Are you in denial about your older clients’ mortgage debt? Pre-retired households are carrying larger mortgages in the wake of the housing bubble and bust, and many are carrying that debt into retirement.
Consider these statistics:
● AARP reports that 53.6 percent of households age 55-64 carried a mortgage in 2010, compared with 37 percent in 1989; among households age 65-74, the figure jumped to 40.5 percent from 21.7 percent. Meanwhile, the median value of mortgage debt among the 55-64 crowd soared to $97,000 in 2010, up from $33,800 in 1989. For households age 65-74, median loan values soared to $70,000 from $15,400.
● The media loan-to-value ratio among homeowners age 50-59 jumped from 10 percent to 38 percent between 1989 and 2010, according to the Joint Center for Housing Studies of Harvard University.
The figures show many households are overweight in real estate due to the run-up in housing prices prior to the bust. Many families invested in larger, more expensive homes or undertook renovations and expansions, and they’re carrying big debt loads.
Does it make sense for these clients to stick with their mortgages, or pay them off? Paying the debt might not be an option for less affluent households, but many older clients have sufficient savings. It’s an option advisers don’t always consider.
“We should be viewing asset allocation on a more holistic basis,” argues Michael Kitces, partner and director of research for Maryland-based Pinnacle Advisory Group. “That means the debts net against the fixed income - and most people are taking a lot more risk than they acknowledge.”
Alan S. Roth, founder of Wealth Logic in Colorado Springs, Colorado, says he often encounters surprise and resistance when he suggests a mortgage payoff to clients. “They worry about losing their tax deduction on mortgage interest, or they argue that the mortgage is cheap money,” says Roth. “But getting rid of the mortgage really is a source of low-hanging fruit. The argument is simple - don’t borrow money with a mortgage at a higher rate than you are lending it out for with a bond.”
Just as important, Roth argues, in a balanced portfolio of stocks and fixed income investments, a mortgage makes the portfolio more aggressive than it looks at first glance, because the mortgage must be netted out against bonds in the portfolio (He makes the case in more detail here).
Some clients no doubt will argue that they can get a higher return in the stock market than the cost of their mortgage. But Kitces argues that’s not good enough, because it doesn’t adjust for risk. The effective “return” of repaying the mortgage - say, carrying a 4 percent interest rate - is guaranteed; the risk premium on stocks traditionally has been about 5 percent. “That means you should demand somewhere from 8 to 10 percent from equities on a risk-adjusted basis if the alternative is paying off the mortgage,” he says.
“I do think it’s valid to have a mortgage and a portfolio,” he adds. “It’s just that you need to be very optimistic about equities – enough to have a reasonable expectation of favorable returns high enough to generate an appropriate equity risk premium. And it doesn’t make sense to have bonds as a part of the leveraged portfolio, given their low yields.”
For older clients creating income streams from accounts, sequence risk is another concern, Kitces says, because they may need to draw down investments to pay the mortgage. “If a terrible bond and stock environment comes along at the same time, and I have to make mortgage payments, I could so deplete my portfolio that by the time good returns show up later I hardly have anything left invested,” he says.
There are two caveats to the mortgage pay-off strategy, Kitces says. First, he always advises clients first make sure they contribute enough to the 401(k) to get any matching employer contribution. And he also wants to make sure the client has sufficient liquid reserve funds that can be accessed in case of an emergency spending need. “But after that, I want people to start deleveraging themselves, if they’re not confident they can get 10 percent-plus on stocks to earn a reasonable equity risk premium.”
What about households that invested so heavily in housing that they really need to tap equity for retirement?
One alternative is to encourage clients to downsize. Most downsizing moves occur close to home, and moving from an expensive inner-ring suburb to a less costly exurban location can help your client extract equity that can be saved, invested and drawn upon in retirement.
Reverse mortgages offer another option for older clients. A reverse mortgage lets homeowners turn their equity - the value that is not mortgaged - into either an upfront lump-sum payment or a line of credit. They’re available only to homeowners age 62 and older; unlike a traditional 30-year mortgage, which reuires monthly payments that increase equity, a reverse mortgage pays out the equity already in a home as cash; the debt level rises and equity decreases.
The U.S. Department of Housing and Urban Development rolled out new rules this month for the most popular loan type, the Home Equity Conversion Mortgage program (HECM). Loan types were consolidated (there are no longer separate standard and saver loans); loan amouts are smaller and fees are higher.
But line-of-credit reverse loans can be a reasonable - albeit somewhat expensive - way to tap equity with no monthly repayment obligations.
Mark Miller is a journalist and author who writes about trends in retirement and aging. He is a columnist for Reuters and also contributes to Morningstar and the AARP Magazine. Mark is the author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work and Living(John Wiley & Sons, 2010). He edits RetirementRevised.com. Twitter: @retirerevised