A Menu of Options to Create More Liquidity
Let’s face it, life inevitably throws some curve balls our way from time to time. Sometimes it feels like they come in multiples. Building options into your financial plan for these sometimes-unforeseen curve balls can often be the difference between making decisions on our own terms versus doing things because we ‘have to’. The goal is to have choices in order to optimize our decision outcomes. Having a lack of options can lead to degraded outcomes, hence ultimately facing more unattractive decisions for moving forward. With this in mind, we would like to share some options that we position in our planning process and during problem-solving consultations.
One of the most traditional ways to create options for yourself is to accrue an emergency fund. A common rule of thumb in financial planning is to have 6 months of living expenses (give or take depending on circumstances) set aside in savings or invested in safe and more liquid investments.
Home Equity Line of Credit
A common substitute for an emergency fund for a homeowner that has equity in their home is a home equity line of credit (AKA: a HELOC or a second mortgage). HELOC’s can often vary in how they are structured. One variation is that some lenders will set this up free of cost or for minimal fees. These loans are typically tied to a short-term interest rate that can fluctuate, with a partial fixed percentage. However, there are some that can vary in terms of fixed or fluctuating rates at certain denominations. It is important to know the variables. Once the credit line is set up, interest is only charged if funds are borrowed. It is common to have a ten-year window of time to borrow funds from the credit line with a set date in the future where a balloon or final payment of the loan is due.
In the same way that a bank can lend you money if you have equity in your house, a brokerage firm can lend you money against the value of your investments in certain stocks, bonds and mutual funds. That borrowed money is called a margin loan, and it can be used to meet short-term lending needs that are not related to investing (or to purchase additional securities). Note, retirement accounts and custodial accounts are not eligible accounts. Margin interest rates are typically lower than credit cards and unsecured personal loans. Unlike the HELOC, there is no set repayment schedule with a margin loan— monthly interest charges accrue to your account, and you can repay the principal at your convenience. Investment dividends and interest paying into the account will automatically be applied to the loan balance, drawing down your loan balance. Another benefit is the margin interest may be tax deductible if you use the margin to purchase taxable investments and you itemize your deductions (subject to certain limitations, consult a tax professional about your individual situation). The amount that can be borrowed will vary by custodian as will the interest rate. In addition, there are minimum equity requirements based on the market value of the investments held.
Mortgage or ‘Cash-Out’ Refinancing
We understand that it is very attractive to enter retirement and be mortgage-free. This is a great goal, but remember the saying, “…there’s good debt and bad debt.” Maintaining the appropriate amount of liquidity for meeting retirement goals can vary greatly depending on various aspects such as one’s balance sheet, expenses, and time frames. For example, if someone is so focused on paying off their mortgage but they don’t have sufficient liquidity to address living expenses or the costs to maintain their home, they may face challenges of accessing the equity they have built up in the value of their home. It’s like seeing money on your balance sheet that’s locked away from direct access.
With interest rates at historic lows, having a mortgage to balance liquidity can be considered “good debt” because it allows the homeowner to have options (or a cushion) in managing living expenses or other objectives. If money is ‘cheap’ to borrow and creates choices, even if for a window of time, it may merit some consideration. Furthermore, there may be opportunities to reduce “bad debt” such as credit cards or other higher rate loans by refinancing a mortgage and taking cash out (expanding the mortgage amount). The goal here would be to pay down or pay off higher rate loans, potentially streamlining the number of loans at lower interest rates, improving the ability make progress paying down debt at lower rates.
A reverse mortgage converts equity in your home into cash. You can receive a large sum all at once, establish a line of credit to draw on as you please, or get paid in monthly installments. If you wish, you can pay it back the same as you would any loan. And if you’ve chosen monthly disbursements, you could continue to collect those for the rest of your life (as long as you’re in your home). We have found that, in general, this option is more popular for an older population who values remaining in their home as long as possible and seeking additional income or capital.
Early Roth IRA Distributions
Retirement accounts aren’t always known for their flexibility, which is why the Roth IRA stands out for its relaxed early withdrawal rules: because these accounts are funded with after-tax dollars, you’re free to pull out contributions at any time (but future tax free growth will be sacrificed, which is important to consider). After-tax contributions (commonly called “basis”) can be withdrawn at any time, for any reason, with no taxes or withdrawal penalties.
Cash Value Life Insurance
Permanent life insurance (also known as whole life or universal life) has a cash value account associated with it that can be accessed for loans or withdrawals, if needed. When you pay your premium, part of it goes to pay the policy’s expenses, and part goes into a cash value account and gets credited with interest or dividends. Types of permanent insurance policies differ and the ways that they credit interest and charge interest on loans also differs. One big advantage is that the cash value account may be distributed for loans or withdrawals on a tax-free basis, if structured properly. You have the choice of paying the loan back, or having the interest capitalized within the policy. You do have to be mindful that taking too much out of the policy may affect the policy performance in the future and may eventually cause the policy to lapse if not planned properly. Nonetheless, life insurance can be a good option if you need to get cash in an emergency (although there is usually a little longer of a processing time, because it’s inside the insurance policy). Many people also use the cash value inside permanent life insurance to plan for cash needs in the future, such as college expenses, retirement income, or other needs.
Reducing Discretionary Expenses
Although one of the most basic options, it can be empowering to determine what expenses can be minimized temporarily or permanently. These are typically very personal choices that we prefer clients to explore if appropriate.
You will realize that when it comes to financial planning, there’s often not a ‘one-size-fits-all’ appropriate solution. It is often an art of determining what seems most suitable or realistic for each individual or family. Finding customized solutions is what we pride ourselves in at Wambolt & Associates. If any of these options interest you, please contact us for a personalized discussion around how we may be able to help you create more liquidity.
Written by Kelly Fraser on behalf of Wambolt & Associates