(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)
What's a representative interest rate on the loans at the moment, Dirk?
ReplyDeleteIt is quite difficult to identify a "typical" HECM rate. Here are a couple of guidelines. If we assumed a lender margin of 3% and added the current 10-year LIBOR Swap Rate of about 1.38%, we would get a rate of about 4.38% for the fixed rate HECM. Some recent research has used 4.45%. HECMs are generally more expensive that conventional home mortgages that currently cost about 3.56%, so that is consistent.
DeleteA much better way to find a rate is to check the HUD portal for a list of approved FHA mortgage lenders and check with them.
Mr. Cotton,
DeleteI would add that the since the adjustable interest rate HECM adjusts either monthly or annually with different caps and cap rules, the adjustable rate changes according to its terms and will change as the related interest index (generally one of the LIBOR indexes) changes up or down to the applicable caps. The expected interest rate we speak of, HUD believes to be a reasonable expectation of what the interest rate will be throughout the loan although neither the lender nor HUD guarantee that will be the case.
Hi Dirk. Good article. thanks. Just a little point, that does change anything you said: Your statement 600k equity minus $100k = $500k. I believe you can normally only able to get around half the equity of your house out via a HELOC when you first apply. So this would leave $300k- $100k. I am not a HELOC expert however: so I may be wrong. And it doesnt change the point you were making in the slightest. Just the numbers.
ReplyDeleteDerek, I think you meant HECM. HELOC is a different animal. If so, you are correct that a HECM would limit you to about 50% of equity if you were a 62-year old and had the funds distributed immediately.
DeleteHowever, the credit limit grows annually by about the amount of the interest rate and, as Wade Pfau says, any borrower who lives long enough will likely see his credit limit exceed the value of the home. Using one of the strategies noted, taking out a HECM loan early in retirement and not using the money until late in retirement, allows the borrower to possibly borrow more than 100% of equity.
It all depends on the strategy you implement.
Good point. Thanks!
Mr. Castle,
DeleteIn the body of the blog the following is stated: "Here's a simple example. Let's say you owe $100,000 on your home's mortgage but have $600,000 equity."
I am fully against discussing home equity when presenting HECMs. Why because of so much confusion about what home equity is. Google correctly states: " Equity is typically the difference between the appraised value of your home and how much of your mortgage you have left to pay off."
So in the example Mr. Cotton provides the appraised value of the home was $700,000 even though he did say so. With a HECM at present HECM expected interest rates, the most a lender can offer at closing is 52.4% up to 75% (based on the age of the youngest borrower) of what is called the Maximum Claim Amount. The Maximum Claim Amount is the lower of the lending limit which is $625,500 or the appraised value of the home. Let us say our borrower is currently 90 and it is his home that is appraised at $700,000 as indicated above. The most a lender could offer as of closing is $469,125 but if the borrower was just 62 the maximum would be just $327,762.
I hope that helps.
Thanks for the additional explanation, Jim. In the example, I was actually thinking about a borrower with an adjustable-rate HECM line of credit who takes out the HECM early in retirement and lets the line of credit grow well beyond these limits before borrowing. I should have been more specific, but I am trying to provide a broad overview of HECMs here and refer readers to other resources for the details.
Delete(That being said, I love it when readers like Jim provide greater detail in the comments.)
Fixed-rate and adjustable-rate HECMs work differently. A fixed-rate HECM is a one-time deal in which the amount you can borrow is set up front. You can't borrow more at a later date. An adjustable-rate HECM allows the borrower to set up a line of credit that grows over time. I believe Giordano's book explains this in an understandable way.
Nice post again Dirk. I used to be in the "use it later" camp of thought when it comes to reverse mortgages. But since the Reverse Mortgage Stabilization Act of 2013. I have come around due to the improvements that have been made to the rules and expenses.
ReplyDeleteA couple of additional points to your well-said post:
1) Reverse mortgages represent tax free income. That means that you get more bang for your dollar because there is no income tax on that dollar. Or, you can receive fewer dollars from a reverse mortgage, and still be ahead budget wise because no income tax is due.
