to home equity lines of credit during retirement.

This chart will give you a basic overview of the differences between a reverse mortgage vs HELOC. We will explore them more in depth shortly

Home Equity Line of Credit (HELOC) vs. Reverse Mortgage Line of Credit (RELOC)
	HELOC	RELOC
Variable interest rate?	Yes	Yes
Monthly payments required?	Yes	No**
Can payments increase if interest rates rise?	Yes	No
Payments increase as more is borrowed?	Yes	No
Cost to get the loan?	Small	Large
Can the credit line be cancelled?	Yes	No
Can the credit line be reduced?	Yes	No
Can the credit line be frozen?	Yes	No*
Guaranteed access to line of credit?	No	Yes*
Is there a mandatory pay off date?	Yes	No*
Can I or my estate be held liable?	Yes	No
Limited time to draw funds?	Yes	No
Increased payments after interest only period?	Yes	No
Annual or monthly service fee?	Usually	No
*Assuming you are meeting loan obligations ** You must still pay property taxes, homeowners insurance and other property charges.

The concerns with a HELOC are the same as having a regular mortgage during retirement because they pose multiple financial risks. However, there are additional risks with a HELOC that are even more unnerving. These risks of using a HELOC during retirement include the following.

8 Reasons Why a HELOC is Generally
Not a Good Choice During Retirement

1. They are an adjustable rate loan, as rates increase the payment will increase which could put additional strain on cash flow as well as retirement accounts. This could leave a spouse financially strained when the other dies.
2. They are typically interest only for the first 10 years. After the interest only period is over, the payment will convert to a principal and interest payment at which time payments can increase significantly causing a hardship.
3. The more you borrow the higher your payment will be. This is a slippery slope for those on a fixed income.
4. They can be frozen, reduced or cancelled at any time. This typically happens when there are recessions, economic concerns, stock markets crash, or real estate markets begin to falter. In other words, when you would need it the most, you may no longer have access.
5. They can give you a false sense of security. Knowing there is ten, fifty or a hundred thousand dollars available can give people peace of mind. Yet, the reality is that access to those funds can be taken away or severely reduced at any time. And if you borrow the funds, it impacts cash flow.
6. They are not designed for retirement and are typically a poor choice for back up funds.
7. They may be unavailable when you need them. Banks and credit unions froze, reduced, or even closed lines of credit during the housing crisis. And even more recently, many banks stopped offering lines of credit when the Covid pandemic started.
8. In a worst-case scenario where the balance on the HELOC exceeds the homes value, you are still personally liable for that debt. Assuming you have died and the HELOC exceeds the home value, the estate is still liable for that debt.

With all of those risks associated with a a HELOC, why would people choose a HELOC vs  Reverse Mortgage? Because they know and understand what a HELOC is. But they don’t understand the risks associated with this loan during retirement, they are aware but don’t care, or don’t know about the reverse mortgage line of credit as an option.

Or it could be one of the reasons below.

6 Reasons Why a HELOC May Be a Better Choice than a Reverse Mortgage

There are definitely times where a HELOC is better than a reverse mortgage. Plus it would be unfair to not discuss when it makes more sense to get the HELOC vs reverse mortgage.

1. It’s Not Your Forever Home – If you are planning on selling your home in the next few years, the HELOC is the clear winner. The main reason is the difference in fees between the two loans. In many cases you could get a HELOC for little to no fees. Whereas the reverse mortgage comes with some rather hefty fees. As long as you can handle increases in monthly mortgage payments, I would usually recommend the home equity loan.
2. It’s Not Your Primary Residence – You can not get a reverse mortgage on a vacation home or rental property. But you can get a HELOC from your bank or credit union on these types of properties.
3. You Just Need A Small Amount of Money – If you only need a small amount of money and even if rates doubled, the payment would not be a big deal.
4. Your Are Going to Pay it Off Quickly – There are plenty of situations where you need some quick cash and have a plan or the ability to pay back the loan quickly.
5. You Don’t Have Enough Equity to Get a Reverse Mortgage – With a reverse mortgage you need a significant amount of equity in the home in order to qualify. If you have less than 50% to 60% equity in your home the HELOC is likely your only option.
6. You Can’t Get the Money You Need – Depending on the equity in your home and the amount of cash that you need, a HELOC may be the only option to access the amount of money you need.

Example of the Benefits of a
Reverse Mortgage vs HELOC

A HELOC is commonly recommended by advisors as a way for retirees to give themselves reserves beyond savings and retirement in case they have cash needs. However, as you will see, the reverse mortgage is generally going to be a better option due to its safety features and financial flexibility.

Clyde and Bonnie are both 67 years old. They own their $800,000 home in Oregon free and clear. They have a combined income of $4,967 per month. Clyde gets $1800 a month in Social Security and Bonnie gets $1100 a month in Social Security. They have an IRA in the amount of $620,00 and they are following the 4% safe draw rate which generates an additional $24,800 per year or $2066 per month.

