Brad Norris

Sometimes the best thing an agent can do for a client is to not sell their home. Believing that the only way that they can live comfortably is to sell, some seniors are overlooking an option that may be more aligned with their needs and desires. For some, a reverse mortgage is the right choice.

There are many myths surrounding the reverse mortgage product and process. It is important to know some of the facts when speaking with a senior client debating what to do with their home. The minimum age to qualify is 62 and the homeowner must have some equity. This is not a solution for someone who is upside down on their mortgage. A reverse mortgage requires no repayment unless the homeowner moves out or sells the property.

Some of the myths are:

•· "It will affect my Social Security or other government benefits"

•· "I will have to pay taxes on the money"

•· "I might lose my house if I live to long"

•· "I won't be able to pass along my property to my heirs"

None of these statements are true. The proceeds of the reverse mortgage are tax free and do not count towards any income eligibility requirements for government benefits. Once the loan is fully paid out to the homeowner, the homeowner may continue to live in the home. Taxes and insurance must of course be maintained. No one outlives the loan. The house may be passed along just as any other property. The loan must be paid off first.

There are different ways for a homeowner to access the loan

•· Fixed monthly payment for life

•· Fixed payment for a specific term (10, 15 years etc.)

•· Lump sum payment

•· Line of credit

•· Combination of fixed payment and line of credit

A senior can always get more information and a list of lenders from the AARP at their website.

For many seniors, their desire is to remain in their homes as long as they can. As we all know, home means more than just a house.

Maybe some of you out there have seen this scenario play out.

Ill-informed financial advisors married up with unscrupulous mortgage originators attempt to drum up business with the following value proposition: Cash the equity out of your home and invest the proceeds. Over the long-run, the S&P 500 has returned over 10%. If you borrow at a rate below this, you will be ahead of the game. Smart, huh?

The cardinal rule of investing is that there can be no return without accepting some level of risk. US Treasury securities are deemed to be the least risky of any asset class. Yields on these securities are therefore lower than other asset classes (stocks, corporate bonds, real estate, etc.). The stock market is certainly not without risk. Wealth can just as easily be destroyed as it is created as a result of fluctuations in stock prices. Many investors in technology stocks in the late nineties have yet to recoup their initial investment.

How can one make a better informed decision when presented with this value proposition? It is a straightforward calculation to measure return. How then should risk be measured? Fortunately, there is a set of tools that can help. The primary measure of an investment's return relative to its riskiness is known as the Sharpe ratio. The ratio measures the return per unit of total risk.

The definition of the Sharpe Ratio is:

S(x) = ( r_x - R_f ) / StdDev(x)

where

x the investment under consideration

r_x is the average annual historical rate of return of x

R_f is the rate of return of a "risk-free" security (US Treasury securities)

StdDev(x) is the range of possible return outcomes of x. Known in statistics a the standard deviation of r_x

Take for example, a scenario with the following characteristics:

x is a stock portfolio with an historical return of 10% and standard deviation of 6%

the risk-free security yields 4%

The Sharpe ratio for such a scenario is:

S = (10%-4%)/6%

S = 1.00

Now suppose instead of this strategy, one wanted to find the same measurement for simply prepaying a portion of one's mortgage.

x is the rate of interest for the mortgage. Assume x =6.5%

StdDev(x) = .01% (technically there is no risk, however the denominator cannot be zero)

The Sharpe ratio for this new scenario is:

S = (6.5%-4%)/.01%

S = 624

Clearly the proposal to retire the mortgage debt produces a superior return/risk tradeoff. Please note that an after-tax borrowing cost will produce a different outcome.

Therefore the un-glamorous financial counsel of "Borrow as little as you need and pay it off as soon as you can." proves to be the most sound.

With the current turmoil in the credit and stock markets, this will probably not be so frequently proposed, but if you do hear of it being proposed to your friend or client, now you may be able to offer them some better advice.