What do you do when an unexpected medical event changes everything?

Hopefully, you have people in your life like our recent client Dr. Thompson.

This is his story and it includes a beautiful example of real friendship.

The Story (Unexpected Medical Expenses)

A few months ago, I received a call from a gentleman named Tom who had just finished watching our YouTube video on Jumbo Reverse Mortgages. He said he was calling from Texas on behalf of a dear friend in California - Dr. Thompson. 

Tom, Dr. Thompson, and Bill all attended a prestigious medical school together forty plus years ago. All three of them stayed close friends ever since. Bill, a smart, thoughtful man with a great disposition, lives near Dr. Thompson in California and was invaluable helping get through all the paperwork.

Unfortunately, Dr. Thompson suffered a minor stroke earlier this year. That trauma unexpectedly and prematurely put an end to his medical career; which was unfortunate, not only for him but for those who relied on and were so fond of him.

Dr. Thompson did not have a lot of liquid assets (stocks, bonds, CDs, etc.) but he had significant equity in his home. We hear this story frequently when we talk to homeowners in highly-appreciated areas like Austin, Los Angeles, San Francisco, Orange County, San Diego, and elsewhere.

In this case, Tom and Bill wanted to help Dr. Thompson fund his need for in-home care that cost roughly $5,000 per month. Following his stroke, Dr. Thompson is mildly impaired but otherwise healthy. Tom and Bill were trying to design a financial plan for Dr. Thompson based on a life expectancy of at least 15 more years.

Tom, Bill, and I had multiple conversations about reverse mortgages. They wanted to learn all the details and were particularly interested in the new Jumbo Reverse Mortgage because Dr. Thomson’s home was worth over two million dollars.

The most important thing to Dr. Thompson was staying in his own home where he’s lived for many years. Not only is his home familiar, but he feels safe there and has a local support network of friends, neighbors, doctors, dentist, and of course, Bill.

Tom and Bill were really looking out for their friend, Dr. Thompson. Believe me, they were very thorough with their questions – no surprise, they’re doctors. One of the things I found to be most touching was what careful stewards of his wealth they were. They were concerned about every dollar, as if it was their own.

Was a home equity solution the best financial strategy among all other options?

The more they asked and understood the mechanics of the loan, and its relative merits to other options, they more comfortable they became. They believed it could allow him to fund his care needs and stay in his home for the next fifteen years – his health willing.

The Claim

How do you reasonably make the claim that a reverse mortgage is the best alternative? What other alternatives are there? What else was considered?

The truth is, when operating with two common constraints:

• I want to stay in my home
• I can’t qualify for a conventional mortgage

There aren't a lot of other options. A homeowner can have a 7-figure net worth and still be in this position, like Dr. Thompson.

We have conversations like this all the time, with trustees, estate planning attorneys, and financial planners. Once they understand the mechanics of home equity conversion mortgages, they often advise their clients that a reverse mortgage is the best choice - when in fact it is. Our role is primarily that of an educator.

Even when clients have considerable wealth in other investments (stocks, bonds, income properties, etc.), financial advisors often prefer a home equity solution because of preferential tax considerations.*

The point of this article is not that a certain strategy or loan product is best. Every client’s situation is unique and new products or changing macro assumptions (future trajectory of interest rates and house prices) lead to different conclusions at different times.

Like all things financial, the most important thing is getting the best outcome for a given set of circumstances. What’s key is looking at the situation holistically, with competent professionals who have a fiduciary orientation and the expertise and tools to analyze all available options.

If you are a Certified Financial Planner™, This is where Dr. Thompson’s story gets interesting. Because we’ve developed proprietary analytical tools, we can model innovative solutions and dollarize the value of our collective advice.

The Hybrid Strategy

For the purposes of this case study, let me leave out discussions we had around inflation, future financial needs, etc. I was told Dr. Thompson’s other assets would be used to meet those needs and/or fill those gaps.

What is, or why did we need a two-step hybrid reverse mortgage strategy?

We were solving for two things:

1. Access $5,000 per month for the next 15 years
2. Minimize the cost of accessing that $900,000 of house-based wealth

Solving condition one was easy - a jumbo reverse mortgage could do that. Condition two required some creativity. Minimizing borrowing costs is about minimizing interest paid. The easiest way to do that is by not borrowing more than one needs. That is a key feature of the FHA reverse mortgage line of credit option.

