Options for Moving in Retirement Using the HECM for Purchase

Options for Moving in Retirement Using the HECM for Purchase

Opt ionsfor Moving in Ret irement Using theHECM for Purchase By: John Salter, Ph.D., CFP ®

SUMMARY Many retireeswill choose tomove from the largehome in which they raised their family into somethingsmaller and moremanageable tomaintain. These retireeswill be facedwith the financial decision of howtobest finance their new home. Traditional financingoptionsexist which includepayingcash for thehome, or usingatraditional mortgage. One newer, and lesser known option, istheHomeEquity ConversionMortgage (HECM) for Purchase, where theHECM reversemortgagecan beused directly for thepurchaseof anewhome. INTRODUCTION Asbaby boomersenter retirement many will decidewhether to stay in the larger home in which they raised their family or move to somethingsmaller andmoremanageable, and onewhich better fitstheir lifestyle. Larger homesrequire more timeand expense in cleaning, repairing, maintaining theyard, andmany other factors. The ideaof ?right-sizing,? or findingan alternative that better meetstheir needsmay take intoaccount these factorsin determining thechoiceof anewresidence. An examplemay include the retireewhoenjoystravelingandmay want tomove toahomewhich requireslittlemaintenancewhile they areaway, such asagarden homeor condominium. Many of these factorsmay be morequalitative, or related to lifestyle, rather than pureeconomic decisions. Financial decisionsmay include lowering expensessuch asutilities, real estate taxes, cost of maintenanceand upkeep, aswell assimply purchasingaless expensivehome in order to freehomeequity tobeused for funding futuregoals. Onemajor financial decision ishowtoapproach financing thenewhome. Traditionally, wehave relied on twomain methods: payingcash or usingatraditional mortgage. Many retireeshavean aversion todebt, particularly with carrying amortgage into retirement. For these retirees, theoptimal method of purchasinganewhomewould bepayingcash and beingmortgage-free. However, for many retireesthisoptionmay not bean option. Fundswould need tobeavailable either from thenet saleof theold homeafter payingoff any existingmortgageor fromalternativeasset sources, such as retirement savings. Onemajor factor in using retirement assetstopurchaseanewhome isthe tax liability froma lump-sumdistribution from retirement accounts, wherearetireemay pay more in taxesby distributingalargeamount from retirement plansfor thepurchase. Alternatively, aretireemay choose toobtain atraditional mortgage for their newhome. In thisscenario, the retiree would only be responsible topay theminimal down payment required, andwould then finance the remainder of the purchase for thedesired loan term. In thisscenario, the retireewould havemore flexibility in resourcesafter the purchase. Onemajor risk to consider isfuturecash flowconsistency. Traditional mortgagepaymentsare required and should any decrease in cash flowoccur, themortgagepayment isnot something the retireecan defer. Resultsin this scenario includebecomingdelinquent, thereby negatively impacting the retireescredit score, needing to sell the property toeliminate themortgagepayment or, at worse, foreclosureof theproperty.

