Equity harvesting has been around for many years but only recently has come into the mainstream. The concept is simple: Borrow money and invest the funds in something tax-favorable.
My question to you is: Would you advise clients to borrow money if they could (1) get an interest rate of less than 7%; (2) write off the interest on the loan; and (3) leverage a vehicle–life insurance–in which the funds can grow tax-free and permit tax-free withdrawals at retirement?
Of course you would! From a financial standpoint, equity harvesting is a no-brainer. Where do you find a lender who will lend clients money to invest and what asset(s) are used as collateral? If the client owns a home, then you know the answer.
Mechanics Of The Plan
For brevity’s sake, we will discuss our favorite equity harvesting solution, a 1% cash flow arm mortgage program on the personal residence. The program is for clients who want to minimize monthly home mortgage payments while investing the saved money for future retirement savings. The technique is not for homeowners who aim to pay off their home mortgage in the standard 15 to 30 years.
The point of the program is to minimize current costs, which frees money for investing. The program has a 1% starting rate that stays low for five years. The payments (not the interest rate) of the arm increase at the rate of 7.5% a year.
At the end of the fifth year, or any time after the third year without penalty, the client can refinance the loan back into a 1% program. The client also can keep the going interest rate on the loan or refinance with any other loan program.
The numbers speak for themselves. Consider a client (male, age 42) who has a $400,000 mortgage on a home with a fair market value (FMV) of $500,000. Chart A shows what happens to the client’s home mortgage payments with a 1% cash flow starting rate vs. a 6% 30-year conventional loan. The amortization with the 1% arm is 40 years.
Remember, the client wants to reduce the mortgage payments to as low as possible so the saved money can be invested. With the 1% arm, the client frees up $73,395 of cash flow over the five-year window.
If the client invests the money saved from lowering the mortgage and has a return of 8%, the investment will yield $93,993 at the end of the fifth year (see Chart B). In the example, we assume the investment vehicle is an indexed annuity, which allows the money to grow tax-deferred.
Starting at age 63, the client can withdraw from the indexed annuity $28,000 each year for 20 years. (The growth above basis would be income taxed, thereby netting $18,450 a year after tax.)
If the client takes the money saved from the first five years and invests it into an equity-indexed life insurance policy earning 7.9% a year, the client can take out $22,000 per year income tax-free from ages 63 to 82. And the client has a sizable death benefit while the policy is in force.
Remember, the numbers above are only from the savings on payments from the first five years. Also note the client is writing off the interest on the loan.