The reasons we couldn't use an FHA or jumbo reverse by themselves:

• Can’t borrow enough with an FHA reverse
• Too much cash up-front with a fixed-rate jumbo reverse

FHA Reverse Mortgages

An FHA reverse mortgage would not work by itself because the government caps the maximum loan size based on an artificial limit on the appraised value; i.e., the government ignores house value beyond their mandated value limit of $679,650.

Based on that limitation, Dr. Thompson would only be able to access about $325,000 of his house-based wealth. We needed $900,000.

Why not just take out a jumbo reverse mortgage?

Jumbo Reverse Mortgages

Quick side story... a few select lenders began offering proprietary products, referred to as jumbo reverse mortgages, in the Fall of 2015. However, most homeowners were not impressed because they couldn’t access much money.

In 2018, new jumbo products and features became available, which have made a big difference for seniors with homes worth over a million dollars. Now, the amount someone can get is attractive.

The fixed-rate jumbo reverse mortgage downfall was its requirement for a large initial cash withdrawal at closing. The new 60% disbursement option, spreading the remaining 40% over five years was included in our analysis below.

Because the doctor only needs $5,000 per month, he didn’t need or want an initial draw of several hundred thousand dollars that would immediately accrue interest. 

Dr. Thompson’s lifelong friends, Tom and Bill, felt that offsetting the interest expense would be tricky in a stock market that was near all-time highs; i.e., one with a cyclically adjusted PE Ratio over 30. And, safer investment alternatives couldn’t reliably generate enough after-tax income to offset the interest expense on hundreds of thousands of dollars that wouldn’t be needed for years.

We try to adhere to the problem-solving principle known as Ockham’s razor, which states that the simplest solution tends to be the correct one. When I worked at Morgan Stanley, one of my financial advisor colleagues used to say, "If the financial product brochure has many glossy pages with color pictures, the customer is paying too much."

We were looking for a plan that was easy to manage and had few moving parts. Mitigating stock market or sequence of returns risk wasn’t something Dr. Thompson or Bill had the bandwidth to take on.

Our solution was a two-step hybrid jumbo reverse mortgage strategy that significantly reduced the total borrowing costs over the 15-year planning period. Translation: preserve wealth for late-life expenses and/or heirs. Here’s how it works.

Step 1 – FHA Home Equity Conversion Mortgage 

Step one was taking out an FHA reverse mortgage with an initial draw of $60,000. That covered the doctor’s needs for the first year. Beginning in year two, Doctor Thompson will withdraw $5,000 per month.

The reason for withdrawing money as slowly as possible is twofold: 1) minimize accrued interest, and 2) take full advantage of the line of credit growth feature.

FHA Credit Line Growth Feature

The unused portion of an FHA reverse mortgage line of credit grows at the accrual rate, (interest + mortgage insurance). By way of a simple example: if a borrower has an unused line of credit of $100,000, and the accrual rate is 5.5%; at the end of one year, the homeowner’s line of credit would be $105,500. In other words, they would have an additional $5,500 in borrowing power.

This is a powerful feature because that growth compounds year over year. By year ten, our example $100,000 line of credit would grow to $170,814.

Below you'll see several charts that show the difference between our two options.**

Specifically:

• House value (identical all scenarios)
• Loan balances
• Total cash out 
• Credit line available

The first two charts show the FHA reverse. When the available line of credit (green dashed line) drops to zero, the FHA reverse mortgage will be refinanced into a new fixed-rate jumbo reverse mortgage (see Hybrid Jumbo below). Ignore the charts on the FHA reverse beyond month 52 because the loan will be paid off after that.

The next two charts show the hybrid jumbo reverse mortgage, which will be in place for approximately ten years (months 53 – 180). Ignore the charts on the hybrid jumbo beyond year 10 because that is the end of our fifteen year planning horizon.

The next two charts show the Jumbo Only. This is the alternate (inferior) approach whereby the borrower takes out a fixed-rate jumbo loan, takes a large initial draw, and keeps this loan for 15 years.

The final two charts show total cash out and cumulative cost of borrowing. For the hybrid solution, consider the FHA chart for the first five years and the jumbo chart through year ten. For the jumbo only approach, consider the jumbo chart through all fifteen years.

FHA Reverse Mortgage (month 0 – 52)

In the doctor’s case, his original credit line was $238,655. He will use that line of credit for 52 months. By that time, he will have taken out $322,685.

Notice, that amount exceeds the original $60,000 taken out plus the starting credit line by $322,685 - $298,655 = $24,030.

