If My Household Income Runs Out, What Should I Do?

Whether it’s a job loss, unexpected medical expenses, home repairs, or any other reduction in income, anyone in financial trouble has a number of options available to them—especially if they already have some equity to borrow against.

Borrowing from a life insurance policy or a 401(k) plan; utilizing a home equity loan; conventional refinancing; or obtaining a reverse mortgage are all options.

Of course, no discussion of these issues would be complete without mentioning the significance of financial planning in order to avoid this scenario. Each of these options has potential drawbacks, to the point where some financial analysts argue that they should be avoided entirely.

Additional sources for information on reverse mortgages and financial planning in general.

The Department of Housing and Urban Development’s information page on Home Equity Conversion Mortgages
click here.

HUD’s HECM counseling agencies

Find a HUD-approved reverse mortgage counselor at this address or by calling 800-569-4287.
click here.

Top 10 things to know if you’re interested in a reverse mortgage
click here.

10 things you should know about reverse mortgages
click here.

Frequently asked questions on reverse mortgages, from the National Reverse Mortgages Lenders Association
click here.

Financial Planning Association

Information on investing and finding a financial planner
click here.

Certified Financial Planner Board of Standards

Consumer guides on financial planning and resources for finding a financial planner
click here.

The National Association of Personal Financial Advisors

Includes a “field guide” on finding and evaluating a financial advisor
click here.

Of course no discussion of these issues would be complete without first mentioning the importance of financial planning to try and avoid this scenario. Each of these options comes with potential drawbacks to the point where some financial analysts argue for just avoiding them altogether.

Bill Palmer, senior financial advisor and a Certified Financial Planner with Win Wealth Management in Denver, Colo. says everyone should have about six months of living expenses set aside in an emergency fund which they can earn interest on, rather than borrowing when they get in a pinch.

“These are solutions for people who are not planning so why not better serve those people by encouraging them to plan and to save and to live within their means, or better yet below their means so that they can save. It’s all about striking a balance between consuming today and starving tomorrow,” Palmer says. “Interest is a reduction in your total cash flow so if you don’t have to pay interest in the grand scheme you’re much better off.”

Palmer suggests keeping a reserve fund in a four-year Certificate of Deposit to earn interest, then pay whatever penalty might arise from having to draw on that money in an emergency.

Yet not everyone is willing or perhaps able to follow that advice. Anyone reading this article might be at the point where they need resources now. That’s why we’ll take a look at each of these options and consider the issues surrounding all of them.

“Any resource can be a tool so long as it’s wisely used. It doesn’t matter whether it’s a reverse mortgage or a home equity credit line or you borrow cash value from your life insurance policy or 401(k) plans,” says Neil Van Zutphen, president of Delta Ventures and a Certified Financial Planner in Mesa, Ariz. “You have to think of each as its own tool and understand the pros and cons of each of the tools.”

He says the first step, before even considering these options, is to cut back on expenses and save as much as possible. While tapping these resources can help those in a bind, they can easily let someone get lulled into a false sense of financial security.

“They spend at a normal level when they should be saying to themselves holy smokes I need to really ratchet this down and spend the least amount possible so that we can preserve and conserve our capital for as long as possible,” Van Zutphen says.

Refinancing

At a time when interest rates are so low, a simple refinance could lower a homeowner’s mortgage payment and provide extra cash in their budget. Unfortunately, a weak housing market means that anyone who purchased a home in the last few years is likely underwater, as their home may be worth far less than the mortgage they have on it.

“If you have at least 20% equity in your home and good credit, you should have a good opportunity to refinance and obtain historic low interest rates,” says Samuel Tamkin, a Chicago-based real estate attorney, real estate expert, and columnist for ThinkGlink.com.

“I recently spoke with someone who stated that they were offered a 2.34 percent interest rate on a 15-year mortgage.” “That interest rate appeared to be almost free money to me,” Tamkin says.

While some homeowners may be tempted to borrow more than they have in their existing mortgage by refinancing, Tamkin says this may be difficult unless the home’s value is significantly higher than the new mortgage amount.

Palmer says refinancing is an option for those with a loan-to-value ratio of 80 percent or higher, but he cautions against taking excess capital out of a mortgage because most people aren’t responsible enough to use that money wisely. Rather than trying to outperform the market, he suggests investing in an index fund.

“I’m okay with having a home mortgage that you take cash out of when you refinance if you immediately invest it in a long-term investment plan and don’t gamble it on speculative investments,” Palmer says. “That’s the only time I’d advise someone to take out cash, but the rule of thumb is if the interest rate on the debt is less than the highly probable expected return, not an end-of-the-rainbow expected return, but something pragmatic and realistic.”

