(I use these little tidbits to rationalize my choice to take four years of Latin in high school instead of learning a language I might actually use.)
So, a mortgage is the eventual "killing" of an obligation to repay something, usually referring to a home loan. Some families work hard to pay off their mortgage before retiring. Some of them should now consider applying for a different kind, a "reverse" mortgage.
The typical American family's home equity constitutes the bulk of its retirement wealth. (Home equity is the amount of money you would have left if you sold your home and paid off all mortgages.)
The Motley Fool reported in 2015 that the median net worth for Americans aged 65-69 was about $194,226 and that roughly 77% of that wealth was tied up in home equity. Most families can't afford to ignore more than three-quarters of their wealth as a potential source of retirement funding.
Fortunately, there are ways to turn that illiquid equity into a spendable asset.
One way is to sell your home and pay off the mortgage and then reduce housing costs. This only works, of course, if you can find a significantly cheaper place to live. Reducing housing costs could be accomplished by downsizing (buying a less expensive home), renting a less expensive property, moving in with relatives, or relocating to a less expensive area. The remaining capital from the sale, minus the substantial transaction costs, can then be invested or used to purchase an annuity to generate retirement income.
Finance writers love to say that "you can’t spend pieces of your home to pay bills.” But, a second way to increase retirement cash flow and consumption from home equity, the oft-maligned reverse mortgage, enables you to spend little pieces of your home indirectly.
Borrowing a reverse mortgage isn't exactly like spending home equity directly because you will have to pay closing costs to obtain the loan and you will have to pay interest on the loan. And, of course, you or your estate will have to repay that loan.
Your choice among selling and downsizing, taking out a reverse mortgage, and leaving your home equity untouched will depend primarily on whether you:
- Intend to sell your home at some point and live somewhere else (it may be better to sell and downsize when you're ready),
- Want to keep your present home for the rest of your life but are not concerned about leaving an unencumbered home to your heirs (consider a reverse mortgage), or
- Want to live in your present home for the rest of your life and then leave it unencumbered by debt to your heirs (just leave the equity untouched).
Most reverse mortgages are offered through the Home Equity Conversion Mortgages (HECM) program administered by the Housing and Urban Development Department (HUD) and the Federal Housing Authority (FHA). A HECM reverse mortgage can be paid out in five different ways, according to HUD:
- Tenure- equal monthly payments as long as at least one borrower lives and continues to occupy the property as a principal residence. (Like a life annuity, but ends when the home is no longer occupied as opposed to annuitants no longer living.)
- Term- equal monthly payments for a fixed period of months.
- Line of Credit- unscheduled payments or in installments, at times and in an amount of your choosing until the line of credit is exhausted. (Useful as an emergency fund.)
- Modified Tenure- a combination of line of credit and Tenure.
- Modified Term- a combination of line of credit and Term.
There are several unique advantages to a HECM reverse mortgage.
The main benefit of a HECM reverse mortgage is that it enables the retiree to spend home equity without selling or otherwise giving up title to their home.
There are no prepayment penalties. The lender charges interest but it doesn’t have to be paid until the mortgage is due. Fees, interest payments and the balance on your old mortgage can all be financed with the new loan if you are granted a large enough loan. In fact, one of the benefits of a reverse mortgage for borrowers with a relatively small balance on their original mortgage is that they will no longer have to make mortgage payments. They can begin to receive a monthly check, instead.
HECM reverse mortgages are non-recourse loans. That means the borrower will not owe more than the property's value when sold or at death. Technically, it means that the lender's only recourse for settling the loan is the home itself. A lender cannot demand repayment from your other assets.
There are downsides.
The reverse mortgage must be repaid when both spouses die or sell the home, or when both spouses move out of the home for a year or more. If you decide to sell your home or are forced by a financial setback to downsize, your mortgage will become due and payable. The non-recourse feature means the outstanding debt can’t exceed the sale proceeds from the house, but if you set up the HECM to make tenure payments, those payments will stop and you may find them difficult to replace.
Retirement researcher, Wade Pfau, notes in Incorporating Home Equity Into a Retirement Income Strategy, that high costs can be an issue. It’s worthwhile for potential borrowers to shop around. Typical closing costs, according to a number of sources including AARP, run from $2,000 to $4,000, but most costs can be financed by the loan, in other words these costs, like interest payments, can be added to the loan balance and will not be due until the loan itself is due.
The borrower is responsible for paying property taxes, insuring the home and maintaining it. Failure (or inability in a financial crisis) to do so is grounds for the lender to call the loan. Of course, that's also true of a conventional mortgage.
Some misunderstand that the borrower loses title to the home when she takes a reverse mortgage. The lender does place a lien against the property ensuring the reverse mortgage will be repaid when the home is sold, but home ownership does not change.