2) With respect to heirs - IF they manage the transition of the inherited home to themselves as heirs, then they may receive what is called a deduction with respect to decedent (some advanced readers may be familiar with income with respect to dedecent). Here's a summary paper on research done by Dr Barry Sacks https://tcbdavison.files.wordpress.com/2016/04/sacks-et-al-recovering-a-lost-deduction-in-journal-of-taxation-april-2016.pdf
I find they are useful not only for the traditional supplemental retirement income need, but also as putting the reserve asset of the home into a liquid position for either survivor lost income replacement (Social Security for example has an automatic pay cut built in for survivors; and some pensions have this occur too, depending on the pension election taken), or for helping pay for Long Term Care expenses.
Retirement planning actually consists of three phases for couples (two for singles): 1) Both are here - traditional focus of retirement planning; 2) One is here - survivor planning; 3) No one is here - estate planning. And the deduction of the interest then repaid on the reverse mortgage may kick in if things are managed properly according to IRS and HUD rules.
I always enjoy your posts Dirk!
Excellent points. Thanks!
DeleteI have come around, as well, except for using home equity loans to avoid selling stocks in a downturn. I plan to explain why soon.
Thanks for the additional info, Larry.
I would like to clarify one point, and add a second. The example you give, of a homeowner with 600K in home equity, needs clarification. A HECM borrower can borrow a portion of the home equity, up to the national lending limit of $625,000. The lending formula (HUD's Principal Limit tables) uses the date of birth of the youngest borrower, the Expected Interest Rate, and the property value (up to the 625,500 cap) to determine the amount that one can borrow. The older the borrower, the higher the percentage of the value at a given interest rate. In today's interest rate environment, a 62 year old can borrow roughly 50% of the property value, up to the limit. So in your example, after paying off the 100K existing mortgage, the borrower would have available not 500K, but rather about 212-213K. No one would be eligible to borrow 600K under the HECM as presently constructed.
ReplyDeleteSecondly, there is another circumstance overlooked here. Many more people today are approaching retirement carrying household debt (mortgage and/or HELOC). There are only two ways to pay that debt: from current income (required on all mortgages/HELOCs except the reverse mortgage), or from equity when the borrower transfers title to the home. The HECM is unique in that its primary method of repayment is from equity upon departure from the home. However, a very powerful and flexible feature of the HECM is the ability to make optional payments. This allows the borrower to control the growth of the debt, including possibly being able to deduct the interest paid, and simultaneously increase their unused Line of Credit, a federally insured (no risk), non-taxable rate of return always equal to the interest and ongoing Mortgage Insurance Premium - currently in the 4 to 5% annual range. And since the HECM has a lifetime re-draw option, as long as one borrower resides in the home, making optional payments avoids the liquidity trap of pre-paying another mortgage. Any person 62 or older carrying household debt should consider refinancing with a HECM and making optional payments whenever possible. That is a far wiser course of action than refinancing to get a lower rate, as is often recommended, since a 30 year mortgage for a 62 year old is a life sentence of mandatory payments, restricting cash flow, and turning income into an illiquid asset of unknown value/marketability.
The HECM is a far more flexible and versatile financial instrument than is usually portrayed.
Jim Dean
NMLS 404697
Jim, I believe your first paragraph is absolutely correct, assuming you are referring to the initial PLF of a 62-year old borrower who borrows from the loan immediately. (I did not make that assumption.) As the research I noted suggests, a borrower can set up a HECM line of credit at an early retirement age like 62 and allow the credit limit to grow before borrowing. Later in retirement, the borrower will have a significantly larger credit limit, possibly even exceeding the value of the home at that time.
DeleteTo quote Wade Pfau's paper, “Meanwhile, opening the line of credit at the start of retirement and then delaying its use until the portfolio was depleted created the most downside protection for the retirement income plan. This strategy allowed the line of credit to grow longer, perhaps surpassing the home’s value before it was used, which provided a bigger base to continue retirement spending after the portfolio was depleted.”
Or in Forbes, “Should the borrower live in the home long enough, the loan balance will likely grow to exceed the value of the home.”
As you mention, “The HECM is a far more flexible and versatile financial instrument than is usually portrayed.” There are many possible retirement strategies using HECMs and the limitations, as well as the benefits, will vary according to the specifics.
Having said that, I think I'll change the loan amount to avoid the added confusion. :-)
Thanks for writing! Appreciate the additional information.