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Onenewer and lesser known option for purchasingahome in retirement istheHECM for Purchaseprogram, where the proceedsof themortgageareused topartially fund thepurchaseof anewhome. TheHECM for Purchasewas implemented by U.S. Department of HousingandUrban Development toallowretireesthe financial ability and flexibility tomoveduring retirement for circumstancessuch asrelocatingcloser to family or purchasingahomebetter physically suited for them. PRIMERON HECM FORPURCHASE TheHECM for Purchaseprovidesmany benefitsaswell asflexibility for the retiree to consider. First, repayment of the loan isnot required, but isallowable. After closing, thehomeownerscanmakepaymentstoward the loan 1 , if they desire, and at thepace they desire, providing flexibility and protection against cash flowfluctuations. A retireemay choose to not repay at all aswell. In thisscenario, thedebt would compound over timeand bepaid upon saleor death. The HECM program isanon-recoursedebt, so thedebt owed upon saleor death isguaranteed by FHA tonot exceed the homevalue. In theworst case, therewould benoequity remainingat saleor death. TheHECM for Purchaseprogram issimilar towhat weknowastheHECM reversemortgage, with thedifferencebeing that thehome isnot required tobeowned prior to initiating themortgage. Otherwise, the requirementstoobtain the HECM for Purchasearealike, and areasfollows: - At least onehomeowner must beat least age62; - Thesubject property must be theowner?sprimary home; and - Homemust besingle-family, FHA approved condominium, up toa4-unit home, or amanufactured home. After obtaining theHECM for Purchase, the following requirementsmust bemet: The loan amount available in theHECM for Purchaseprogram, or theprincipal limit, isafunction of theyoungest borrower?sage, thevalueof thehome, and forward-looking interest rates. These factorsare the inputsintowhat is known asthePrincipal Limit Factor (PLF), or thepercent of thehomevalueavailable. ThePLF factorsaredetermined and published by HousingandUrban Development. - Ageof youngest borrower ? the factor isdetermined based on theageof theyoungest borrower, or theeligible non-borrowingspouse lessthan 62 yearsold. Theolder theyoungest spouse, thehigher thePLF. In essence, theprogramprovides?agecredits,?whereby thePLF increaseswith age. Thisisdue to the timedebt can compound, younger borrowershave longer time for thedebt to compound and grow. - Valueof thehome? theprogram requiresaformal property valueappraisal, and thisappraised value isused as thevalueof thehome. One important note isthemaximumhomevalueallowable in the formulais$636,150, meaningaHECM for Purchasecan beused on a$1million home, but themaximumvalue in the loan amount calculation islimited to$636,150. The$1million homewould have thesame loan amount availableasa $636,150 home. - Forward looking interest rates? thePrincipal Limit Factor iscurrently based on the10-year LIBORSwapRate. Likeage, expected interest ratesimpact thecompoundingof debt over time, so thehigher theexpected rates, the lower thePLF. In recent years, and still today, wehavebeen in alow-rateenvironment wherePLFshave been higher. Asratescontinue to increase, PLFswill decrease. - Taxesand insurancemust bepaidwhen due; - Homemust bemaintained over time; and - Thesubject property must be theborrower?sprimary residence.

1 Interest ispaid first, andmay bedeductible. Not tax advice. Consult atax professional.

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Thecoststoobtain aHECM for Purchasearealso like thoseof other HECM programs. Up-front costsinclude origination fees, an FHA mortgage insurancepremium, counseling fee, and other coststypical of traditional mortgages. - FHA Mortgage InsurancePremium (MIP) ? FHA guaranteestwoaspectsof theHECM product. First, the non-recourse featuredescribed above, and second, in theevent the lender becomesinsolvent. TheMIP is calculated in twomanners, dependingon the initial amount borrowed: - Lessthan 60%of availablecredit dispersed in first 12 months: 0.5%of thehome?svalue. - Greater than 60%of credit dispersed in first year: 2.5%of thehome?svalue. - Origination feesarecharged by the lender related to their cost of originating themortgage. A limit existson the amount alender can charge, which is2%of the first $200,000 of homevalueand 1%of thevalueover $200,000, up toamaximum$6000 total origination fee. - Other costsinclude those likeatraditional mortgage include title feessuch astitle insurance, recording fees, document preparation, etc. aswell asaformal property valueappraisal. - TheHECM programalso requiresaformal, third-party counselingsession which generally costs$125. The purposeof counseling istohelp ensure thehomeowner understandsthe reversemortgageprogrambefore closing. In addition to theup-front costs, theHECM includestheongoingcost of borrowing. TheHECM programseither have afixed rate, or avariable rate. Variable ratesaregenerally for lineof credit options, and fixed ratesarecommonly selected by theborrower for full, initial dispersion of money (or loan amount) madeavailable. For variable rateHECMs, theongoingcost isthesumof the following: - FHA MIPof 1.25%; - Lender margin, generally between 2%and 4%, which isafeepaid to the lender over time; - One-month LIBOR rateor theone-year LIBOR rate (theborrower chooses). In theabove, theone-month LIBOR rate istheportion of theborrowing ratewhich isvariable. The fixed portion essentially incorporatestheMIPand lender margin, but fixestheportion of the rate related toLIBOR. (For lineof credit options, theabovedescribesboth theborrowing rateand thegrowth rateof the lineof credit). EXAMPLEHECM FORPURCHASESCENARIO Asan example, let?stakearetired couple, husband isage65 andwifeage62. They desire topurchaseanewhomeworth $300,000. In today?senvironment, thecouplewould haveaPLF, based onWife?sageof 62, of 52.4%. Theamount of money available for use in theHECM for Purchasewould be$157,000. In thisscenario, thecouplehasup to$157,000 of the$300,000 able tobe financed in theHECM for Purchase. The remaining$143,000 would be financed from proceedsof thesaleof their old homeor fromother financial assets. If weassume thecouplesold a$500,000 with no mortgage, they would have$357,000 after thepurchase touseasthey wish, aswell ashaving flexibility inmaking futurepayments. Up-front costsin thisexamplewould include the following: - Maximumorigination feeof $5,000; - Up-Front Mortgage InsurancePremiumof $7,500, asgreater than 60%of the initial $157,000 wasused. - Other closingcosts, includingcounseling, would vary by location, but per theNational ReverseMortgage Lendersonlinecalculator, would beapproximately $2,500 .

