New Reverse Mortgage Rules Open Door To A More Secure Retirement
Original Article by Jamie Hopkins published in Forbes Personal Finance blog, on May 18th, 2015
Owning a home has always been part of the American Dream. Therefore it should be no surprise that home equity represents a large portion of the average retiree’s net worthaccording to the Consumer Financial Protection Bureau statistics. Now, as many Americans near retirement, properly leveraging that home equity will become a crucial part of a secure retirement plan. There are a variety of ways to tap into one’s home equity, such as downsizing, taking a traditional home equity loan, home sharing, entering into a sale leaseback arrangement, or entering into a reverse mortgage. However, each of these strategies is not suitable for every retiree. For instance, the history of reverse mortgages has taught us that they are not the right financial strategy for everyone. In April 2015, new rules have been implemented to help prevent previous miscues often associated with reverse mortgages. While it remains true that entering into a reverse mortgage is not a suitable financial decision for all retirees, for some, a reverse mortgage can be properly utilized to significantly improve retirement income security. This article will examine three different strategic uses of reverse mortgages within a retirement income plan and will illustrate how these strategies are for more than just the cash-poor, house-rich client.
Before taking a deeper dive into the possible strategic uses of a reverse mortgage, the nuts and bolts of such an arrangement are worth mentioning. A reverse mortgage enables homeowners, aged 62 and older, to get a loan and tap into their home equity without losing their home in the process. The amount of the loan is based on the value of the home, the homeowners’ ages, and the prevailing interest rates. There are three different types of payment options available for a reverse mortgage: a tenure option payment, in which you receive a monthly payment for as long as you live in your home; a lump sum, in which you get the amount of the loan upfront; and a standby line of credit, in which you can borrow from a line of credit as you choose. Additionally, the loan does not need to be repaid for as long as the homeowner continues to live in the home. Furthermore, the loan is non-recourse, meaning that the bank entering into the reverse mortgage only gets the value of the loan and does not get a windfall if the home value exceeds the loan. The homeowner does not owe anything more than the value of the home in the event the loan value exceeds the value of the home.
In recent years there have been concerns about homeowners with reverse mortgages going into technical default, a condition that affects about 10% of reverse mortgages. This can occur when the homeowner is unable to pay their property taxes, their home insurance premiums, and other homeowner fees. The failure to pay property taxes could cause the homeowner to lose his or her home, even if they had previously entered into a reverse mortgage. In order to reduce the number of reverse mortgage homeowners going into technical default and getting behind in property taxes, the government has added further consumer protection measures in the form of a financial assessment screening test to help determine whether potential borrowers can afford to enter into a reverse mortgage. The new rules apply to the Home Equity Conversion Mortgage (“HECM”) program, which is the primary reverse mortgage program representing approximately 95% of the market. The new rules will require potential borrowers to demonstrate their ability to pay property taxes, fees, and insurance premiums based on their income and available credit. The new rules will disqualify a tremendous number of people who would have been able to qualify for a reverse mortgage just a few months ago.
If you can qualify for a reverse mortgage, the next question becomes when, if ever, should you enter into one? In the past many reverse mortgages were used for the wrong people at the wrong time and outside the context of a comprehensive plan. Home equity has often been used as a line of last resort against unexpected future expenses or when an individual has run out of money. However, there are a variety of strategic uses for reverse mortgages that might prove to be more beneficial to the homeowner, especially when it comes to retirement income planning.
First, a standby reverse mortgage line of credit can be used to mitigate market risk and other retirement income planning risks. Don Graves, President of the HECM Advisors Group calls it the “Swiss Army Knife of Retirement Income Planning.” Instead of using a reverse mortgage towards the end of one’s retirement when assets might be dwindling, strategic use of a reverse mortgage closer to the front end of one’s retirement could be even more beneficial. For example, one of the biggest risks that retirees face in retirement is sequence of returns risk, especially during the first few years of retirement. A reverse mortgage line of credit can be used in variety of ways, and Graves offers just two of the possible examples. In the first example, the reverse mortgage line of credit could be used in its entirety during the first few years of retirement. This method would enable the retiree to avoid taking substantial withdrawals from an investment portfolio in the early years, thus allowing it to continue to grow. It would also safeguard against taking needed withdrawals from the growth portion of their investments during periods when the market is in a decline. In the second example mentioned by Graves, the reverse mortgage line of credit could be used in a coordinated fashion with the returns of your portfolio, namely living off of the income from the standby line of credit only in the years following a negative return on your investments. The second strategy would only tap into home equity if you experienced negative or low returns in the first few years of retirement. Either way, the retiree could significantly improve the longevity of their investment assets by reducing the risk of sequence of returns risk to a portfolio. Furthermore, when the market rebounds, the retiree could use the excess income in those years to repay the reverse mortgage and preserve the value of their home.
The second strategic use of reverse mortgages can be to postpone claiming Social Security benefits, or to defer one’s employer sponsored pension plan. This strategy (depending on the value of your home) actually uses up a large portion of your equity early on in retirement, instead of relying upon it later in retirement. Let’s take a look at how you might be able to utilize your home equity to defer Social Security benefits. Joe is a single individual aged 62 with a $200,000 home with no remaining mortgage. Joe expects to receive roughly $1,000 a month from Social Security if he collects at age 62. However, Joe wants to consider pushing off benefits to age 70. Joe could enter into a reverse mortgage which would enable him to get access to roughly $97,000 of his home equity. In order to generate a line of credit withdrawal to make monthly $1,000 payments for the next 8 years to replace his Social Security income while in deferral, Joe would need to use up about $75,000 of his home equity. This means his line of credit would still have roughly $22,000 remaining for other uses, and his home would still have over half of its equity left at the start of the loan. This would enable Joe to defer his Social Security income to age 70 and receive roughly 78% higher benefits (roughly $1,780 a month), based on an average increase of 7% to 8% per year. Additionally, this higher benefit would also be subject to cost of living increases to help protect against inflation. Joe would also still have roughly $137,000 of home equity left over at age 70, assuming 4% annual appreciation in the value of his home. This strategy could also be employed for anyone who wants to defer taking withdrawals from their 401(k), IRA, or pension plan.
The third strategic use of a reverse mortgage can be to exchange debt for income by replacing a traditional mortgage payment with a reverse mortgage. More and more retirees enter into retirement with an outstanding mortgage. This creates a cash outflow event for the retiree, requiring the retiree to generate more income and take larger withdrawals from his or her investments in order to pay the mortgage each month. Instead, some retirees are now taking a reverse mortgage to pay off their traditional mortgage, and at the same time creating a line of credit or generating additional income. The biggest benefit of this strategy is the reduction of one’s cash outflow in retirement. Research by Michael Kitces shows that this strategy can significantly extend the longevity of an investment portfolio by reducing the amount of distributions taken in the early years of retirement.
Using a reverse mortgage is no longer just for the cash poor and house rich. Instead, reverse mortgages can be used strategically as one part of a retirement income plan designed to build a buffer against sequence of returns risk early in retirement, help defer Social Security benefits or reduce cash outflow from traditional mortgage payments. Reverse mortgages can be used properly, but there are risks associated with using them, as there are with any other financial or investment strategies. As such, you need a comprehensive understanding of the risks and costs associated with a reverse mortgage before you decide to enter into one. This means that any reverse mortgage decision should only be made after doing your due diligence, consulting an expert, finding a reputable lender, and incorporating the decision into your overall retirement plan.