Posted for Shelley:
DeleteDear Dirk and Jim,
Your discourse on this issue has been interesting. Jim, I especially appreciate your comments on mortgage lending in general, the history of FHA, and the evolution of the HECM. ~ Shelley Giordano
Jim, I, too, found the history lesson extremely helpful. Thanks!
DeleteMr. Dean,
DeleteI cannot agree with the following: "... in your example, after paying off the 100K existing mortgage, the borrower would have available not 500K, but rather about 212-213K. No one would be eligible to borrow 600K under the HECM as presently constructed."
Mr. Cotton states the following above: "Here's a simple example. Let's say you owe $100,000 on your home's mortgage but have $600,000 equity."
Google correctly defines equity as: "Equity is typically the difference between the appraised value of your home and how much of your mortgage you have left to pay off."
So if the equity is $600,000 and the mortgage (the only lien against the property) is $100,000, then the appraised value of home MUST BE $700,000. This is why most of the time I am shaking my head when I hear mortgage originators discuss equity because they discuss in the oddest terms. So the Maximum Claim Amount now would be $625,500, not $500,000 as you state.
I fully disagree that current income is required to pay down debt. I have worked with many taxpayers who sell stocks to pay down their mortgage. I have had others who borrowed against the rentals they held in LLCs to pay down their mortgages. Income is a whole other subject.
HECMs are not unique as to repayment. Almost all mortgages in California are by lender nonrecourse even though the lender has the right to recourse on those mortgages that qualify for recourse treatment but that is beyond the scope of this comment. What is unique about all reverse mortgages (not just HECMs) is that by design they are compliant with all payment requirements even if the first payment pays off the mortgage in full at termination.
I have no idea what you mean when you claim: "That is a far wiser course of action than refinancing to get a lower rate, as is often recommended, since a 30 year mortgage for a 62 year old is a life sentence of mandatory payments, restricting cash flow, and turning income into an illiquid asset of unknown value/marketability." Why can't the borrower get a HECM after the underlying 30 year mortgage reaches required seasoning? "Life sentence" seems slightly over the top unless you are talking about immediate compensation to the originator! If the HECM is right for the borrower, I usually keep in touch with the prospect until seasoning is reached and begin addressing refinancing if a HECM is still the right answer at that time.
As to the HECM being a far better financial product than generally portrayed (even by our "friends" at AARP), you are so right. I know Mr. Barry Sacks in particular agrees with you on that specific point.
Mr. Cotton,
DeleteBefore changing your example, because read my comments about it. Equity is not the same as appraised value. Here is how Google correctly defines it: "Equity is typically the difference between the appraised value of your home and how much of your mortgage you have left to pay off."
So if the equity is $600,000 and the mortgage is $100,000 then the appraise value of the home MUST BE $700,000. The problem is so many in our industry use equity interchangeably with value that eventually some see no distinction and might as well accuse one as being crazy for distinguishing between the two.
Thanks, Jim. I assume that most of my readers know how to calculate home equity and would realize that $600K equity with a $100K mortgage implies a $700K home value, but perhaps some don't.
DeleteThe definition you provide is a good one, but I usually explain it like this. Home equity is what you would have left over if you sold your home and paid off the mortgage. This explanation also covers the transaction costs. In this case, transaction costs would probably add a little to that implied $700K to cover sales commissions, for example.
Thanks!
As to the HECM being a far better financial product than generally portrayed (even by our "friends" at AARP), you are so right. I know Mr. Barry Sacks in particular agrees with you on that specific point."
DeleteFrom a retiree or planner's perspective, whether a financial product is "good" or "bad" depends on the individual retiree's financial needs, not on the product, itself.
Furthermore, a product's reputation in the market place is irrelevant to the planner and retiree once both have a thorough understanding of the facts.
(I personally find AARP's current position on HECMs to be quite reasonable.)
I would prefer to focus the discussion on the pros and cons of HECMs in various applications and forgo concerns about whether financial products are inherently good or bad or who thinks they are either. That's a marketing issue for the HECM industry.
