As we discussed in “The New American Dream,” delayed gratification is often the route to realizing our dreams. And in fact the 15-year mortgage definitely pays off for those who are patient. You will not only have the loan paid off seven years faster, which can be a huge boost come retirement, but also your total interest payments with the 15-year loan will be about $90,000, compared to $165,000 for the 22-year loan. That’s a savings of $75,000.
LOWER YOUR MORTGAGE COSTS WITHOUT A REFINANCE
If you determine a refinance doesn’t make sense for you—maybe you lack the equity, don’t have the money for a cash-in refinance, or your credit score won’t qualify for a great rate—you can still get ahead on your mortgage. Simply add extra money to your monthly payment. All you need to do is verify with your loan servicing company that the money is to be applied to paying down your principal. This is in fact my recommended strategy if you have any doubt about your job security, or if you do not want to lock in the responsibility of higher payments on a 15-year loan. By sticking with your existing mortgage and just making optional extra payments you have the flexibility to stop those extra payments if the need arises. A table on
this page
in the class on retirement strategies in your 40s and 50s illustrates the advantages of this very clearly.
TIP:
Lenders usually have programs that offer to help you speed up your payment process. But there are often fees charged to enroll in such a program, and in my opinion they are a complete waste of your money. The fact is, you can pay off your mortgage ahead of schedule without incurring any monthly fees, by simply sending in a larger payment than is due each month. Ignore those bank come-ons and use common sense.
LESSON 6.
THE DANGERS OF HOME EQUITY LINES OF CREDIT
Those of you who have been following my advice for years know that I have never liked borrowing against the equity in your home, especially for expenses that don’t qualify as needs. Given that I have asked you to embrace the concept of living below your means but within your needs, I hope it is patently clear why I think it is frankly dishonest to borrow against your home equity. It is often an indication that you are in fact trying to live above your means.
In the immediate wake of the financial crisis, lenders were reducing or terminating outstanding home equity lines of credit (HELOCs). But I bet those of you with ample equity and good credit have recently started receiving new offers to open a HELOC. With the eye of the storm past, lenders are looking for ways to generate revenue, and homeowners with strong financials are a likely target.
And the timing could not be worse. While I have always advised against HELOCs, there is a looming risk tied to what is going on in our economy that makes HELOCs especially dangerous right now.
The vast majority of HELOCs are variable-rate loans. The rate is tied to a financial benchmark, such as the federal prime rate. The prime rate is typically 3 percentage points higher than the federal funds rate that you hear about so often in news reports. As I write this in early 2011, the federal funds rate is right about 0.25%, and thus the prime rate is 3.25%. When the prime rate moves up or down, so too does the interest rate charged on a HELOC. Lenders will charge a premium above the prime rate—called the margin—that can add 0.50 to 1.0 percentage point or more to the prime rate. For example, in the fall of 2010 some lenders were offering borrowers with good credit a HELOC at 3.75% (prime + 0.5%). That 3.75 sounds so enticing. In fact, lenders are quick to point out how smart it is to take out a low-rate HELOC and pay off your high-rate debt, such as credit card debt or a car loan. Or to finance a car purchase with a HELOC.
Here’s what the lender might not be so quick to explain to you:
Interest rates are going to rise, and when that happens your HELOC payments will go up
. In the coming months and years we will see short-term interest rates controlled by the Federal Reserve rise. It may not happen this year, but sooner or later rates must rise off their historic lows. That makes HELOCs risky; with the future direction of the prime rate up, not down, you will likely encounter higher payments. Consider what happened just a few years ago: In May 2004 the prime rate was 4%; by the end of 2005 it was 5%. A year later it was at 7% and by December 2006 it had shot up to 8.25%. Homeowners who had HELOCs tied to the prime rate saw their rate more than double! Take out—and use—a large HELOC and in a few years you may well find yourself stuck paying the line back at a much higher interest rate.
