Wise Reverse Mortgages Can Be the Saving Grace of
Unprepared Retirees
If, after considering other
housing options, you have decided to remain in an eligible home or to move into
a new home, you may want to consider a Home Equity Conversion Mortgage (HECM) –
more commonly known as a reverse mortgage – as a source of retirement income.
The vast majority of reverse mortgages in the United States are
HECM reverse mortgages, which are regulated and insured through the federal
government by the Department of Housing and Urban Development (HUD) and the
Federal Housing Authority (FHA). Other options outside of the federal program
pop up occasionally, like jumbo reverse mortgages that exceed federal limits.
The HECM program includes both fixed rate and variable rate loans,
though fixed rate loans are uncommon and require the entire allowed credit to
be taken as an initial lump-sum amount. We will not concern ourselves with
fixed rate loans, only variable rate.
Any discussion of reverse mortgages as a retirement income tool
has typically focused on real or perceived negatives related to traditionally
high costs and potentially inappropriate uses for these funds. These
conversations often include misguided ideas about the homeowner losing the
title to their home and hyperbole about the American Dream becoming the
American Nightmare.
Any acceptance of reverse mortgages in financial and retirement
planning was as a last resort after all other possibilities had failed. Reverse
mortgages continue to carry a negative connotation thanks to late-night
television commercials that leave many suspicious of their viability as a
retirement income tool.
However, developments of the past decade have made reverse
mortgages harder to dismiss outright. The federal government has been refining
regulations for its HECM program since 2013 in order to:
·
improve the sustainability of the underlying mortgage insurance
fund;
·
better protect eligible non-borrowing spouses,
·
ensure borrowers have sufficient financial resources to continue
paying their property taxes, homeowner’s insurance, and home maintenance expenses.
The thrust of these changes has been to ensure reverse mortgages
are used responsibly as part of an overall retirement income strategy, rather
than to simply fritter away assets.
On the academic side, several recent research articles have
demonstrated how responsible use of a reverse mortgage can enhance an overall
retirement income plan. Importantly, this research incorporates realistic costs
for reverse mortgages, both in relation to their initial upfront costs and the
ongoing growth of any outstanding loan balance. Any quantified benefits are
understood to exist after netting out the costs associated with reverse
mortgages.
In short, well-handled reverse mortgages have been suffering from
the bad press surrounding irresponsible reverse mortgages for too long. Reverse
mortgages give responsible retirees the option to create liquidity for an
otherwise illiquid asset, which in turn can potentially support a more
efficient retirement income strategy (more spending and/or more legacy). This
liquidity is created by allowing homeowners to borrow against the value of the
home with the flexibility to defer repayment until they have permanently left
the home.
With so much bias, it can be hard to view reverse mortgages
objectively without a clear understanding of how the benefits can exceed the
costs. To understand their role, it is worth stepping back to clarify the
retirement income problems we seek to solve.
Retirees must support a series of expenses – overall lifestyle
spending goals, unexpected contingencies, legacy goals – in order to enjoy a
successful retirement. Suppose retirees only have two assets – beyond Social
Security and any pensions – to meet their spending obligations: an investment
portfolio and home equity. The task is to link these assets to spending
obligations efficiently while also mitigating retirement risks like longevity,
market volatility, and spending surprises that can impact the plan.
The fundamental question is this: How can these two assets meet
spending goals while simultaneously preserving remaining assets to cover
contingencies and support a legacy? Spending from either asset today has
implications for future spending and legacy.
Spending a portion of financial assets today surrenders future
market gains (or losses). Spending home equity today reduces future spending
potential or legacy and increases the loan balance due on this spending.
When a household has an investment portfolio and home equity, the
“default” strategy tends to be to spend down investment assets first and
preserve home equity as long as possible, with the goal of supporting a legacy
through a debt-free home. A reverse mortgage is only used as an absolute last resort
option once the investment portfolio has been depleted and vital spending needs
are threatened.
The research of the last few years has generally found this
conventional wisdom constraining and counterproductive. Initiating the reverse
mortgage earlier and coordinating spending from home equity throughout
retirement can help meet spending goals while also providing a larger legacy.
That is the nature of retirement income efficiency: using assets in a way that
allows for more income and/or more legacy.
For heirs wishing to keep
the home, a larger legacy offers an extra bonus of additional financial assets
after the loan balance has been repaid. The home is not lost.
Legacy wealth is the combined value of any remaining financial
assets plus any remaining home equity after repaying the reverse mortgage.
Money is fungible and the specific ratio of financial assets and remaining home
equity is not important. In the final analysis, only the sum of these two
components matters.
While taking money from the reverse mortgage reduces the home
equity component, it does not necessarily reduce the overall net worth or
legacy value of assets. Wanting to specifically preserve the home may be a
psychological constraint which leads to a less efficient retirement. As Tom Davison described the matter, a reverse
mortgage allows a retiree to gift the value of the house, rather than the house
itself. Should the heir wish to keep the house, the value of the house they
have received as an inheritance can be redeployed for this purpose, as long as
net legacy is large enough to do so.
The Underlying Mechanisms of
Why Reverse Mortgages Can Help
Two factors give opening a reverse mortgage earlier in retirement
the potential to improve retirement efficiencies in spite of the loan costs.
First, coordinating draws from a reverse mortgage reduces strain on portfolio
withdrawals, which helps manage sequence of returns risk.
Investment volatility is amplified by sequence of returns risk and
can be more harmful to those who are withdrawing from, rather than contributing
to their portfolio – namely, retirees. Reverse mortgages provide a buffer asset
to sidestep this sequence risk by providing an alternative source of spending
after market declines.
The second potential benefit of opening the reverse mortgage
early, especially when interest rates are low, is that the principal limit
which can be borrowed from will continue to grow throughout retirement. Reverse
mortgages are non-recourse loans. Sufficiently long retirements carry a
reasonable possibility that the available credit may eventually exceed the
value of the home. In these cases, mortgage insurance premiums paid to the
government on the loan balance are used to make sure the lender does not
experience a loss.
In addition, the borrower and/or estate will not be on the
hook for repaying more than the value of the home when the loan becomes due.
This line of credit growth is one of the most important and confusing aspects
of reverse mortgages. I will return to this for a deeper explanation later.
As the government continues to strengthen the rules and
regulations for reverse mortgages and new research continues to pave the way
with an agnostic view for their role, reverse mortgages may become much more
common in the coming years. Many Americans rely on home equity and Social
Security as the two primary available retirement assets.
As gerontologist and visiting professor at the American College,
Dr. Sandra Timmerman, said, “The transition to retirement is a wake-up call for
many middle income Baby Boomers who haven’t saved enough money to last a
lifetime and want to age in place. With their homes as a major untapped
financial resource, the smart use of reverse mortgages will be their saving
grace.”