One of the major choices a borrower contemplating an adjustable rate HECM must consider is "What lender's margin should I select?" The lender's margin is the fixed portion of the adjusting interest rate, the varying porting being the index used. The answer to this question will impact the amount, if any, of the lender/broker credits that borrower is offered (this affects the closing costs charged to the borrower), and the rate at which the Principal Limit (and thus the debt as well as the unused Line of Credit) will grow, over the lifetime of the mortgage. Further, if the borrower is inclined to request a monthly payment option, he/she should know that the lender's margin affects that calculation as well. In a maximum value loan, the difference between a lender's margin of 2% and one of 3.625% can be several hundred dollars a month on the tenure option.
ReplyDeleteThis illustrates the point that it is crucial that the borrower understand the options and their consequences. A good loan originator will seek to understand the borrower's objectives (i.e., minimizing debt, maximizing cash flow, etc.) and then will be able to explain the various options that the borrower can select to accomplish his/her objectives. This is a very powerful financial instrument, and "one size does not fit all" - it needs to be tailored to respond to the borrower's needs.
In selecting the lender's margin, it is also crucial to ensure that the Expected Interest Rate (an element in HUD"s Principal Limit formula) does not exceed HUD's floor of 5.06%.
Amen. Especially to the first sentence of your second paragraph.
DeleteIMHO, HECMs are probably a product most people are going to need expert help with.
Thanks!
And this is why, after so many years of neglect and disparagement, it is heartening to see financial analysts starting to take the HECM seriously, even if they to date have only comprehensively looked at some of the ways in which it can integrate with retirement income planning. There are two main cash benefit insurance programs run by our federal government to benefit the senior population, Social Security and the HECM. Both need to be more fully integrated into retirement planning.
DeleteGiven that most households haven't been able to adequately save for retirement and most of the wealth they do have is in home equity, it would be foolish not to look at reverse mortgages.
DeleteThese papers analyze several strategies. I'm on board with any of them except using a mortgage to increase investment risk.
Thanks again for the info!
Mr. Dean,
DeleteSocial Security and HECMs are very different. The mortgage is not insurance. The insurance covers the lender and preserves FHA's claim of right to the collateral in case something happens to the lender. Social Security benefits do not accrue costs to Social Security beneficiaries. When do they have to be paid back? Under Congressional principles, Social Security is considered an entitlement but HECMs are included in the HUD budget. So since Congress created both....
I agree that Jim should have left "insurance" out of "There are two main cash benefit insurance programs run by our federal government to benefit the senior population", but these are the two main Federal government programs that help with a retiree's financial challenges, which I assume is what he meant. Perhaps a more important difference is that Social Security retirement benefits last for the recipient's lifetime while the HECM lasts for as long as they continue to live in a specific principle residence.
DeleteJim, please e-mail me at JDCPlanning@gmail.com if you don't mind helping me with a question. Thanks.
ReplyDeleteDoesn't reverse mortgage defeat the purpose of disaster protection?
ReplyDeleteIn case of fire, flood, or eminent domain that would force me out of my home permanently, if I carried a reverse mortgage, would I have to repay the lender?
Isaac, my response is below.
DeleteIsaac, I'm not sure I understand your first question, but I'll answer the second.
ReplyDeleteWhen you take out a reverse mortgage, you are obligated to maintain homeowners insurance, pay your property taxes, and maintain the property. If you fail to do all three, the lender can call the loan and you will be required to pay off the balance of the reverse mortgage.
Presumably, if you were financially unable to keep these three commitments, the house would have to be sold to pay off the mortgage balance. If the sale of the home doesn't produce enough cash to pay off the loan, you are not on the hook for the shortfall. You will never owe more on the reverse mortgage than the house is worth.
If there is a fire, the losses will be covered by your homeowners insurance. If the home is a total loss, then you would repay the mortgage balance with the check from your insurance company.
Homeowners insurance does not cover floods. You can only buy flood insurance from FEMA. If your home is damaged or destroyed by flood, a reverse mortgage would be called and payable if you could not afford to repair the home.
I'm not an eminent domain expert, but based on what I have read, you would not owe more on the reverse mortgage than the government offers you for the home. You would take the government's check and pay off the balance.
If by "disaster protection" you mean insurance, I don't see how a reverse mortgage would defeat the purpose of insurance.
Hope that answers your question. Thanks for writing!