If you fall behind on a HELOC the lender can foreclose on your house
. A HELOC is what is known as a secured loan, meaning it has collateral. And that collateral is your home’s equity. If you were to get in so much trouble you could not keep up with your HELOC repayments, the lender could foreclose on your home to use the equity to settle your balance due. That is why it never—and I mean absolutely
never
—makes sense to use a HELOC to pay off credit card debt or to pay for a car. Credit card debt is unsecured; if you can’t pay it off no one can come take your house from you. But if you transfer the credit card debt to a HELOC you have put your home at risk if you don’t keep up with the payments. I also don’t think it ever makes sense to use your home to pay for a car; I’d rather you use a regular car loan. In the event you fall behind on a car loan, you risk losing just the car, not your house.
HOME EQUITY LOANS
I also have to say that I am not a fan of a home equity loan (HEL) either. A HEL typically has a fixed interest rate. That indeed will make it more appealing than a HELOC in a rising-rate environment. But the more pressing issue is why you are tapping into your home equity at all. It is a clear signal, in the majority of instances, that you are trying to live beyond your means. My bottom line is that if you are tempted to use a HELOC or a HEL, take that as a warning signal that perhaps you are not standing in the truth of living below your means but within your needs.
LESSON 7.
REVERSE MORTGAGES
In the coming years I expect reverse mortgages to become increasingly popular among retirees who are eager to find extra income. A reverse mortgage is available to anyone who is at least 62 years old and owns a home outright, or has a small mortgage balance remaining. If you are married and both spouses are on the home’s title, the youngest spouse must be 62 before you can consider a reverse.
With a reverse the borrower can opt to receive a lump payment, or an ongoing payment for a set period of time, or a line of credit in which the home equity is the collateral for the loan. It is literally a way for retirees to live off their homes.
While I think a reverse can make sense in certain circumstances, it is not nearly the win-win it is often made out to be. There are many costs and risks to doing a reverse that you must fully understand.
REVERSE MORTGAGE BASICS
The vast majority of reverse mortgages are loans that are insured by the Federal Housing Administration. The formal name for these FHA-insured loans is Home Equity Conversion Mortgage (HECM). The maximum home value that can be tapped for an HECM is based on home values in your area. The upper limit in 2011 for people living in high-cost areas is $625,500. But that is just a limit used to calculate the benefit you can receive; in fact, no one can receive a payment anywhere near the full value of their home; typically your original loan amount might be 60% or so of your equity.
The percentage of your equity that you can tap is based on a calculation that factors in your age and current interest rates. Your credit score is not a factor.
The younger you are the less you can borrow. For example, in early 2011 a 62-year-old with a fully paid-off mortgage and a home value of $625,500 in a high-cost area might qualify for a maximum reverse mortgage of about $365,000. A 72-year-old might qualify for a $392,000 payment. All reverse mortgage payments you receive are tax-free.
I realize that sounds like a lot of money—it is a lot of money—but what you must realize is that once you borrow the money your account begins to ring up interest charges. You never have to repay a penny while you live in the home. But when you move, or you die, the loan must be repaid. (If you move into an assisted living facility or nursing home for more than twelve months you are deemed to no longer live in your home, and the reverse loan must be repaid.) And you, or your heirs, will owe the principal and the interest. Now one great aspect of a reverse mortgage is that you will never owe more than the value of your home when you leave, but every penny of the sale could well indeed go to the reverse mortgage lender to settle your loan—meaning you or your heirs may not have any equity left when all is said and done.
Another consideration is the cost. Traditionally, reverse mortgages have been quite expensive. The up-front fees to open a standard HECM reverse mortgage can add up to 10% of the loan amount. In late 2010 a new type of reverse, called the HECM Saver, was introduced. It eliminates many of the up-front fees, though the amount you can borrow through the program is about 15% or so lower than what is available with a standard reverse mortgage. In both versions you will pay an ongoing annual “insurance” premium of 1.25% of your loan amount.