The next chart shows how the net equity (house value – loan balance), represented by the black dash line, continues to increase over time even though cash is being extracted. The reason is because at a conservative house appreciation rate of four percent, the home’s value is growing more quickly than the loan balance, shown in red.

FHA Reverse Mortgage (month 0 – 52)

At about the 4-1/2-year mark, the credit line will be used up. Then, we’ll have to originate a jumbo reverse mortgage to continue providing a $5,000 monthly income stream for the remaining ten and a half years of our strategy - getting us to the end of fifteen years.

Step 2 – Jumbo Reverse Mortgage with delayed disbursement

When we switch from the FHA reverse mortgage to the jumbo reverse, the loan balance will be $397,135. Remember earlier when I mentioned one of the drawbacks of jumbo reverse mortgages is the requirement of taking all the money upfront? Now there’s a new feature that allows the borrower to spread out part of the available principal limit (amount one can borrow) over the next 60 months; i.e., 5 years.

This will be advantageous because we want to minimize excess cash proceeds that have to be managed separately. Since the FHA reverse lasted through month 52, the jumbo will provide the target monthly cash for 128 months.  The hybrid strategy then totals 15 years.

For comparison purposes, we’ll model a jumbo loan amount of $910,000, so that we can compare the hybrid strategy to a Jumbo-only strategy.

The delayed disbursement feature allows us to spread out $362,000 that we’d otherwise have to take up front. Obviously, this reduces the net interest expense. The delayed disbursement feature still results in excess cash proceeds that will have to be managed and prudently invested to be available for the doctor and to offset the interest carrying costs.***

For the sake of this illustration, we modeled a relatively safe, liquid return based on the iShares National Muni Bond ETF with a 5-yr total average annual return of 3.11% as a proxy.***

The offset investment account will not, over time, change:

• Total cash out
• Loan balance
• House value
• Net equity

Here are the hybrid jumbo reverse mortgage charts. 

Hybrid Jumbo Reverse Mortgage (128 months)

Hybrid Jumbo Reverse Mortgage (128 months)

Jumbo Reverse Mortgage Only (month 1-180)

Contrast the two charts above with what it would look like if instead of using a hybrid jumbo reverse mortgage strategy, we simply used one jumbo reverse mortgage from the beginning.

Jumbo Reverse Mortgage Only (180 months)

Jumbo Reverse Mortgage Only (180 months)

Recap, the cumulative cost of borrowing for the combination FHA/jumbo home equity solution is $782,212. The FHA loan covers the first 52 months. The jumbo loan covers the next 128 months.

FHA Reverse Mortgage (52 months)

 Hybrid Jumbo Reverse Mortgage

The Value of Our Advice - Key Takeaways

Here are the key takeaways when comparing the hybrid FHA/fixed rate jumbo reverse mortgage (with a side investment account) to a jumbo reverse mortgage (with a side investment account):

• Total cash out = $900,000; $5,000 per month
• Borrowing cost difference: Jumbo only (with delayed disbursement) vs. FHA/jumbo hybrid: $228,863
• Borrowing cost difference: Jumbo only vs. FHA/jumbo hybrid: $302,728
• Borrowing cost advantage of delayed disbursement feature (spreading 40% of proceeds over 5 years): $73,865

Based on our assumptions (utilizing a side investment account for both options to invest excess proceeds), the hybrid two-loan strategy may save Dr. Thompson $228,863 compared to just taking out a fixed-rate jumbo reverse mortgage.**

As a mental point of reference, Tom and Bill asked, "What if the doctor just borrowed the money with a conventional mortgage?" The only way to do that and compares apples-to-apples would be to take a cash out loan of $1.8 million and use the loan’s proceeds to make the monthly payment. That would be sort of a synthetic reverse mortgage and the math doesn’t actually work.

But, for sake of conversation:

• A conventional 30-yr fixed rate loan of $910,000 at 5.99; total interest = $1,052,021
• Payments = $5,450/month
• A conventional 30-yr fixed rate loan of $910,000 at 5.0%; total interest = $848,627
• Payments = $4,885/month

The doctor’s hybrid reverse strategy actually results in a lower cumulative cost of borrowing; $848,627 – $782,212 = $66,415. That is, he’d pay $66,415 less in interest with the hybrid reverse strategy than if he borrowed the same amount of money with a traditional mortgage and someone else made his mortgage payment.

He couldn't borrow the money because he couldn't qualify for the loan or afford to make a $5,000 per month mortgage payment.