Isaac,
ReplyDeleteA reverse mortgage is a mortgage. Whenever you have any mortgage on a home, you must maintain homeowner's insurance, flood insurance if you are in a flood zone, pay your property taxes, maintain your property, etc. Any insurance settlement for a total loss must be applied to the mortgage first, with any balance going back to the homeowner.
There are only two ways to pay a mortgage: from current income, usually by way of monthly payments; or from equity when title is transferred to another. All mortgages(except the reverse mortgage) and home equity products require that you make monthly payments under the terms of the mortgage contract. If you want to transfer title to another before the mortgage balance is zero, you must pay off the mortgage in the process of transferring title.
The reverse mortgage is unique in that payments out of current income are completely optional, albeit beneficial. But the default on a reverse mortgage is to make no payment on the mortgage while residing in the home. All mortgages are based on charging the borrower interest on money borrowed, from the date it is borrowed until the date it is repaid. If the reverse mortgage borrower elects not to make periodic payments (the default option)the interest is added to the loan balance, which therefore is rising. This is what is meant by negative amortization. If the mortgage debt when the mortgage comes due is greater than the value of the home at that point, the borrower has consumed the equity, and the home is "underwater". But by contract, the reverse mortgage is secured only by the real estate - it is a "non-recourse loan" - no person or other assets are pledged as collateral.
Obviously, this poses an unacceptable risk to the mortgage lender in most circumstances, which is why experiments in developing a reverse mortgage failed in the 1980s. As a result, Congress directed the Federal Housing Administration to develop a solution. Just as FHA insurance in the late 1930's provided the foundation for the long-term, fixed rate, amortizing mortgage, and thus the foundation of the development of housing wealth for most Americans, so too is FHA insurance the foundation of the reverse mortgage market.
The reverse mortgage is just a mortgage, a lien on the property that must be cleared before title can be transferred, but the borrower retains all the rights and responsibilities of home ownership.
Thanks, Jim! When you first look into reverse mortgages, it's kind of amazing how much they are like conventional mortgages.
DeleteThanks, Dirk and Jim! A risk of retirees is being forced to be homeless when they lose their homes. Although reverse mortgage is risk-free for the lender, it is risky to the borrower. By "disaster protection," I mean being able to receive the replacement value of my home when I lose it so that I can buy a comparable home. It seems to be a good idea for retirees not to spend their home equity if they can afford. After all, no one becomes homeless because of sequence of returns risk. They become homeless because of disasters (spending shocks). I agree with Dirk that it seems unwise to take on a reverse mortgage to reduce sequence of returns risk (only to increase the financial damage of a potential disaster).
DeleteThese are two different issues, Isaac. You properly state my beliefs regarding sequence risk.
DeleteRegarding,"being able to receive the replacement value of my home when I lose it so that I can buy a comparable home", the issues are similar regarding the reverse and conventional mortgages -- you need to buy insurance to ensure that you can replace your home after a disaster with either type of mortgage.
An important advantage of the reverse mortgage is that you will never have to repay more of the mortgage than your home is worth. (HECMs are "non-recourse" loans.) That isn't true with a conventional mortgage.
A reverse mortgage is not risk-free to the lender, though they have insurance in the event that your home value falls below their loan amount. All loans are risky to both the borrower and lender, with the possible exception of short-term TIPs bonds.
Mr. Cotton,
DeleteReverse mortgages are conventional nonrecourse mortgages with special and also unusual benefits for its borrowers.
If the amount of the debt at termination exceeds the value of the home, a borrower will have to pay off the loan in full to keep title to the home.
Let me summarize my understanding of the two issues, and clarify my question on the potentially unique risk from carrying a mortgage when I'm too old to be gainfully employed.
DeleteIf I lose my home, insurance will pay me the replacement value of my home. I can simply cash the check to buy a comparable home.
If I carry a mortgage, I will have to split the check to pay the lien-holder first. Whatever left will not be enough for me to buy a comparable home.
Is it possible to allow me to buy a comparable home *after* paying the lien-holder?
If that is possible, it would require me to insure for more than 100% of the replacement value of my home. This would require me to pay more each month for insurance premium. An increased monthly withdrawal amount would, in turn, increase my sequence-of-returns risk. However, reverse mortgage provides liquidity that lowers sequence-of-returns risk. Am I better (or worse) off having the reverse mortgage *and* paying the increased insurance premium?
