Four reasons to consider a reverse mortgage when you retire
Are you wondering how you’re going to come up with enough money to retire, especially considering the potential for major spending shocks such as nursing-home care?
If you’re a homeowner, taking a line of credit via a reverse mortgage just might be the answer, according to a new book by retirement-income researcher Wade Pfau.
In “The Retirement Researcher’s Guide to Reverse Mortgages,” Pfau offers a detailed analysis of the pros and cons of using these products as part of a comprehensive plan for generating income in retirement. (His book and this article focus on the reverse-mortgage program managed by the Housing and Urban Development Department; the loans are known as Home Equity Conversion Mortgages, or HECMs.)
Before delving into four reasons a reverse mortgage might be appealing now, here are a few things to keep in mind: With a HECM, the total amount you can borrow will depend on your home’s appraised value (calculated on the value up to $625,000 but no higher), the youngest borrower’s age (one borrower must be 62 years old but a spouse may be younger), the lender’s margin (a fixed rate) and prevailing interest rates.
You’ll have to pay an origination fee, an initial mortgage insurance premium and closing costs—some lenders offer deals on these costs. Then there is the ongoing variable interest rate that accrues on the loan balance, plus the lender’s margin rate (the main source of revenue for the lender) and the ongoing mortgage insurance premium—these two rates are fixed, and set at the beginning of the loan. (Pfau offers excellent detail on this in his book.)
You don’t have to make loan payments during the course of the loan, but you must be able to pay ongoing property taxes, homeowners insurance and maintenance costs. You will never owe more on the loan than the house is worth. When the youngest borrower (or “nonborrower”—more on this later) dies, then the heirs can pay back the loan by selling the house, taking out a standard mortgage to pay off the reverse mortgage, or by using other assets, if available, to pay off the loan. They can also essentially hand over the house to the lender.
Still interested? Here are four reasons, gleaned from Pfau’s book, why reverse mortgages can be a valuable tool for retirees:
1.A reverse mortgage can help you avoid “sequence of returns” risk. That is the risk that you have the bad timing of retiring—and pulling money out of your investment account—just as the stock market tanks. An investment account that’s depleted both by withdrawals and market losses may never recover, making it likelier that a retiree outlives her assets. Reverse mortgages offer “an alternative source of spending after market declines,” Pfau writes.
2.Interest rates are low. The lower interest rates are, the higher the percentage of equity you can pull from your home. “The current low-interest-rate environment provides an advantage when opening a reverse mortgage as the PLF is higher than in the past,” Pfau writes, referring to the “principal limit factor,” which is the percentage of your home’s value you can borrow when you first take out the loan (it also determines how the principal limit grows over time). The PLF calculation is complex, but both the age of the youngest borrower (or “nonborrower” if one spouse is under age 62) and interest rates come into play. The older the borrower and the lower the interest rate, the higher the percentage of home value you can borrow. However, “interest rates are much more important than age” in that calculation, Pfau writes. For example, he says, if the youngest eligible nonborrower is 58 years old and the expected rate is 5%, the PLF is 50%. But if the rate rises to 6.5%, then the PLF doesn’t reach 50% until that youngest borrower is 81.
3.With a reverse mortgage, the amount you can borrow grows over time (you’ll never owe more than the home is worth). “The ability to have an unused line of credit grow is a valuable consideration for opening a reverse mortgage sooner rather than later,” Pfau writes. “It is also a detail that creates a good deal of confusion…perhaps because it seems this feature is almost too good to be true,” he says. Here’s a simplified example, as per Pfau’s book: Say you and your neighbor Fred each take out reverse mortgages with principal limits of $100,000, and both limits are slated, as per the required calculation, to grow to $200,000 over 10 years. Fred takes out the full $100,000 right away, but you don’t tap any of the money available to you. After 10 years, Fred owes $200,000—that balance reflects the payment he received plus interest payments and insurance premiums. Meanwhile, your $200,000 principal limit at the end of the 10 years is the value of the line of credit available to you. These different results occur because the principal limit is calculated with the implicit assumption that interest and insurance payments will be accruing, but if you don’t tap the money, they don’t accrue. “Line of credit growth may be viewed a bit like an unintended loophole that is strengthened by our low interest rate environment,” Pfau writes. That loophole may not last, he suggests.
4.New rules protect younger spouses. The reverse-mortgage rules have always required that borrowers be 62 years old or older. In the past, if a married couple wanted to take out a reverse mortgage and one of the spouses was too young, the younger spouse often would be removed from the house title, putting that spouse—the “nonborrowing spouse”—in the position of potentially having to sell the house to pay the loan if the older spouse died first. Thanks to the new rule change, the loan balance doesn’t have to be repaid until after the nonborrowing spouse leaves the home—even if the borrowing spouse has left or died (as long as certain requirements are met, such as having been the spouse when the loan closed). The nonborrower can stay in the house, but can no longer receive payments from the reverse mortgage. (Also, Pfau notes a glaring and problematic caveat: the loan may become due if the main borrower ends up in a nursing home or other institution for at least a year.) Keep in mind, too, that the maximum amount you can borrow will be based in part on the youngest spouse’s age—the younger that spouse, the smaller the portion of home equity you can borrow. That’s because the government is trying to reduce the likelihood that the final loan balance vastly exceeds the home value (even though the nonborrowing spouse can’t receive payments after the borrower dies or leaves, interest and mortgage premiums continue to accrue on the outstanding loan balance). The mortgage insurance premiums pay into a fund that protects lenders and borrowers from this situation of an outsize loan balance, but “the program would be unsustainable if this happened frequently,” Pfau writes.
Of course, there are reasons why a reverse mortgage may not be right for you. All financial advice is specific to your own situation. Do your research.
Keep in mind that the program may change in the future. One important consumer safeguard is that these are nonrecourse loans: you can never owe more than the home is worth. The mortgage insurance premiums that all reverse-mortgage borrowers pay help cover lenders’ losses in the event the house is worth less than what was owed. Pfau notes that he is concerned “about whether the mortgage insurance premiums collected by the government will be sufficient to cover the nonrecourse aspects of the reverse mortgage, especially if some of the strategies I discuss grow in popularity.”