Clyde and Bonnie are in their go-go years. They are taking advantage of their retirement by traveling in their RV and visiting friends and family in other states. They love to go out to dinner and never miss a play.

However, they both are a little worried about running out of money, future housing costs and medical expenses. They know that a single financial event could derail their retirement plans.

Initially they were considering a home equity line of credit, but a friend of theirs gave them a book about the strategic uses of reverse mortgages. They decided to get a reverse mortgage vs HELOC.

Here are their numbers for the reverse mortgage standby line of credit.

Principal Limit (most they can borrow): $340,000
Initial Interest Rate: 5.745%
Growth Rate: 6.245% (rate at which available funds in line of credit grow):
Expected Rate: 5.435% (used to determine how much can be borrowed)
Fees:
Origination: $6,000
3^rd Party Fees: $5,312.45
Initial Mortgage Insurance: $16,000
Total Fees: $27,312.45
Line of Credit: $ 313,139

Rates as of 9/12/2022. The initial APR is 5.745%. The loan has a variable rate, which can change each month. The rate is tied to the 1 year CMT plus a margin of 2.375%. There is a 5% lifetime interest cap over the initial interest rate. This means that the maximum APR that could be imposed is 10.745%. Rates and funds available may change daily without notice. Closing costs vary by property state. Please call or visit online for further details.

Here is what their numbers look like over time assuming interest rates don’t change, they don’t draw funds from the line of credit.

The light gray bar is home value assuming 3% appreciation. The dark gray bar is the loan balance. The black bar is the line of credit.

You can see on this chart that in just 10 short years their reverse mortgage line of credit has grown from $313,140 to $583,784. That is a significant cushion should they need access to cash.

Clyde and Bonnie were not thrilled with the idea of mortgage on their home so they decided to make payment of $521 a month for the next 5 years so they could get the loan balance paid down as low as possible without paying the loan off completely. They had enough monthly income to do this and it was not impacting the fun they were having.

Here is what those number look like by making that payment.

The benefit to making the payments is twofold. First, they are paying the loan balance down. Second, they are increasing the line of credit. Making monthly payments on the loan increases their line of credit by $49,956 over 10 years, $67,196 over 15 years and $93,114 over 20 years. Those numbers make for a really good incentive to make payments on the loan.

At this point, I am sure you are still trying to figure why in the world this couple would want to get a reverse mortgage especially with the amount of fees that are required to get it.

Having access to hundreds of thousands of dollars is great, but what is the point if they don’t need it? Remember, they are not getting the reverse mortgage because they need it today, they are getting it to protect their retirement should something bad happen in the future.

The strategic use of a reverse mortgage as a standby line of credit should be viewed as an insurance policy. Retirement can last 30 years or more and there is a whole bunch of stuff that could go wrong financially regardless of how good your plan is. You could look at the fees as a lump sum insurance premium. Or, in this example, Clyde and Bonnie are making payments for 5 years to insure their retirement against disasters.

According to data gathered by Insurance.com, over a lifetime of driving, the average person will spend about $84,000 on car insurance. That is a huge number. Almost 5 times the cost of the reverse mortgage in this example.

The overall cost for car insurance is huge, but people don’t notice because it is dripped out monthly over time. If people spend $84,000 protecting their cars, why wouldn’t they spend $15,000 to $20,000 protecting themselves financially during retirement?

There are multiple benefits and strategies through the use of reverse mortgage standby line of credit.

Utilization of Home Equity Last with a Reverse Mortgage vs HELOC

Out of all the strategic uses of a reverse mortgage, implementing a standby line credit has been proven by researchers to be the best strategy to reduce the chances of running out of money during retirement. The strategy is simple. Get it early in retirement and let it grow. Once funds from a retirement account have been exhausted, funds are drawn from the line of credit.

This strategy may seem like using the reverse mortgage as a last resort. This is especially true since we are using it as a last resort with this strategy. But there is a big difference. We are getting the reverse mortgage early on in retirement and letting the line of credit grow and grow and grow.

Wade Pfau PhD, CFA, published a research paper in the Journal of Financial Planning (2016) titled “Incorporating Home Equity into an Income Retirement Strategy”. He compared various reverse mortgage strategies that had been researched. This research was based on the following data points.

His research was based on a $500,000 home owned free and clear. The borrower was 62 years old. The initial growth rate in the line of credit was 4.45% but fluctuated based on short term interest rates. The client had a million-dollar tax deferred portfolio with assets split evenly between stock and bonds. It was assumed they were in 25% tax bracket. The draw from the portfolio was 4% post tax, which meant the actual draw was 5.33%, far beyond the 4% safe withdrawal rate. Draws were inflation adjusted over time. This strategy was simulated using 50,000 Monte Carlo simulations for 10-year bond yields, equity premiums, home prices, short-term interest rates, and inflation.

