The homeowners are past clients I helped obtain a mortgage several years ago. They were looking to purchase a second home in a resort area, to enjoy with their adult children and grandchildren. The purchase price was approximately $900,000. The decision they wanted to discuss with me was how to finance the acquisition of the second home. They were evaluating the following options:
- Pay cash for the entire purchase price, approximately $900,000, using funds from their investment account.
- Obtain a mortgage on the second home property to facilitate the purchase. The question was how much the down payment should be and how much the mortgage should be.
- Obtain a mortgage on their primary house to facilitate the purchase. The question was how much the down payment should be and how much the mortgage should be.
One of the homeowners is a semi-retired Certified Public Accountant while the other is a semi-retired researcher. They were both in their early 70’s. They were financially sophisticated and had the ability to pay cash for the second home. They also had the income to qualify for a traditional mortgage and make monthly payments if they chose this route. They did not have a mortgage on their current home.
Their financial position was as follows:
- Their primary home had a value of approximately $1,700,000. With no mortgage, their net equity position was $1,700,000.
- They both earned income from part-time employment and received social security income.
- They had substantial balances in both before tax and after-tax investment accounts.
- Their children were financially secure, so passing on wealth was not a priority. Living a fulfilling life in retirement and meeting their goals was the primary consideration.
At the time the homeowners contacted me they were leaning towards paying cash for the second home by withdrawing the funds from their taxable investment account. The consequences of withdrawing $900,000 were two-fold:
- In order to withdraw the necessary cash from their investment account, they would need to sell investments. The sale of investments would have generated capital gain income and resulted in a tax liability for Federal and State income tax; and
- Once they withdrew the $900,000 they would no longer earn income or a return on the amount withdrawn from their account. While the funds would be invested in real estate which could appreciate, in the current environment their investment accounts generated substantially higher returns than owning real estate.
I showed them a different strategy that involved the use of a Reverse Mortgage. The strategy I presented allowed them to use their current home to increase their net worth by managing their liquidity and tax situation.
First, they would not need to withdraw $900,000 from their investment account which means they would save a substantial amount of money by not having to pay federal and state income tax. More importantly, they could leave their cash in their investment account earning income, growing and compounding.
The Reverse Mortgage also had the potential to give them access to a line of credit that would grow each year. A little-known feature of a Reverse Mortgage line of credit is that the unused balance essentially earns interest each year and grows. Lastly, with the Reverse Mortgage line of credit, payments on the amounts borrowed are optional for as long as they continue to live in the home. The Reverse Mortgage option provided the homeowners control of how they managed their assets (including their home equity), income and liquidity.
After reviewing the alternatives and various scenarios, the homeowners decided the following:
- Obtain a Reverse Mortgage line of credit on their current home for approximately $550,000.
- Purchase the new home by withdrawing approximately $500,000 from the investment account and using approximately $400,000 from the Reverse Mortgage line of credit to purchase the second home.
After the obtaining the Reverse Mortgage, here are highlights of the homeowners’ position:
- They were able to leave $400,000 in their investment account which continued to earn $40,000 to $60,000 per year. Over 5 or 6 years this would amount to $300,000 to $400,000, with compounding. This exceeds the return they would have received from investing the $400,000 in the second home.
- They had access to a $150,000 line of credit that was available to draw upon at any time, never expired and could never be frozen. The line of credit provided an additional source of liquidity.
- The unused balance on the line of credit would grow each year at 5% or more, tied to the interest rate on the line of credit.
- They had the option to not make any payment for principal or interst on the outstanding mortgage balance or to pay principal, interest or both whenever they wanted. The option to make or not make a payment for principal and/or interest exists for as long as they live in home or until they pay the balance in full.
- They retain ownership of the home until they sell it.
- They retain all future appreciation on the home and the second home.
- Most importantly, the Reverse Mortgage allowed them to accomplish their objective to purchase the second home.
The Reverse Mortgage allowed them to use the equity in their home to accomplish very specific financial and lifestyle goals. It also allowed their new worth to grow at a faster pace than it would have if they had paid cash for the second home.