Home equity loans

Home equity loans and Home Equity Lines of Credit are essentially rebranded second mortgages. They enable homeowners to borrow against the equity in their home at lower interest rates than other forms of borrowing, such as credit cards. (See the sidebar)

A home-equity loan offers a single lump sum payment at a fixed rate and is typically used for a specific amount of money for a specific purpose, such as home repair or addition construction.

A HELOC has a variable interest rate that typically tracks the prime lending rate plus a few percentage points. Borrowers receive special checks that they can cash at any time and are frequently used as an emergency fund.

The HELOC does not accrue interest charges until the borrower uses the line of credit, so it can serve as a backup financial plan in the event of an emergency. The bank can revoke or change a HELOC at any time for a variety of reasons, such as a significant decline in a home’s value or a change in the homeowner’s finances.

“It exists only in the event of a true emergency.” “If you or both of you lose your jobs,” Van Zutphen says. “You try not to use it all at once; you use it as you can and then try to pay it back as soon as possible.”

Tamkin believes that interest rates are low enough to make a home equity loan affordable, though anyone who purchased a home within the last seven years or so is unlikely to have enough equity to borrow against.

“Some markets may have seen prices return to around the year 2000, but if you bought in 1994 and have been in your home almost 20 years, you may still have a significant amount of equity in your home, particularly if when you refinanced you only refinanced prior balances and did not take additional money out,” Tamkin says.

Palmer recommends keeping a HELOC on hold with a bank as a backup resource to an emergency fund that can be used after a six-month savings reserve has been depleted.

Tapping a 401(k)

The ease with which a 401(k) plan loan can be obtained is perhaps its most significant advantage. Whereas borrowing from a bank can require a lengthy credit application, accessing 401(k) funds is as simple as filling out a form and paying a small fee, though not all plans allow this.

Reverse mortgage costs:
There are several costs and fees involved in a reversible mortgage, otherwise known as a Home Equity Conversion Mortgage. They can be paid out of pocket or covered by the loan itself.

Mortgage Insurance Premium for mortgage insurance, charged at closing, based on the lesser of the home’s appraised value, the mortgage limit of $625,000 or the sales price:
2% of the loan for a HECM Standard
.01% for a HECM Saver
Also charged an annual MIP of 1.25% of the mortgage balance

Third party charges:
Closing costs from third parties can include an appraisal, title search and insurance, surveys, inspections, recording fees, mortgage taxes, credit checks and other fees.

Origination fee:
A lender can charge a HECM origination fee up to $2,500 if your home is valued at less than $125,000. If your home is valued at more than $125,000 lenders can charge 2% of the first $200,000 of your home’s value plus 1% of the amount over $200,000. HECM origination fees are capped at $6,000.

Interest rate:
You can choose an adjustable interest rate or a fixed rate. If you choose an adjustable interest rate, you may choose to have the interest rate adjust monthly or annually. Lenders may not adjust annually adjusted HECMs by more than 2 percentage points per year and not by more than 5 total percentage points over the life of the loan. FHA does not require interest rate caps on monthly adjusted HECMs.

Service fee:
Lenders may charge a monthly service fee of no more than $30 if the loan has an annually adjusting interest rate and $35 if the interest rate adjusts monthly. At loan origination, the lender sets aside the service fee and deducts the fee from your available funds. Each month the monthly service fee is added to your loan balance.

Source: U.S. Dept. of Housing and Urban Development
More information at: click here.

Most of these loans must be paid off within five years, although those borrowing for a down payment on a house will have longer than that depending on their plan. Craig Copeland, senior research associate at the Employee Benefit Research Institute, says such loans usually have a low interest rate and the money goes right back into the borrower’s own account so they’re essentially paying interest to themselves.

He says another difference between borrowing from a 401(k) plan vs. a bank is that a 401(k) loan doesn’t require the borrower’s home to be used as collateral so there’s no risk of losing it if the loan isn’t paid back.

A 401(k) loan isn’t entirely without a hitch, as a borrower would have to pay taxes on whatever funds they don’t pay back as well as a $10,000 fine. A 401(k) loan would also have to be repaid in full if the borrower leaves their job for any reason.

“You may be a better investment, particularly when the stock market is down. It kind of depends upon the timing of your loan versus markets, now that’s going to be really hard to do if you decide to take out a loan based on the markets because it is all based on timing, but in a way you are giving yourself guaranteed income back by repaying the loan,” Copeland says.

The Internal Revenue Service does allow withdrawals from 401(k) plans without the $10,000 penalty under certain hardship cases, although income taxes would still have to be paid on what was taken out of the plan.

The IRS says hardship distributions are for “an immediate and heavy financial need of the employee” including their spouse, dependents or beneficiary.

Circumstances include medical expenses, tuition, preventing foreclosure on a principal residence, certain home repairs and burial and funeral expenses. A distribution is not considered necessary if the employee has other resources available such as commercial loans and the assets of a spouse and minor children, unless the child’s assets are held in an irrevocable trust.