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It should benoted that afew lendersarenot chargingan origination feewhich reducesup-front coststo clients, especially on higher valuehomes. Furthermore, it should alsobenoted that when clientsuse theother payment options, such asacredit lineor monthly payment, afew lendersareprovidingsignificant lender creditsthat can reduce the initial coststo clients, especially on higher valuehomes, toaslittleas$125. 2 Thecouplewould have theoption touseaportion of the fundsavailable, to include theseup-front costsaspart of the HECM for Purchase loan. Thecurrent estimated fixed rate interest (including theFHA mortgage insurancepremium) on borrowingwould equal 6.3%, which isthe rate the loan would compound over time. EVALUATINGTHEUSEOF THEHECM FORPURCHASE What might be thebest way toevaluate theoptimal useof theHECM for Purchase isby theoverall financial statusand overall financial resourcesof the retiree. The followingevaluation will focuson twogroups, thosewith limited financial resourceswhoessentially have littlechoice in purchasinganewhome, and thosewith thechoiceof either payingcash or seekingother fundingalternativessuch astraditional mortgagesor reversemortgagestrategies. LIMITED FINANCIAL RESOURCES Unfortunately, thenational statisticsconsistently concludemany retireeswill fall into thecategory of limited financial resources. These retireeswould be thosewith limited retirement savingsand limited fixed incomesources. Retireesin thiscategory will have limited financial optionswhen looking tonewhomeoptions. TheHECM for Purchasemay bemost applicable to these retirees, particularly because therearenot many other optionsavailable. Payingcashmay or may not bean alternative, however payingcash will also lock thevalueof the equity in thehome, and aportion of thisequity could beused for maintainingafuturestandard of living. Qualifying for atraditional mortgagewould likely bean issue, asincomeand resourcesare limited. Asan example, Husband andWifewhoareboth 80, decide they need tomove toanewhome tobecloser to family, which isin ahigher priced area, tohelpwith their care. Thecouplehas$25,000 left in savingsand ahousewhich ispaid for worth $200,000, and thenewhomewill cost $250,000. Both Husband andWifeareon limited fixed income, and likely would not qualify for amortgage. They donot have theavailable resourcestopay cash. Thisisthescenariowhere theHECM for Purchasewasdesigned. Using theHECM for Purchase, their principal limit on the reversemortgagewould be$151,000. After maximum closingcostsestimated at $13,000, thecouplewould have$138,000 tohelp finance thenewpurchase. Thecouple would then be responsible for only $112,000 of cost of thenewhome, and after the$200,000 sale, would net $88,000 toadd to their $25,000 nest egg, increasing their total nest egg to$113,000 tobeused for future livingand expensesof care. In thisexample, assuming thecoupledid not makepaymentsin the future, their loan would obviously compound over timeand erode thehomeequity over time relative tobequeststoheirs. However, thecouplemoved closer to family for their help in care, thereby savingmoney fromother healthcareavenuesand lessened thechanceof alsobeingafinancial burden on their family.

2 With thispricingoption, borrower receivesalender credit coveringnearly all closingcosts. Up-front cost shown isfor anon-refundable independent counseling feeof approximately $125 on average, which theborrower paysdirectly to thecounselingagency. Not available in all states. Certain conditionsand feesapply.