Isaac, I think you may be confusing two forms of insurance. Regardless of mortgage type, the lender will insist that you carry homeowner's insurance. That insurance may replace your home if it is lost due to a fire, for instance.
DeleteThe "MIP" insurance we're discussing is unique to HECM reverse mortgages and won't replace your home or pay you any benefit, at all. It will pay your lender for any loss he incurs when selling your home when you move out isn't sufficient to pay back the HECM reverse mortgage. You don't get to decide how much MIP insurance to buy.
When you talk about sequence risk, you are implying that you would have both a portfolio and a HECM loan. That is substantially more complicated and isn't a strategy that I am comfortable with at present.
Dirk, do you think that it is a good idea to spend down the portfolio first, before considering an HECM loan for discretionary retirement income?
DeleteIsaac, my answer is a bit more complicated.
DeleteDo I think that it is a good idea to spend down the portfolio first?
Yes, I do, for several reasons that I plan to write about soon. The more recent idea that the "conventional wisdom of spending the HECM as a last resort is wrong" seems flawed to me.
Do I think that it is a good idea to spend down the portfolio first, before considering an HECM loan?
No. I think the best idea is to consider a HECM up front as an integral part of your retirement plan. Also, currently there are benefits to opening an adjustable-rate HECM line of credit early in retirement and not borrowing from it until later in retirement when the line of credit will likely be much larger.
Do I think that it is a good idea to spend down the portfolio first, before considering an HECM loan for discretionary retirement income?
Maybe later in retirement when it appears that you can perhaps spend more than you have been then the HECM can be considered for discretionary expenses. Spending it on discretionary expenses earlier in retirement might lead you to spend more than you otherwise would and not have the HECM borrowing available later in retirement when you might need it for emergencies.
At present, I believe the best use for a HECM is as a backup resource late in retirement, but that you should open the HECM line of credit as soon as you can. I'm still studying this and discussing it with others and perhaps my position will change. But, that's how I feel about it today.
Good question. Thanks!
Great answer. I completely agree. Thanks a lot!
DeleteDirk,
ReplyDeleteI appreciate the opportunity to share some thought about the HECM with you, and I would like to start by asking you to challenge the self-imposed limitation that you set forth in your original blog posting:
"You will need to have paid off your mortgage, or nearly so, since the first thing you must do with a reverse mortgage is to pay off your existing mortgage."
It helps to understand the history of the HECM, in order to see how this unnecessary limitation came to be the conventional wisdom.
From its origins until Columbus Day weekend of 2008, the HECM was oriented towards lower value homes, and by implication, lower income/net worth individuals/borrowers. The HUD Maximum Lending Limit ranged from a floor of 48% of the Conforming Loan Limit (the max that Fannie/Freddie could purchase) to a high of 87%. In the summer of 2008, that meant that the Maximum Lending Limit ranged from $200,260 to $362,750, clearly limiting the usefulness of this product to lower value homes.
In the summer of 2008, Congress passed two separate bills, which they never reconciled in conference. One set the HUD limit at 100% of Conforming ($417,000), the other at 150% ($625,500) nationwide. In that summer of financial and legislative chaos, the discrepancy was not resolved through the normal legislative process. Finally, over the Columbus Day weekend, HUD announced that the HECM Lending Limit would be 150% of Conforming, nationwide. Initially this appeared to be temporary, but it has been continued since, though not always without a little drama, waiting for HUD to announce it each year. One year, a prominent financial blogger confidently (and incorrectly) predicted that the Lending Limit would soon revert to $417,000 - and the next week HUD announced it would remain at $625,000 - OOPS!
When the limits were lower, the program was mostly of interest to lower income persons, with lower value homes. Higher income persons, and higher value home, were not excluded, but they generally found the HECM to be too restrictive to be of interest. To some extent that is a limitation even today, though much less than prior to 2008.
The HECM has never been income-restricted, and its benefits have never been restricted to lower income borrowers with lower value homes.