The outcome proved that getting a reverse mortgage standby line of credit was the best way to use the reverse mortgage to significantly reduce the chances of running out of money.

The probability of success (not running out of money) with this plan, getting a reverse mortgage early on, letting it grow, and only drawing from it after other assets were depleted was 90%.

Ignoring home equity, the probability of success (not running out of money) was 40%.

Utilizing the reverse mortgage as a last resort, the probability of success was 67%.

In other words, this strategy improved the success rates in this retirement plan by as much as 50%. I would much prefer a 90% chance of not running out of money over a 60% chance of running out of money.

If you were to get a HELOC after running out of retirement funds. You would be adding another expense to the budget at a time when you could least afford it.

Using the Reverse Mortgage Line of Credit to Deal With Spending Shocks

The failure of a financial plan is rarely due to the plan itself nor is the failure due to the way the client was invested. Plans usually fail due to overspending and spending shocks.

These shocks include housing repairs and maintenance, giving/lending children money, health care, long term care, marital changes after retirement, investment losses, inflation and taxes. All very good reasons why it’s much better to get the reverse mortgage vs HELOC

The following is from the Society of Pension Professionals & Actuaries

“Very few shocks financially devastate long-term retirees. The expenses that do are long-term care, divorce and providing major financial support to children. A separate SOA report explains that the types of shocks and unexpected expenses most often reported by retirees include major home repairs and upgrades (28%), major dental expenses (24%) and significant out-of-pocket medical and prescription expenses (20%).

While 3 in 10 retirees (28%) report experiencing none of the shocks or unexpected expenses listed in the study, 13% say they encountered three types of shocks in retirement and nearly one in five (19%) encountered four or more. One-quarter (24%) of retired widows indicate they have encountered four or more.”[1]

The last bit is the scariest. There is over a 70% chance you are going to experience a spending shock during your retirement.

Mitigating Sequence Risk with a Reverse Mortgage

Sequence of return risk or sequence risk is the timing danger of withdrawals from retirement account that will have a negative impact on the overall returns of the portfolio as well as how long the retirement portfolio will last. Quite frankly, timing is either going to be a matter of luck or misfortune.

What if you have a spending shock and needed cash immediately, where would you pull the money from? For many people, that money is going to come from their retirement portfolio. What if you need that cash right after the market dropped and you lost 30% of your portfolio? That is sequence risk.

Let’s look at spending shock and sequence risk scenario. We will use the same scenario of George and Wilda from the “Making the Switch”. Wilda needs to put George in a nursing home for his and her health and safety. She needs to withdraw $360,000 to pay for a year of care and taxes.

Let’s assume she has a million-dollar portfolio. The week before she pulls the funds out, the market drops, and she loses 25% of her portfolio which leaves her with $750,000.

She then pulls out $360,000 over the next year to pay for George’s care. The market performance is wishy washy over the next year and her returns are 0%.

Between the market drop and the long-term care needs, their portfolio is only worth $390,000. In a single year, their retirement portfolio which took a lifetime to accumulate, drops by 61%.

If they had a reverse mortgage line of credit. Wilda could use those funds to cover the spending shock. This would allow her portfolio time to recover from the substantial loss it experienced in the market.

The Reverse Mortgage Line of Credit Can Exceed the Home’s Value

It is crazy to think about this as a possibility. However, it is possible for the reverse mortgage standby line of credit to exceed the home value. The following chart shows what that could look like. The assumption is that rates have gone up and have averaged 9%, they never made any payments towards the loan, and the home appreciated 3% annually.

In this example, you can see that, in just 15 years the amount available in the reverse mortgage line of credit begins to exceed the value of the home.

In 20 years, it exceeds the home value by almost $533,000. There is no guarantee that the line of credit will exceed the home value as it is impossible to predict future home value or interest rates.

It is important to understand that not only is it possible, but that you still have access to those funds even if the line of credit exceeds the home value.

Another thing to consider is that this growing line of credit is a way to protect home equity as well. Imagine if home value dropped by $300,000 in year 10. In the previous example, they still have access to all of those funds which would exceed the homes value.

Getting a reverse mortgage standby line of credit creates a source of income tax-free cash to combat spending shocks and sequence of return risks. It can do this because it creates liquidity in an illiquid asset.

It removes the financial constraints that surround, what is for most people, their largest asset.

It establishes the ability to have a more efficient retirement income strategy while lowering risks during retirement.

With a few rare exceptions, in the battle between a reverse mortgage vs HELOC, the reverse mortgage is almost always the better option.

 

 

[1] https://www.asppa.org/news-resources/browse-topics/what-are-biggest-financial-shocks-retirement