Sunday, December 25

Week 286 - Should You Take Out A Reverse Mortgage?

Situation: Young couples are often advised to make payments each month on 1) a home mortgage, and 2) a “whole life” insurance policy. Homes are not good investments, and neither are “whole life” policies. They’re a form of compelled savings. If we later find ourselves unprepared for retirement, we may be guided to recoup those savings by “taking out” a reverse mortgage or “borrowing against” a whole life policy. The government joins the party by compelling us to save during our working years (under the Federal Insurance Contributions Act of 1935), and then guides us to recoup our “Social Security” savings in retirement. 

Mission: Look at the costs and benefits of reverse mortgages. NOTE: To obtain more detailed information, I suggest reading this article that appeared in USA Today on October 28.

Execution: “On the plus side, reverse mortgages are considered loan advances to you, not income you earned. Thus, the payments you receive are not taxable. Moreover, they usually don't affect your Social Security or Medicare benefits.” Emotional benefits play a role, given that 1) you get to keep living in your home without paying rent, and 2) your children get to inherit a house that retains considerable equity. And, reverse mortgages make a great Rainy Day Fund.

On the negative side, there is “opportunity cost”: You are giving up the opportunity to invest a large sum of your own money, if you sell the house and rent a place more suited to your needs. Transaction costs on the sale are the same as those for taking out a reverse mortgage (6%), which leaves 94% for you to invest. We provide an example (see Table) of how you might set up an online investment in bonds and stocks that pays out at least 2%/yr (after transaction costs) and grows those payments at least 2%/yr.  

Administration: The investment example has an asset allocation of 50% bonds/50% stocks. The bonds are “zero risk/zero cost” 10-Yr Treasury Notes accessed through the government website; that site also offers inflation-protected Treasury Notes. You can invest in KO, JNJ and WMT online but have to use a different website to invest in PG. Each pays a good and growing dividend, and had Total Returns/yr during the Housing Crisis that were better than those for our key benchmark, the Vanguard Balanced Index Fund (VBINX; see Column D in the Table). 

It is best to make these investments over time, starting with 40% of your proceeds then adding $100/mo to each of the 4 stocks and $1200/qtr to T-Notes. So, 60% of the proceeds from selling your house would initially go to an FDIC-insured savings account paying little interest. Part of that 60% will never be invested because it serves as your Rainy Day Fund. Nonetheless, you’ll be in a position to withdraw $9600/yr for electronic transfers to bond and stock accounts. Annual transaction costs come to ~$72/yr (see Column N in the Table).

Bottom Line: Reverse mortgages can be a good idea, if you’ve paid off your home mortgage and have almost no source of retirement income outside of Social Security. But inflation will always be with us, so it might be better to sell your house and move to a place that is not designed for raising children. Then, you can invest the proceeds from selling your house in a manner that costs you little and provides an opportunity to protect yourself from inflation.

Risk Rating: 4 (where 10-Yr Treasury Notes = 1, S&P 500 Index = 5, and gold bullion = 10)

Full Disclosure: I dollar-average into PG and JNJ, as well as inflation-protected Savings Bonds (which are an IRA-like version of 10-Yr Treasury Notes). I also own shares of KO and WMT.

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