Annuity+Interest only mortgage in Retirement

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
ScubaHogg
Posts: 712
Joined: Sun Nov 06, 2011 3:02 pm

Annuity+Interest only mortgage in Retirement

Post by ScubaHogg »

Before he left the forum Hedgefundie was proselytizing the advantages of interest-only (IO) mortgages. He even claimed that one could find 30-year fixed rate IO mortgages. Assuming that to be true and given today's low mortgage rates, I'm wondering if there is a subset of people that have an effective arbitrage opportunity with a Single Premium Immediate Annuity.*

Take this scenario:

65-year old Male/Female couple. They can pay off mortgage or get a 30-year fixed rate IO combined with an annuity. Since I don't know if these actually exist or how to find the rates, I'm going to take a wild guess and say the couple could get a 3.5% 30-year fixed rate IO mortgage. This would take them to age 95 where if they were still in the house (unlikely) they could get a new mortgage that they would only need to service for a few years at most.

Home Value: $500,000
Home Equity: $100,000
$400,000 Fixed Rate IO @ 3.5% annual payments: $14000

Joint Life with 10-years certain annuity with a $400,000 premium (for some reason this was a higher payout than simple Joint Life on Immediate Annuities, state Arkansas): $19,524

After reading Wade Pfau's book "Safety First" I know that the full value of a annuity payout isn't taxed. I don't really know how to figure out what part is taxable, so I'll show one example where the full payout is taxed at 15% and one where it's taxed at 0%.

Annually--taxed
Annuity Payout: $19,524
Taxes: ($2928)
Mortgage: ($14,000)
Net: $2596

Annually--no tax
Annuity Payout: $19,524
Mortgage: ($14,000)
Net: $5524

If the couple could actually get a mortgage as described above they would have successfully paired a nominal liability with a nominal income stream. Assuming the taxes are roughly accurate they would receive somewhere between $216-$460 additional guaranteed a month without taking on virtually any more risk.**

I'm sure I'm missing a lot here, but I wanted to throw this out for comment by folks on the board smarter than me. Thanks

*folks more interested in a legacy obviously wouldn't benefit as much and neither would folks who wanted to use their home equity in the future for something else (like nursing home costs, etc.)

**conversely the couple could buy a annuity whose payout is exactly the same as the mortgage and invest/spend the difference
“Unexpected Returns dominate the Expected Returns” - Ken French
User avatar
David Jay
Posts: 9360
Joined: Mon Mar 30, 2015 5:54 am
Location: Michigan

Re: Annuity+Interest only mortgage in Retirement

Post by David Jay »

Hedgefundie is in the accumulation stage and has enough assets to "play" with his portfolios.

30 years is a long time, $400,000 is a lot of money. No way I would give up control of that much of my portfolio for 2K- 5K per year. You will not be interested in "arbitrage opportunities" in your late 80s.

Pay off the mortgage, it will feel a lot better. And the equity is there if you ever need it.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius
IowaFarmBoy
Posts: 822
Joined: Fri Jan 22, 2010 8:19 am

Re: Annuity+Interest only mortgage in Retirement

Post by IowaFarmBoy »

This is an interesting idea but kind of feels like I would be trying too hard if I were to adopt it. Basically trading home equity for a higher income stream. My willingness to use it would probably depend on how much I felt I need the extra income each month. As David Jay said, you are giving up control of a lot of money.

Some comments:
  • You are effectively spending 400k of home equity over the 30 years of this plan. The "juice" in this plan comes using this 400k to buy an annuity thus gaining the mortality credits on the annuity. Your first footnote mentions this- this plan is not good if you want to leave a legacy or think you might need the cash.
  • It is unlikely they will want to refinance at 95 but if they do, they may not have the income to afford/qualify for a new mortgage with the annuity gone. Especially if one of them is gone and SS/pension income is lower.
  • Have you thought about comparing this to some kind of reverse mortgage? It seems like that might be a way around the forced "exit" at 95. I have no idea whether there are suitable reverse mortgage products available now.
  • The annuity would carry some risk of default by the insurance company.
  • If they are in a position to itemize, there could be tax advantages with the mortgage deductibility.
  • As mentioned in the bullet points above, there is some risk in this plan- the risk of outliving it and needing the home equity either to spend or renfinance and the insurance company risk. These are small but they are risks.
Last edited by IowaFarmBoy on Thu Aug 27, 2020 2:36 pm, edited 2 times in total.
IowaFarmBoy
Posts: 822
Joined: Fri Jan 22, 2010 8:19 am