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TheHECM for Purchasemay be thebest alternative for thosewith limited resourceswhodonot have thealternative resourcesavailable topursueeither fully purchasingwith cash or obtainingamortgage. In addition, theHECM for Purchase for these retireesmay open additional financial resourcesfor futureuse inmaintaining their standard of living, for healthcarecosts, or for renovatinghomestomeet physical needs. For retireeswith limited incomewho can pay cash for their home, theHECM for Purchaseshould still beconsidered to extract homeequity for future financial use. In addition to theHECM for Purchase, the lineof credit or tenure payment option should alsobeconsidered. If wechangeour lowresourceexample to sellinga$250,000 home tobuy a$250,000 home, hereare the threeways these retireescould benefit from the threeHECM programs: - HECM for Purchase? scenariowould remain thesame, however the retireeswould net $138,000 toadd to their nest egg, increasing their savingsto$163,000. - Lineof Credit ? rather than incur debt up-front, the retireescould set up alineof credit option using the HECM program. Their initial lineof credit would equal theprincipal limit. In thecaseof this80-year-old couple, their credit line, net of closingcosts, would be$120,519. Closingcostscould either bepaid directly or financed by theHECM, but either way lessthan 60%of theproceedswould beused so closingcostsin this examplecould be lessthan $2,000. Theunused lineof credit would then growby thebeforementioned formula monthly, and the retireescould drawfrom the lineof credit asneeded, or when their savingsdepleted. 3 Currently, thegrowth rate for credit line isapproximately 7.07%. Thismeansthat in ten yearsthecouple?s availablecredit linewould growto$281,325, which exceedstheoriginal valueof thehome. - TenurePayments? thehomeequity can essentially be?annuitized?into lifetimepayments. In thisscenario, the couplecould receivean approximateadditional $8,000 per year. Each payment isaloan distribution, so the loan accumulatesaspaymentsaremade. - Combination of theabove? theHECM programprovidesahigh level of flexibility in benefit types, including theability to combineany of theabove. For example, lessthan 60%of theprincipal limit could beused for purchasingahome, saving2%of thehomevalue inMIP closingcosts, and the remaining40%could bekept asa lineof credit. GREATERFINANCIAL RESOURCES Asfinancial resourcesincrease, sodooptionsof purchasing thenewhome. Retireeswith adequate income, such as Social Security related tohigher earnings, corporatepension plans, etc. and thosewith higher levelsof retirement savingsmay have the luxury of multiple financial avenuesof purchasing thenewhome, includingpayingcash, obtaining amortgage, or using theHECM for Purchase. For thisdiscussion, we revert toour first retireeexampleof our 65 and 62-year-old couple. They wereselling their $500,000 home topurchasea$300,000 home. Thecouplehas $500,000 in retirement assets, soenough to fund even purchasingasomewhat moreexpensivehome. Thebasic question is, fromafinancial planningperspective, what isthebest option for thiscouple? Theanswer is, asit often isin financial planning, it depends. - First, fromafinancial planningperspective, wecan eliminatepayingcash without implementingaHECM strategy asinferior frompreviousresearch. In all financial planning research related to reversemortgages, strategiesimplementingaHECM arealwayssuperior to ignoring thehomeequity. The reason why should be obvious, theHECM allowstheuseof homeequity in generatingor protecting retirement income.

3 If part of theborrower?sloan isheld in alineof credit upon which youmay draw, then theunused portion of the lineof credit will growin size eachmonth. Thegrowth rate isequal to thesumof the interest rateplustheannual mortgage insurancepremium ratebeingcharged on your loan.