I have read of family issues raised by children who expected to inherit a home only to find that their parents had spent the equity and the home needed to be sold to repay the reverse mortgage, or the heirs needed to take out a new mortgage. This is more a family issue than a financial one. Having this family discussion early on should set proper expectations.
Lastly, a potential downside of HECM reverse mortgages is the maximum loan amount, currently $625,500. Retirees with more home equity than that might free up more by selling and downsizing.
Recent research has changed some opinions on reverse mortgages.
Although reverse mortgage have gotten bad press over the years, Pfau and others have a better opinion of HECMs as a result of research beginning in 2012 and program changes in 2013. “I think it’s really important for advisors who may have done their due diligence about reverse mortgages 10 or 15 years ago to look at what all has changed starting in 2012 and to do their due diligence over,” Pfau recently stated at ThinkAdvisor.com.
Harold Evensky has said that the motivation for the reverse mortgage research at Texas Tech came about when home equity lines of credit (HELOC) kept getting canceled during the financial crisis in 2008. A HECM reverse mortgage, unlike a HELOC, is guaranteed to be available when you need it.
Bankrate.com provides a nice overview of how reverse mortgages work but a more detailed explanation can be found at Tom Davidson's Tools for Retirement Planning blog. Here's a simple example.
Let's say your home is valued at $700,000 and you owe $100,000 on your home's mortgage leaving you with $600,000 equity. You could borrow a $200,000 reverse mortgage and the lender would immediately pay off your $100,000 existing mortgage, leaving you $100,000 (less fees) to borrow. Your old mortgage payments go away.
You could annuitize the $100,000 with tenure payments, effectively replacing your monthly mortgage payments with a monthly check to spend for as long as you live in the home. You still own your home, though the lender will place a lien on the title. Your estate must repay the mortgage, but only the part that doesn’t exceed the home’s then-current market value. If the estate cannot cover the outstanding balance, your heirs may be able to arrange for a new mortgage if they want to keep the home.
Pfau also points out the advantages of applying for a reverse mortgage early in retirement and not spending the money right away. The HECM credit line grows over time. To quote Pfau from Forbes magazine, “Should the borrower live in the home long enough, the loan balance will likely grow to exceed the value of the home.”
Who might use a reverse mortgage?
The latest research is usually adamant that reverse mortgages aren't for everyone. Every article you read about these products states that, but very few tell you who they are for:
- You must be at least 62 years of age.
- You will need to have paid off your mortgage, or nearly so, or have adequate additional liquid assets available to pay off existing liens since the first thing you must do with a reverse mortgage is to pay off your existing mortgage.
- You must be willing to hold a mortgage on your home – perhaps not attractive to people who once worked hard to become mortgage-free.
- You must be able to pay property taxes, keep up with homeowners insurance, and pay for regular maintenance on the home.
- You should want to age in-place in your current home. You can change your mind later, but when you sell your home you will need to repay the reverse mortgage.
- You must accept the risk that your estate won't have adequate resources to pay off the reverse mortgage without selling your home.
- The home must be at least one spouse's principal residence.
Reverse mortgages are extremely complicated and the expenses can be substantial. If you think this might be an attractive alternative to consider, I recommend you find a good, unbiased financial planner to guide you and that you shop around for rates.
Furthermore, you need to fully understand what could happen to borrowers in the worst-case financial outcomes. A retired borrower with other financial pressures might need to sell the home earlier than planned. In that event, the HECM will become due and payable when they move out and they could see the reverse mortgage called at the worst possible time. Those lenient repayment terms might disappear when they're needed most. I'll post about that one day soon.
Lastly, some researchers have recently recommended using reverse mortgages to reduce sequence of returns risk and permit higher withdrawal rates. As I have previously hinted, I'm not on board with that concept, at least not yet. I'll post about that soon, too.
Reverse mortgages have gotten a bad rap, but recent research suggests that they are worth a second look. They're complicated, some uses are risky, and they’re not appropriate for every household. But bottom line, if a lot of your wealth is tied up in home equity, a reverse mortgage can help you increase retirement cash flow and consumption without selling your home.
[Tweet this]You worked really hard to pay off your mortgage before you retired. Want another one?
Wade Pfau referenced several recent papers on this topic. If you're interested in the research, check out the following:
Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income, Sacks and Sacks (2012)
Standby Reverse Mortgages: A Risk Management Tool for Retirement Distributions, Salter, Pfeiffer, and Evensky (2012)
HECM Reverse Mortgages: Now or Last Resort?, Pfeiffer, Salter, and Evensky (2013)
The 6% Rule, Wagner (2013)
AARP Reverse Mortgage Pamphlet (downloads PDF)