Re: Annuity+Interest only mortgage in Retirement

Post by IowaFarmBoy »

duplicate deleted
Topic Author
ScubaHogg
Posts: 712
Joined: Sun Nov 06, 2011 3:02 pm

Re: Annuity+Interest only mortgage in Retirement

Post by ScubaHogg »

IowaFarmBoy wrote: Thu Aug 27, 2020 2:13 pm Have you thought about comparing this to some kind of reverse mortgage? It seems like that might be a way around the forced "exit" at 95. I have no idea whether there are suitable reverse mortgage products available now.
Could be, I honestly know diddly-squat about reverse mortgages. Might be to accomplish the same thing.
“Unexpected Returns dominate the Expected Returns” - Ken French
Topic Author
ScubaHogg
Posts: 712
Joined: Sun Nov 06, 2011 3:02 pm

Re: Annuity+Interest only mortgage in Retirement

Post by ScubaHogg »

David Jay wrote: Thu Aug 27, 2020 2:08 pm Pay off the mortgage, it will feel a lot better. And the equity is there if you ever need it.
If you don't like that plan, and you could use tax free money for the annuity, you could use $287,000 to buy an annuity that pays out $14000 year and invest the remaining $113,000.

Using a 60/40 mix for 20 years (your 80s in your example) has historically gotten you somewhere between $348,000-$1.08M (nominal)/$208,000-$653,000 (real), going by the 10th and 90th percentiles in a Monte Carlo simulation in Portfolio Visualizer.

https://bit.ly/2EqAzpM

(for some reason each time I open the link the total returns numbers are slightly different, so my numbers above might be a tad off)
“Unexpected Returns dominate the Expected Returns” - Ken French
not4me
Posts: 893
Joined: Thu May 25, 2017 3:08 pm

Re: Annuity+Interest only mortgage in Retirement

Post by not4me »

The trick may be in finding a mortgage they qualify for at a rate with that much differential with the annuity. Is the idea that the mortgage is interest only for full 30 years? So, then the estate would have to pay off the principal or they would when hitting 95? I think most interest only have a shorter time period when interest only & there is a pre-payment penalty (which I guess the estate would have to pay if they die in less than 30 years). Don't know how you grabbed that rate, but does it assume only the best credit score? Several things unclear to me about the mechanics since I'm not familiar with these.

But real reason for posting was to say that I believe the taxation of the annuity is based on life expectancy, terms of annuity, etc. For example in your example, the "10 year certain" term would affect the amount taxed compared to not having the certainty period. Once past the life expectancy, it is all taxable. Taxable amounts are always "ordinary income". If their income is at a certain level and/or IRA distributions kick in, it could trigger, more social security being taxed, IRMAA, etc.
bsteiner
Posts: 5117
Joined: Sat Oct 20, 2012 9:39 pm
Location: NYC/NJ/FL

Re: Annuity+Interest only mortgage in Retirement

Post by bsteiner »

At the end, the annuity payments will come to an end, but you'll still owe $400,000 on the mortgage.
Topic Author
ScubaHogg
Posts: 712
Joined: Sun Nov 06, 2011 3:02 pm

Re: Annuity+Interest only mortgage in Retirement

Post by ScubaHogg »

bsteiner wrote: Thu Aug 27, 2020 3:44 pm At the end, the annuity payments will come to an end, but you'll still owe $400,000 on the mortgage.
Assuming the couple is alive, why would the annuity payments come to an end? They are LIFE with 10 years CERTAIN. The mortgage would come do. Assuming you couldn't roll it (don't know why), you would have a few things going for you:

- You are still receiving the annuity
- 30 years prior you still had $100,000 in equity. Given even modest inflation the home value should be more than enough to pay off the mortgage with room to spare
- You could take my second example I gave to David Jay. Buy an annuity for $287,000 that pays off the yearly interest (assuming no tax, like through a ROTH I suppose), and invest the remaining $113,000. Assuming you stay in the house (I assumed 20 years), in almost all historical cases you'll end up with more money than you would have with just paid off the mortgage. Now you have the annuity AND more money.
Last edited by ScubaHogg on Thu Aug 27, 2020 3:57 pm, edited 1 time in total.
“Unexpected Returns dominate the Expected Returns” - Ken French
Topic Author
ScubaHogg
Posts: 712
Joined: Sun Nov 06, 2011 3:02 pm

Re: Annuity+Interest only mortgage in Retirement

Post by ScubaHogg »

not4me wrote: Thu Aug 27, 2020 3:41 pm I think most interest only have a shorter time period when interest only & there is a pre-payment penalty (which I guess the estate would have to pay if they die in less than 30 years). Don't know how you grabbed that rate, but does it assume only the best credit score? Several things unclear to me about the mechanics since I'm not familiar with these.