Given the unpredictability of the financial markets, Palmer does not recommend borrowing from a 401(k) plan. He says it’s impossible to know for sure when a bear market is happening, but the market will generally increase over time so the chance that a 401(k) loan will hurt investment growth is high.

“Oftentimes there’s an interest rate you’re paying yourself but it’s probably not what your expected return would have been on the investment that you’re taking the money out of,” Palmer says. “What I know is 70 percent of the time, plus or minus, the market goes up. So if I invest in the market my odds of success are very high and since I don’t know if it’s a bull market or a bear market if I put my money in the odds are with me.”

Van Zutphen says he borrowed from his own 401(k) plan as part of a down payment to buy out his business partner. At the time he had refinanced his mortgage and hadn’t reestablished a HELOC, but thought buying out his partner was a suitable investment opportunity.

“In this marketplace if you’re buying some real estate maybe the value of the real estate is a really great buy and an investment opportunity as well. As long as you’re gainfully employed and you can pay those things back then it’s a great tool,” Van Zutphen says. “If you’re taking it out of the plan and you’re buying something then you’re using it as an investment tool to buy a potential appreciating asset, and then you just have to weigh the pros and cons of the interest charged by the plan and the cost of funds that you could get otherwise for the down payment.”

Borrowing from life insurance

Unlike term life insurance, which is for a set period of time, whole life, universal life and variable life insurance policies come with a cash benefit that can be tapped as a resource. These plans are not only more expensive than term life insurance, their premiums would steadily increase over time if not for the cash value component.

To avoid such an increases, whole life and other such policies have fixed premiums and part of the money received by the insurance company is invested as a cash value that is attached to the policy. As the cash value grows over time, the company draws on those funds to offset the increasing cost of maintaining the policy.

It’s sort of like a savings account or a mutual fund that helps pay part of the premiums later on in life. The cash value can be borrowed from, provided it has reached a sufficient level.

Just like borrowing from a 401(k) plan, Tamkin says borrowing from a life insurance policy can hurt someone’s investment prospects even if the money is paid back.

“It may cause your investment strategy to change and you may not get the same benefit that you would have if you had invested that money in whatever the plan was going to invest in,” Tamkin says. “If your plan was to have a whole policy to save money and defer income, borrowing against it is going to reduce the benefits that you’ll accrue in the future. That may not be a wise investment decision.”

Van Zutphen says he would consider borrowing from a life insurance plan before he would opt for a home equity loan or a HELOC and he’s borrowed from his own life insurance plan before, yet it would be risky to borrow too much from the cash value as it could put a policy at risk.

“If you borrowed all the cash out of your policy the premiums you pay would be insufficient to keep the policy active,” Van Zutphen says. “The cash that was going to be used to help maintain the cost of the policy, benefits and everything else level or at a reasonable price would change because the cash is no longer there. The insurance company doesn’t get to use that cash and since they don’t get to use the cash, it’s likely that the policy will lapse.”

Palmer has a different approach entirely as he doesn’t think whole life policies are even necessary. He suggests people start with term life insurance when they’re younger but then self-insure themselves by taking what they would’ve spent on a whole life policy and invest the money instead.

“Insurance is absolutely essential but it’s for a defined quantifiable need. You have to have an insurable interest,” Palmer says. “Once your net worth gets high enough to support those that depend on you, you don’t need life insurance.”

Rather than thinking of a whole life or a variable policy as an investment, Palmer suggests keeping a balanced portfolio instead because a life insurance policy cannot beat the returns offered by an index fund.

“Generally speaking you should buy insurance as insurance and investments as investments because as soon as you mix the two something is compromised,” Palmer says. “It’s like two and two end up equaling three.”

Reverse Mortgage

A reverse mortgage, also known as a Home Equity Conversion Mortgage, is when a homeowner receives a sum of money from a bank and when they die or move out of the house, the house is sold and the proceeds are used to pay off the loan. Like a traditional mortgage, interest is charged on the loan and accumulates over time.

The majority of them are non-recourse loans, which means the borrower or their descendants will never owe more than the amount borrowed—as long as the home is sold to a third party in a “arms length transaction” at market value.

For example, if a homeowner dies with a reverse mortgage balance of $100,000 and the home is sold for $120,000, the estate will receive $20,000 after the loan is paid off. If the house sells for less than $100,000, the estate receives nothing but does not owe any additional funds.

Individuals aged 62 and up are eligible for reverse mortgages. If the property is held jointly, both owners must be of legal age. The amount available for borrowing is determined by the age of the youngest homeowner and the type of loan obtained. The borrowable limit rises in proportion to the owner’s age.