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- Obtain atraditional mortgagecan bedeemed inferior aswell; though atraditional mortgage isleveraging the portfolioover time, arisk isintroduced through the fact traditional mortgagepaymentsare required. Should a point arisewherepaymentscannot bemade, thedecisionmust bemade to sell thehome, likely with damage to credit scoresfrommissingpayments. Alternatively, the remainingbalancecould be refinanced intoaHECM in the future, but risk remainsrelated to future interest ratesand thePLF available, aswell asrisk of policy changes related to theHECM program itself. In addition, thisstrategy isnot extractingany value from thehomeequity available, and asmentioned, strategiesincorporating thedirect useof homeequity havebeen deemed superior in previousresearch. The remaining two strategiesto consider in proactively usinghomeequity in the retirement incomesolution are: - Obtain aHECM for Purchase? asmentioned, theHECM for Purchasewould alleviate the risk of the inability tomake futuremortgagepaymentssince repayment isoptional, andwould also result in increasing retirement assetsusing theprevioushomesaleproceedsasadown payment on thehome. Theunused proceedsfrom the previoushomesalecould then be invested for futureusealongwith theother retirement assets. TheHECM for Purchasewould result in acurrent debt, which without repayment would compound over timewith the possibility the loan valueexceedsthehomevalue, though thenon-recourse featurewould keep thehomeowner frombeingunder water. Nevertheless, there isthepossibility thenet valueof thehome in the future iszero. Essentially, thecouplewould be leveraging their portfoliousing theHECM for Purchase loan. - Pay cash for thehomeand establish alineof credit ? theHECM lineof credit would alternatively result in the principal limit beingavailable in asecured lineof credit rather than available for investing. Theunused lineof credit growsover timeat thepreviously discussed rate, and doesso independent of thehomevalue. Thisgrowth featureprovidesfutureprotection on an as-needed basis. Should the lineof credit never beused, there isno debt to repay. 4 Should fundsbeborrowed, thesame repayment flexibility existsaswith theHECM for Purchase. Existing retirement assetswould beused first, relyingon thegrowth in the lineof credit for future use. Essentially, thecouplewould be leveraging the lineof credit using their portfolio. Determiningwhich of these isthesuperior strategy relieson thegoal of thecouple. In financial planning, the risk and reward of any strategy must beweighed. At times, theremay bestrategieswhere the risk and reward are tradeoffs betweenmaintainingastandard of livingversuspossibly havingmoreassetsin the future. Selectingbetween these two strategiesinvolvesthisconsideration. Goingback toour couple, theoptimal solution can beevaluated by performingsimulationsrelated to their future throughMonteCarloModelling. The followingassumptionswere incorporated into theanalysisrelated to theexample couple. - 62-year-old couple, lifeexpectancy of 92. - Spendingneeds: $28,000 per year, adjusted by inflation. - Portfolio: 50%Equity/50%Fixed Income, Rateof Return 6.3%, StandardDeviation 10.3% - HECM for PurchaseFixedRate: 5.3% - HECM PLF: .524 - General Inflation: 3% - Real HomeAppreciation: 0 - LIBOR: 2.8% - Lender Margin: 3% - Number of Scenarios: 1,000

4 HUD requiresaminimal ($1or more) loan balance for the lineof credit to remain open.

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PAYINGCASH ASA BASELINE Our 62-year-old clientssell their previoushome for $500,000 and directly purchase their newhomeworth $300,000. At theend of thistransaction, they have$200,000 they can add to their portfolio tohelp fund future needs, however noHECM strategy isimplemented. Our client would haveaprobability of meeting their lifestyleneedsof 78%after 30 years, amedian net worth of $1.3 million, and amedian portfolio valueof $666,000.