Taxable amounts are always "ordinary income".
- As I mentioned in the original post, a previous forum member (Hedgefundie) stated that these 30-year fixed IO loans were available. I just went with him at his word, as it appears you have to call around to find them and I didn't want to do that. For the interest rate, I've seen traditional 30-year mortgages being quoted at 2.5%, so I just added a full point to those. I literally have zero idea if that is reasonable or not, but it didn't seem exceptionally unreasonable

- As for taxes, what if you bought the annuity out of a ROTH?
“Unexpected Returns dominate the Expected Returns” - Ken French
User avatar
Nate79
Posts: 6411
Joined: Thu Aug 11, 2016 6:24 pm
Location: Delaware

Re: Annuity+Interest only mortgage in Retirement

Post by Nate79 »

I don't understand interest only mortgages - essentially you are just a renter. So why not just rent? Sure you can hope and pray that the house value increases in the 30 years but that is certainly not guaranteed.
surfstar
Posts: 2241
Joined: Fri Sep 13, 2013 12:17 pm
Location: Santa Barbara, CA

Re: Annuity+Interest only mortgage in Retirement

Post by surfstar »

I second that you should compare this vs a reverse mortgage.
surfstar
Posts: 2241
Joined: Fri Sep 13, 2013 12:17 pm
Location: Santa Barbara, CA

Re: Annuity+Interest only mortgage in Retirement

Post by surfstar »

Nate79 wrote: Thu Aug 27, 2020 3:56 pm I don't understand interest only mortgages - essentially you are just a renter. So why not just rent? Sure you can hope and pray that the house value increases in the 30 years but that is certainly not guaranteed.
Rents go up. Landlords/Management changes, sometimes you get kicked out, etc. While owning requires maintenance, you also get to choose whether to upgrade, paint, etc. Renting and owning each have their advantages.
Topic Author
ScubaHogg
Posts: 712
Joined: Sun Nov 06, 2011 3:02 pm

Re: Annuity+Interest only mortgage in Retirement

Post by ScubaHogg »

Nate79 wrote: Thu Aug 27, 2020 3:56 pm I don't understand interest only mortgages - essentially you are just a renter. So why not just rent? Sure you can hope and pray that the house value increases in the 30 years but that is certainly not guaranteed.
Cause you would still have all the advantages of owning and avoid the disadvantages of renting. To quote Hedgefundie from a different thread:
HEDGEFUNDIE wrote: Sat Feb 22, 2020 6:56 pm Renting has the following drawbacks:

1. The rent can go up
2. Your lease could be terminated by the owner
3. You can’t do much to the property to improve quality of life

An interest-only loan can have a fixed rate for up to 30 years, during which time you have certainty of expenses. You also participate in any home value appreciation (but of course this is a risk as well).
The biggest one is with an IO mortgage your housing "payments" are fixed in stone for 30-years (yes yes, maintenance and all that, but that still holds true if the mortgage is paid off). With rent it will almost certainly go up.

And to be clear, you don't need the home value to go up. Given the second option I outlined above, you could buy a $14,000/year annuity for ~$287K and invest the remaining $113K. Historically, after 20+ years you would have had more money AND the annuity in almost every case.
“Unexpected Returns dominate the Expected Returns” - Ken French
User avatar
#Cruncher
Posts: 3051
Joined: Fri May 14, 2010 2:33 am
Location: New York City
Contact:

Re: Annuity+Interest only mortgage in Retirement

Post by #Cruncher »

ScubaHogg wrote: Thu Aug 27, 2020 1:15 pmIf the couple could actually get a mortgage as described above they would have successfully paired a nominal liability with a nominal income stream.
The two cash flows are not paired. If you assume the mortgage isn't "rolled over" after 30 years then,
bsteiner wrote: Thu Aug 27, 2020 3:44 pmAt the end, the annuity payments will come to an end, but you'll still owe $400,000 on the mortgage.
If you assume the mortgage is rolled over at the same interest rate, they are still not paired. The annuity is an income stream that continues for a joint lifespan, but the interest only mortgage is a cash outflow that continues forever. And "forever" is longer than any lifespan.