All this discussion about savings several hundred thousand dollars with a hybrid jumbo reverse mortgage strategy begs the question, “How do you know?”

• How do we know what interest rates will be in 5 years when he's ready to take out the jumbo loan?
• How do we know what home values will be?
• How do we know we won’t have another recession and jumbo reverse mortgage won’t disappear again?

The answer is: we don’t. Just like none of us knows if our IRA’s and 401-k’s should be over-weighted in stocks, bonds, or cash.

Being a good steward of wealth is about making the best possible decision based on the current environment with currently available products and educated guesses about the future.

To address the risk that things may change, we offer annual client reviews where we check our assumptions and adjust our strategy as necessary. It is part of our unique six-step process. Our annual review is part of our Smart Borrower Advantage™. If better loan alternatives become available between now and then, we'll adjust accordingly.

Conclusion

We typically notice 3 different reverse mortgage motives:

• Need: expenses exceed income, limited reserves based on life expectancy, don’t run out of money

• Lifestyle: have more fun, age in place, pay for care

• Wealth management: portfolio preservation, tax considerations, gifting and early inheritance bequests

Ironically, net worth is not always indicative of motivation. And, some clients fall into more than one category.

There are very few Certified Reverse Mortgage Professionals™ in the United States. Even fewer who have investment advisor backgrounds and proprietary tools for analysis. Kent Kopen has all three.

Because interest rates have risen, many conventional loan officers’ businesses have slowed down so they’re now promoting reverse mortgages. The problem is, most of them don’t know what they’re doing, nor do they have the support to make the process a decent experience for the borrower.

Expertise makes a difference. If you’d like an accurate assessment of your options we will generate a report from our reverse mortgage calculator based on your unique situation. Call Kent at (800) 208-1252 or click the button below.

* Always review financial decisions with your own legal and tax professionals. Assumptions subject to change. Conclusions not guaranteed. 

• Investment account based on MUB iShares National Muni Bond ETF 5yr total return
• FHA rates and house price inflation held constant for illustration; they will change
• Loan proceeds tax-free – consult with your tax advisor
• Certain names were changed to protect privacy
• Jumbo Flex-required servicing fee = $30/mo.
• Jumbo third-party closing costs = $3,800
• FHA third-party closing costs = $3,901
• House appreciation rate = 4%
• Jumbo fixed rate = 5.99%
• 1-yr Libor index = 2.908%
• FHA margin = 1.75%
• FHA MIP = $13,593

***Investment cross-selling prohibitions

HUD HECM Counseling Manual: Reverse mortgage proceeds may be used for any purpose the homeowner chooses. The borrower is free to invest loan funds in an annuity or some other investment vehicle, or to buy long-term care insurance, among other things. While none of these activities is prohibited, lenders are prohibited from requiring the purchase of such products as a condition of loan eligibility. Brokers and lenders are specifically prohibited from personally participating in the sale of such products in connection with loan origination.

CFPB, Reverse Mortgages, Report to Congress, prohibitions on cross-selling; section 6.3.2a.: In the Housing and Economic Recovery Act of 2008 (HERA), Congress adopted rules restricting the sale of other products or services with a HECM mortgage. HERA prohibits a reverse mortgage lender from requiring a borrower or any other party to purchase an insurance annuity or other similar product as a condition of obtaining a HECM mortgage.345 HERA also generally prohibits a HECM mortgage originator or any other party that participates in the origination of a HECM mortgage from participating in, being associated with, or employing any party that participates in or is associated with any other financial or insurance activity. However, an exception to this general provision applies if the originator establishes “firewalls and other safeguards” designed to ensure that “(i) individuals participating in the origination of a HECM mortgage have no involvement with, or incentive to provide the mortgagor with, any other financial or insurance product; and (ii) the mortgagor shall not be required, directly or indirectly, as a condition of obtaining a mortgage under this section, to purchase any other financial or insurance product.” 

Federal law restricts the use of HECM loan proceeds, including prohibiting the use of such for payments to or on behalf of an "estate planning firm."

About the Author

Kent Kopen earned his Reverse Mortgage Specialist credential in March 2007. Last year Kent earned the CRMP (Certified Reverse Mortgage Professional) designation. There are less than 170 CRMP designees in the United States. Mr. Kopen also provides education, tools, and strategies to professionals who offer financial and legal advice to others. "Our resources help financial advisors, CPAs, and estate planning attorneys help seniors optimize their home equity to provide greater security and peace of mind."