Probability

Median Portfolio Median Net Worth

78%

$666,000

$1,200,000

HECM FORPURCHASESTRATEGY In theHECM for Purchasestrategy, our 62-year-old couplesellstheir old home for $500,000. Based on thePLF, the HECM for Purchaseproceedsavailable for down payment on thenewhome isapproximately $157,000. Assumed closingcostsof $13,000 are included in the loan, resulting in $144,000 beingavailable for financing through the HECM for Purchase, which isalso theamount being leveraged. Of their $500,000 old homesaleproceeds, $156,000 isused asadown payment on thenewhome. Thecouple?sretirement portfolio increasesfrom$500,000 to approximately $844,000. After running1,000 possible futuresfor thecouple through theMonteCarlo simulation, thepercent of scenarios funding their lifestyleafter 30 yearsisnear 88%. Their median portfolio value isnear $1.2 million. Because the loan was never paid back, and by age90, the loan?saccumulated valueof $924,000 hasexceeded theestimated homevalueof $707,000. Thenon-recourse featureof theHECM loan would limit the loan payableupon saleor death to thevalueof thehome. Hence, the$1.2 million portfolio value in thiscase isour client?snet worth. In thiscase, though the loan valueover timehasabsorbed thehomevalue, theadditional amount invested in theportfoliohasoutpacedwhat would havebeen theappreciation of thehome?svalue, resulting in apossiblehigher bequest amount, or moreavailable if the clientswerestill living. HECM LINEOF CREDITSTRATEGY In theHECM Lineof Credit Strategy, our client simply nets$200,000 from the transaction of selling their old home and purchasing thenewhome. Their portfolio isnow$700,000. Thecouple then establishesalineof credit which would havean initial valueof $157,000. Themaximumclosingcostsof $7,000 areassumed tobepaid by theportfolio tomaximize theavailable lineof credit. The lineof credit wasassumed tobe left togrowover time, andwasonly used if theportfoliodepleted. In thiscase, the lineof credit wasused to fund thecouple?sstandard of living. In thisstrategy, 75%of the trialsresulted in theportfoliobeingexhausted by age90, likeour payingcash scenarioabove. However, because the lineof credit wasavailable touse to continuemeeting livingexpenses, theability for our client to fund their goalsusingall their resources(portfoliopluslineof credit) wasover 95%. Probability Median Portfolio Median Net Worth 88% $1,400,000 $1,400,000

Probability

Median Portfolio Median Net Worth

95%

$600,000

$1,200,000

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CONCLUSIONS Asweevaluatestrategiesfor purchasinganewhome in retirement it isapparent, from theaboveanalysisand frompast research, proactively incorporatinghomeequity isimportant and yieldsbetter resultsfor maintainingastandard of living over time. When resourcesarevery limited, theHECM for Purchasemay benot only thebest option, but an option which will allowthepurchaseof anewhomeand alsomay freesomehomeequity tobeused for future living, healthcare, and other expenses. When evaluating thechoicebetween theHECM for PurchaseandHECM Lineof Credit option for thosewithmore options, thedecision tobeeither goals-focused (probability of meetinggoals) or resource-focused (probability of having more later) must beweighed. Thiscaseanalysis, aswith previousresearch by WadePfau in hisJournal of Financial Planningarticle, ?Incorporating HomeEquity intoaRetirement IncomeStrategy,?demonstratesthispoint. Theearly useof proceeds, such asthe HECM for Purchase, may decrease theprobability of meetinggoals, but may provide thepossibility of havingmore later to satisfy long-termgoalssuch asbequest motives. Thosestrategiesdeferring theuseof theHECM proceeds, such as the lineof credit, improve theprobability of meetinggoals, but at timescan drastically reducewhat may beavailable in the future. The reasoning for thedifference in probability and future resourcescan besummed by twopoints: - Using thegrowth in theHECM Lineof Credit later requirestheuseof theportfolio to fill thenear-term spendingneeds; thiscomparesto theHECM for Purchaseessentially pulling from theHECM available funds first. In theLineof Credit strategy, portfolioassetsareused beforeusingany HECM proceeds, so theportfolio value islesstobegin with, andwill be lessover time. - Theprobability of successishigher with theHECM Lineof Credit strategy because, between the lineof credit and theportfolio, the lineof credit hasabetter risk-adjusted return on itsresourcecompared to theportfolio. Essentially, theportfolio?sgrowth in the future isriskier than the lineof credit. The risk of the lineof credit growth rate1) isonly related to thevariation in theone-month LIBOR, and 2) historically hasnot been negative. Portfolioassets, though, growat ahigher rate, haveahigher risk and havecertainly historically been negative. A very general conclusion, though individual analysiscannot beemphasized enough, isthat thosewhoaregoal-focused may bebetter off seekingaHECM Lineof Credit Strategy, and thosewhoare resource-focused, or looking tohave more later, might seek aHECM for Purchaseoption. Thisanalysisexamined the impact of down-sizing, oneadditional consideration tonote istaxeswhen up-sizing. Toenter aHECM Lineof Credit strategy, thehomemust be first paid for. Should alargedistribution fromassetsbeneeded that would trigger ahigh tax burden, theHECM for Purchasemay result in abetter option toavoid paying thehigher up-front tax.

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