The proper comparison is between the interest rate of the mortgage and the return (not the payout) of the annuity. Given your example of $400,000 buying $19,524 per year and assuming a 30-year joint lifespan, this would be 2.7%.
2.7% = 12 * RATE(30 * 12, 19524 / 12, -400000, 0, 0) using the Excel RATE function
not4me wrote: Thu Aug 27, 2020 3:41 pm... I believe the taxation of the annuity is based on life expectancy, terms of annuity, etc. ... Once past the life expectancy, it is all taxable.
Yes, the taxation of a commercial annuity is based on life expectancy, but it isn't tax free until that time and fully taxable afterward. Rather a portion of the annuity is tax free every year. This is the "General Rule" as explained in IRS Publication 939:
... the tax-free part of each annuity payment based on the ratio of your investment in the contract to the total expected return.
where "expected return", as stated here in Pub 939, is
Joint and survivor annuities. If you have an annuity that pays you a periodic income for life and after your death provides an identical lifetime periodic income to your spouse (or some other person), you figure the expected return based on your combined life expectancies.
A 10-year period certain feature would increase the expected return, but I doubt by much.
User avatar
Uncorrelated
Posts: 1021
Joined: Sun Oct 13, 2019 3:16 pm

Re: Annuity+Interest only mortgage in Retirement

Post by Uncorrelated »

Interest only mortgages are a bad deal, unless:

There are considerable tax advantages, as is the case in my country.
you have liquidity issues.

If those don't apply do you, you are better off leveraging stocks using options of futures. An interest only mortgage is just an expensive form of leverage after all. I'm not sure how this works with annuities specifically, but holding both bonds-like products and a mortgage is generally considered to be a very stupid idea unless the above criteria apply.
not4me
Posts: 893
Joined: Thu May 25, 2017 3:08 pm

Re: Annuity+Interest only mortgage in Retirement

Post by not4me »

#Cruncher wrote: Fri Aug 28, 2020 6:59 am
not4me wrote: Thu Aug 27, 2020 3:41 pm... I believe the taxation of the annuity is based on life expectancy, terms of annuity, etc. ... Once past the life expectancy, it is all taxable.
Yes, the taxation of a commercial annuity is based on life expectancy, but it isn't tax free until that time and fully taxable afterward. Rather a portion of the annuity is tax free every year. This is the "General Rule" as explained in IRS Publication 939:
... the tax-free part of each annuity payment based on the ratio of your investment in the contract to the total expected return.
where "expected return", as stated here in Pub 939, is
Joint and survivor annuities. If you have an annuity that pays you a periodic income for life and after your death provides an identical lifetime periodic income to your spouse (or some other person), you figure the expected return based on your combined life expectancies.
I hadn't seen the need to be very specific in my previous post & didn't mean to imply that it was tax free before reaching life expectancy. I just mentioned there were variables "that would affect the amount taxed" -- didn't realize some would think that meant NONE was taxed. As for after expectancy (or if joint, expectancies) passes, it may not be precise at that time, but I still believe that every year won't have a portion tax-free. Same IRS pub you cited also says: "However, if your annuity starting date is after 1986, the total amount of annuity income that is tax free over the years can't exceed your net cost."

Weeds getting too deep for me & unsure it matters in this specific; just trying to clarify for future readers...
User avatar
#Cruncher
Posts: 3051
Joined: Fri May 14, 2010 2:33 am
Location: New York City
Contact:

Re: Annuity+Interest only mortgage in Retirement

Post by #Cruncher »

not4me wrote: Fri Aug 28, 2020 7:47 amI ... in my previous post ... didn't mean to imply that [the annuity] was tax free before reaching life expectancy.
I was wrong to read your post that way.
not4me in same post wrote:As for after expectancy ... I still believe that every year won't have a portion tax-free. Same IRS pub you cited also says [here]: "However, if your annuity starting date is after 1986, the total amount of annuity income that is tax free over the years can't exceed your net cost."
Thanks for pointing this out, not4me; I wasn't aware of it. The net result is that after the IRS designated life expectancy, all of the annuity will be taxable -- as you say. Using the example in the original post:
  • The joint life expectancy of a man / woman couple both age 65 according to Table II in publication 939 is 22.0 years.
  • The initial tax free portion each year would therefore be 0.931 [400000 / (19524 * 22.0)] of $19.524 or $18,177.
  • Over the first 22 years the tax free portion would (ignoring rounding) equal the $400,000 cost (18177 * 22).
  • Therefore after 22 years none of the annuity would be tax free.
Topic Author
ScubaHogg
Posts: 712
Joined: Sun Nov 06, 2011 3:02 pm

