25 Aug Incorporating a Reverse Mortgage into a Financial Plan

Imagine a loan that is noncancelable, requires no monthly payments, and is non-recourse – meaning the borrower (or his or her estate or heirs) will never owe more than the loan balance or the value of his or her home, whichever is less. Sounds too good to be true, right? Yet, that’s a reverse mortgage – a loan that allows homeowners age 62 or over to borrow a portion of the equity in their personal residence. In the past, these types of loans were quite expensive, with closing costs in the tens of thousands of dollars, but recent rule changes by the Federal Housing Administration (FHA) have reduced borrowing costs while also lowering risks to homeowners. Nowadays, the reverse mortgage can become a valuable part of an overall financial plan and help secure retirement.

According to 2011 U.S. Census data, home equity makes up more than two-thirds of the total wealth for couples aged 65. Many retirees plan to remain in their homes for as long as they possibly can. A key risk facing these couples in retirement is longevity risk – outliving their retirement portfolios. Home equity is an option to mitigate this risk. There are a variety of ways to tap into home equity in retirement, such as selling the home and downsizing, using a traditional home equity line of credit (HELOC), or securing a reverse mortgage, among others. The reverse mortgage is attractive because of its key features; it’s noncancelable, nonrecourse, and offers flexible repayments.

REVERSE MORTGAGE BASICS:

The reverse mortgage allows the borrower to convert a portion of the equity in a home into cash. It was originally introduced in 1989 as an FHA insured loan for people age 62 or older. Currently, the Home Equity Conversion Mortgage (HECM) is the predominant reverse mortgage program in the United States and is heavily regulated by the U.S. Department of Housing and Urban Development (HUD) and the FHA.

To qualify for the FHA’s HECM, the homeowner must be 62 years of age or older, own a home outright (or have a low mortgage balance that can be paid off at closing with proceeds from the reverse mortgage), have the financial resources to pay ongoing property taxes and insurance, and must live in the home. Also, the borrower needs to attend a personal counseling session on home equity options from an FHA-approved counselor and receive a counseling certificate.

The borrower can choose to receive the loan proceeds in a variety of ways, such as a one-time single disbursement lump sum, term payments (over a specified term), or tenure payments (over the time the borrower remains in the home). However, the most flexible – and most interesting – is the line of credit option. The borrower establishes a line of credit that he or she can access as needed. Unlike a traditional home equity line of credit, the credit limit of a reverse mortgage increases each year. The longer the duration, the more cash becomes available. Loans can be drawn and repaid indefinitely provided the borrower remains in the home (remember, it’s noncancelable and repayments are optional), and any funds repaid can be borrowed again in the future. This makes the reverse mortgage an incredibly powerful tool. To learn more about the growth of the line of credit, see here.

USING A REVERSE MORTGAGE IN RETIREMENT:

So, how does the reverse mortgage fit into a financial plan? The following are ways a homeowner can use a HECM to help secure retirement:

Home renovations: Loan proceeds can be used to fund home renovations to allow retirees to age in place.

Pay existing long-term care insurance policies: More than one third of individuals with long-term care insurance at age 65 will lapse their policies. Home equity can be used to pay premiums and keep policies in force.

Delaying Social Security Benefits: For some retirees, delaying social security benefits – up to age 70 – is recommended to maximize social security benefits. Each year Social Security benefits are delayed, the benefits grow by about 8%. Using home equity as a bridge to delay benefits may make sense.

Roth Conversions: The loan proceeds are not taxable, which may allow a retiree to stay in a lower marginal tax bracket when converting their traditional IRAs or 401(k)s into Roth IRAs.

Contingency for Spending Shocks: Disbursements from a reverse mortgage can be used to cover unexpected health care expenses, long-term care expenses, and even divorce settlements.

Coordinate with Portfolio Withdraws: A newer approach to using the reverse mortgage is to coordinate with portfolio withdraws for retirement spending. Options include spending the home equity first to keep more invested in a retirement portfolio for longer in hopes of high returns in those early years. Or, a retiree could use tenure payments to reduce portfolio withdrawals in order to make the portfolio last longer.  Also, a retiree could coordinate the HECM draws on a line of credit to mitigate sequence of return risk.

ACADEMIC RESEARCH

Academic research has confirmed the value of a reverse mortgage in retirement. Sacks and Sacks (2012) first demonstrated that a strategy that coordinates the draws from a reverse mortgage line of credit with withdraws from an investment portfolio can increase the probability of success. Simultaneous research by Salter, Pfeiffer, and Evanesce (2012) confirmed the strategy, and coined the term “stand-by reverse mortgage” to refer to the line of credit option.

In 2016, Pfau analyzed six methods for incorporating home equity in a retirement income plan through a reverse mortgage. These six methods were 1) home equity as a last resort – the old conventional wisdom 2) use home equity first 3) the coordination strategy identified by Sachs and Sachs 4) a modified coordination strategy used by Salter, Pfeiffer, and Evanesce, 5) using a tenure payment plan and 6) use home equity last.

Pfau’s research suggests that strategies that spend the home equity more quickly (method 2) increase the overall risk of the retirement plan because more downside risk is created when home equity is used without the portfolio necessarily creating high market returns, but there is more upside potential because of the delay in taking distributions from investments. However, opening the reverse mortgage line of credit at the start of retirement and delaying its use until an investment portfolio has been depleted (method 6) creates the most downside protection for the retirement income plan because it allows the line of credit to grow longer, potentially surpassing the value of the home and providing a larger base to continue retirement spending after the portfolio has been depleted. Methods 3, 4, and 5 provide a middle ground between the upside potential of using home equity first and the downside protection of using home equity last.

CONCLUSION

Essentially, the reverse mortgage works because it becomes a buffer to mitigate sequence of return risk. It’s not going to work for homeowners who already have a large mortgage on their home, or retirees who will not spend the home equity wisely. Also, retirees who are not planning to stay in their home for the foreseeable future should not consider the reverse mortgage. But for those homeowners who wish to age in place, a reverse mortgage line of credit should at the very least be considered. The earlier the line of credit is established, the larger the available line of credit will grow, which may help secure retirement.

Originally posted 8/25/2017