I have to say that I think reverse mortgages are a potentially dangerous step for many retirees. It is far too easy to get blinded by the prospect of receiving much-needed income today and overlook some important considerations.
Please understand that after you take out a reverse mortgage you are still responsible for all costs associated with running your home—the property tax bill, the insurance bill, the utilities, and all maintenance costs. If you can’t afford the upkeep of your home it makes no sense to do a reverse mortgage. You will just end up having to sell eventually when you realize you can’t afford the home, and whether you have any equity left after the sale depends on the size of the reverse loan that must be settled.
And as I mentioned, a reverse will also impact the estate you leave for your heirs. When you die, the loan comes due. The lender cannot charge more than the value of the home, but every penny of the sale could in fact go to the lender, leaving your heirs without an inheritance. I also want you to know that if your heirs decide they want to keep the home after you pass, they would in fact owe the lender the full value of the loan, even if it exceeds the sale value of the home. For example, if your reverse mortgage balance is $300,000 when you move or die, and the home sells for $260,000, the lender will receive just the $260,000. You or your heirs would not need to come up with another $40,000 to settle the loan. But if your heirs decided they in fact wanted to keep the house, then they would owe the full $300,000.
My recommendation is that you think of a reverse mortgage as a last-resort emergency fund in retirement, not a primary piece of your retirement plan from day one. If money is so tight at age 62 that you think you need a reverse mortgage, my concern is what happens at age 72 or 82? If you tap all your home equity through a reverse at 62 and then at 72 you realize you can’t really afford the home, you will have to sell the home, and you may end up giving most or all of the sale price back to the lender to settle up. What will you live on then? I would much rather you base your retirement on other income sources—your savings, Social Security, and a pension. If later on in retirement you need extra income, then you can consider a reverse mortgage, but go in with your eyes open.
You can learn more about reverse mortgages online at
www.hud.gov/offices/hsg/sfh/hecm/hecmabou.cfm
. You can calculate an estimate of what you might be able to receive from a reverse mortgage at
www.revmort.com/nrmla
.
LESSON 8.
INVESTING IN REAL ESTATE
Whether you are considering buying investment property today or are wondering what to do with an investment that is now underwater, it is important to understand how very different the rules and regulations are for income property compared to a home you live in as your primary residence.
WHAT YOU NEED TO KNOW BEFORE YOU BUY INVESTMENT PROPERTY
With home values down 30 to 50%—or more—I know that many of you think now is a great time to invest in real estate. I have to say, my experience is that the people who are so quick to see the upside often don’t properly prepare for the potential downside. Owning investment property is a risky investment. There is no guarantee the property will rise in value—or rise in time for you to flip or refinance as you had hoped—nor is there any guarantee you will always have responsible tenants. Please do not consider buying unless you have carefully prepared for all the what-ifs:
You must have an eight-month personal emergency fund
plus
a one-year fund to cover the carrying costs on your rental property
. If you are going to invest in a rental property your personal emergency fund is not to be a part of your plan. You must have a separate fund that can cover up to one year’s worth of mortgage, tax, insurance, and maintenance costs for your property. The biggest mistake I see people make is that they wrongly assume they will always be able to rent out the property, that rental rates will always rise, and that their tenants will treat the property with great care. That is what I would call wishful thinking—and it could lead you down the road of ruin. You must have an ample investment property emergency fund to fall back on.
Real estate must be part of a diversified investment portfolio. I
have had too many conversations with people who told me they lost everything in real estate when the bubble burst. They insist they were well diversified because they owned several properties in different neighborhoods. That is not my idea of diversification. That is owning a lot of the same type of asset. Investing in real estate must be done after you have taken care of your other investment goals. If you are not contributing to your retirement funds you have no business investing in real estate. And if you do own investment property, that is never a reason to stop or slow down your retirement savings.