Re: Annuity+Interest only mortgage in Retirement

Post by ScubaHogg »

#Cruncher wrote: Fri Aug 28, 2020 6:59 am The annuity is an income stream that continues for a joint lifespan, but the interest only mortgage is a cash outflow that continues forever. And "forever" is longer than any lifespan.
Yeah, but the question is, do you care? After your joint lifetime ends, what difference does it make to you if the mortgage still has to be serviced?
Last edited by ScubaHogg on Fri Aug 28, 2020 2:13 pm, edited 1 time in total.
“Unexpected Returns dominate the Expected Returns” - Ken French
Topic Author
ScubaHogg
Posts: 712
Joined: Sun Nov 06, 2011 3:02 pm

Re: Annuity+Interest only mortgage in Retirement

Post by ScubaHogg »

Uncorrelated wrote: Fri Aug 28, 2020 7:14 am Interest only mortgages are a bad deal, unless:

There are considerable tax advantages, as is the case in my country.
you have liquidity issues.

If those don't apply do you, you are better off leveraging stocks using options of futures. An interest only mortgage is just an expensive form of leverage after all. I'm not sure how this works with annuities specifically, but holding both bonds-like products and a mortgage is generally considered to be a very stupid idea unless the above criteria apply.
What liquidity issues would you have? Especially taking the second example I gave way above where you annuitize just enough to make the $14k/year interest payments, a couple could put the remainder (~$113k) back into equities. This would almost certainly increase, not decrease, their liquidity. All while still but guaranteeing they can make house payments.*

The rate might be relatively expensive, but it is locked for decades and basically no more work is required. As for options and futures, not a lot of folks are capable of doing that in their prime, much less in their 80s. If it appealed to them, a very average couple (in terms of financial sophistication) could follow this plan.

*those numbers assumed that annuity payments weren’t taxed at all. I assume that would be the case if you used ROTH funds, but I don’t know. I also don’t know how wise it would be to use ROTH funds like this, but I’m just exploring the options.
“Unexpected Returns dominate the Expected Returns” - Ken French
User avatar
Uncorrelated
Posts: 1021
Joined: Sun Oct 13, 2019 3:16 pm

Re: Annuity+Interest only mortgage in Retirement

Post by Uncorrelated »

ScubaHogg wrote: Fri Aug 28, 2020 2:13 pm
Uncorrelated wrote: Fri Aug 28, 2020 7:14 am Interest only mortgages are a bad deal, unless:

There are considerable tax advantages, as is the case in my country.
you have liquidity issues.

If those don't apply do you, you are better off leveraging stocks using options of futures. An interest only mortgage is just an expensive form of leverage after all. I'm not sure how this works with annuities specifically, but holding both bonds-like products and a mortgage is generally considered to be a very stupid idea unless the above criteria apply.
What liquidity issues would you have?
If you don't have any liquidity issues, it is fairly obvious that paying off the mortgage results in higher expected utility. A mortgage is used when you need leverage and other cheaper instruments (futures, options) aren't available. Or if you need money for food and all your net worth is locked inside your house. The latter seems to be the case in your example.

Obviously this liquidity is expensive. The insurance company takes a cut of the annuity, and the mortgage broker takes a cut of the interest rate. If I did my math right (say 0.5% annually for a very cheap annuity, 2.2% above the risk-free rate for a very cheap 30y mortgage in my area) that accounts to approximately 2.7% expenses annually. That sounds terrible... But I suppose if you're in a tight spot, and have no bequest motives, it does help to free some liquidity.

It appears as if annuitizing in parts results in higher expected utility. The annuity payout becomes higher and higher as you get older. You could say the optimal strategy is to annuitize "just in time". This may increase the risk because the mortgage company might be unwilling to refinance the property multiple times over.



You mentioned earlier that you can put the remainder in equities. At an expected (excess) return of 5% for the stock market and guaranteed return of 2.7% for paying off the mortgage, it's probably a better idea to pay off the mortgage instead or use that money to delay annuitization. I say probably because the math is quite complicated. Some sources suggest that between age 72 and 81 all stocks should be exchanges for annuities (link to paper). Owning an expensive mortgage probably means annuitization should be done sooner, but I'm not sure.
Post Reply