A married couple looking for a reverse mortgage may be tempted to remove the younger partner’s name from the home’s ownership in order to qualify for the maximum amount possible, but this is not a decision to be made lightly.

According to Lori Trawinski, senior strategic policy advisor in the American Association of Retired Persons’ Public Policy Institute, if only one name is on the reverse mortgage and that person dies or has to move out, the surviving spouse must either give up the house or pay off the loan in full.

“This causes issues because if the person named on the mortgage note dies, the loan becomes due and payable,” Trawinski explains. “It’s a risky strategy, and historically, some people have had problems with it, such as non-borrowing spouses receiving a due and payable notice for the loan.”

Home Equity Loans and Home Equity Lines of Credit

A home equity loan acts like a second mortgage, so the owner must have sufficient equity in the home to borrow against. This is not an option for properties that are “under water” (worth less than the outstanding mortgage).

Here are the basics:

  • Borrow up to $100,000 and deduct interest from tax returns
  • Generally 5 to 25 years in duration
  • Must be paid off in full at the end or if the home is sold
  • Lower interest rate than credit cards and other forms of credit
  • Typically used for major items like education, upgrading home or medical bills
  • Usually non-recourse loans—borrower’s liability limited to only the asset/collateral.
  • Borrowing limit often set at a percentage of home’s appraised value (say 75%), minus balance owed on the existing mortgage.
  • May have a “balloon payment” with balance paid off at the end of term
  • If home is your principal dwelling, you have three days after opening account to close it at no cost in fees

There are two kinds of home equity loans, fixed rates and a Home Equity Line of Credit:

Fixed rate:

  • · Single, lump sum payment to the borrower
  • · Payments and interest are set in stone
  • · Good if need a set amount of money for a specific purpose (such as building an addition)

Home Equity Lines of Credit:

  • · Variable interest rate
  • · May have minimum monthly payment (interest only), which changes according to the interest rate. It’s usually indexed to the prime rate, plus a points margin, and must have a cap on the total increase for the life of the loan.
  • · Banks may freeze or alter the loan if the property sees a significant decline in value, or if there’s a change in your ability to pay it back.
  • · Usually get special checks to draw on, or a “credit card”
  • · May have limitations on use, such as $300 min per draw
  • · Can access at any time and use as a reserve or emergency fund

Fees:

  • · Some lenders waive some or all of closing costs
  • · Appraisal, application, closing costs, attorney fees, taxes, property and title insurance.
  • · Points based on a percentage of the entire loan
  • · Annual loan fee

For more information, see the Federal Reserve’s “What you should know about Home Equity Lines of Credit.” Click here.

As a result, the Department of Housing and Urban Development mandated in August 2011 that couples seeking a reverse mortgage meet with a HUD-approved counselor before applying for a loan.

For reverse mortgages, there are two options. A HECAM standard loan allows the most funds to be borrowed, but at a higher cost. A HECAM SAVER loan has lower fees but a lower borrowing limit (see sidebar). Trawinski believes that the saver option is better for those who need loans for a shorter period of time because the fees are lower.

Whatever loan is chosen, borrowers must maintain the property, pay property taxes, and keep the home fully insured. Failure to do so may result in the loan going into foreclosure. If they leave the residence for more than a year, they must also remain in it or surrender it to the bank.

“You’re not gaining lifetime income; you’re gaining income for the duration of your residence,” Trawinski explains. “The loans are intended to be in place for as long as people are permanent residents of their home, so if they sell it, die, or permanently move out, the loan must be repaid.”

Borrowers can receive loan proceeds in a variety of ways, including a lump sum, a line of credit, or a monthly payment for a set period of time. According to Trawinski, seniors frequently use reverse mortgages to pay off their regular mortgage or if they need home repairs but do not have enough income to qualify for a home equity loan.

“In these cases, a reverse mortgage can be the solution because you can borrow the money and not have to make repayments,” Trawinski says. “These loans are sometimes the only option for people who need money.”

Because of the fees involved, Palmer considers a reverse mortgage to be “the worst of the bunch” among these financing options. Instead of paying 3 to 6 percent in fees, he advises homeowners to sell their home and use the proceeds to move into a small apartment.

Tamkin advises anyone considering a reverse mortgage to have significant equity in their home and to consider other options first, as a $50,000 reverse mortgage loan could cost the borrower $6,000 in fees.

A standard refinance or new mortgage may be a better option for some, as Van Zutphen points out, because it provides a lump sum of money that the borrower can use for living expenses. A reverse mortgage, on the other hand, can pay off an existing mortgage, provide the homeowner with cash, and relieve the stress of making monthly mortgage payments.

“To me, that’s kind of a neat way of using a reverse mortgage as a tool,” Van Zutphen says, “assuming the client or couple wants to stay in that home their entire lives and aren’t looking at the home equity as an additional tool that they’ll use later in life.”

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