The assertion that one must have paid off their mortgage (or at least have a low remaining balance) is based on the unspoken assumption that HECM borrowers have no other assets. In fact, the HECM works perfectly well for those who have relatively high mortgages, as long as they can discharge all liens in the process of refinancing with a HECM - even if they have to bring additional funds to the closing table - i.e., increase their equity in the property from other sources. I have known borrowers (myself included) who found it worthwhile to bring funds to closing in order to refinance a high mortgage with a HECM, especially if they are able to manage the growth of their mortgage debt and increase their liquidity (unused Line of Credit) by making optional and random payments on the HECM. This is a vastly under-appreciated and under-utilized feature of the HECM, about which I will share some other thoughts later.
Also prior to October 2008, the HECM was limited to being a refinancing mortgage. There was no intrinsic reason for this limitation (the Fannie Mae Home Keeper reverse mortgage allowed its use as a purchase mortgage), but that was the way the HECM was set up, probably reflecting its origins as a solution for "house rich but cash poor" senior homeowners. That changed in the fall of 2008, when Congress and HUD authorized the HECM for Purchase program, but that is another story. Here I will stick with the HECM as a refinancing mortgage, as that is what financial planners are beginning to focus on.
(continued in next posting)
This comment loses focus on fact in favor of telling a story so let us at least get the facts right. For example, the following is incorrect: "In the summer of 2008, Congress passed two separate bills, which they never reconciled in conference. One set the HUD limit at 100% of Conforming ($417,000), the other at 150% ($625,500) nationwide. In that summer of financial and legislative chaos, the discrepancy was not resolved through the normal legislative process. Finally, over the Columbus Day weekend, HUD announced that the HECM Lending Limit would be 150% of Conforming, nationwide. Initially this appeared to be temporary, but it has been continued since, though not always without a little drama, waiting for HUD to announce it each year." All one has to do is read Mortgagee Letter 2008-35 which is dated 11/6/2008 and states that as of November 6, 2008, there was a new single limit of $417,000 for HECMs [as found in HERA and signed into law on July 30, by President G.W. Bush (PL 110-289)]. That limit stayed in place until the issuance of Mortgagee Letter 2009-07.
DeleteMortgagee Letter 2009-07 dated February 24, 2009 set the HECM limit at $625,500 under what is commonly called the Obama Stimulus Act (but actually named the American Recovery and Reinvestment Act of 2009, PL 111-5) signed into law by President Obama on February 17, 2009. The Stimulus Act was not been written until January 26, 2009.
As to HECMs for Purchase, HECM law 12 USC 1715z-20(m) was added by HERA. There was no need for a purchase product in the mind of HUD other than to avoid some duplication of costs. HECMs were not created so seniors can go "cash" broke by buying "up" as this provision permits; of course, financial assessment helps temper that now. It is generally believed that the cash flow problem that can occur by buying up was an unintended result of the legislation.
Otherwise the story Jim tells is rather interesting and informative.
Continuation of previous post:
ReplyDeleteThe HECM is mortgage debt. Debt is not intrinsically bad; rather it is how one manages debt that matters most, and how debt impacts one financial circumstances. Debt that entails mandatory monthly payments can be very constricting; debt that requires one to give up ownership of assets in order to be serviced (401K/IRA withdrawals to make mortgage payments, for example) can be catastrophic; spending down all one's other assets to achieve debt-free ownership of one's home can also be catastrophic, since real estate is not liquid, and its value depends on the market conditions when one wishes to sell it. Over the last 8 years I have seen numerous examples of all of those courses of action - and it has not been a pretty picture.
As I mentioned yesterday, there are only two ways to pay mortgage debt: current income or equity upon departure. The power of refinancing with a HECM as soon as it is possible to do so lies in the fact that it liberates one from the obligation of paying one's mortgage debt from current income. The power of making optional payments on a HECM is vastly under-appreciated, especially by the financial planning community, and that is something, if you are interested, that I would like to turn to in a subsequent post.
Thanks, Jim, I will expand that bullet to include the possibility of paying off the conventional mortgage with other assets. A retiree with enough liquid assets can, of course, pay off their existing mortgage whether or not she then takes out a HECM.
DeleteIn these situations, the retiree or planner must then also decide whether taking out a reverse mortgage is the best use of those substantial liquid assets. The strategic decisions around what you are trying to achieve should be made first (see A Model of Retirement Planning).
Is using those liquid assets to take out a HECM sometimes the best strategy? I don't know. Worth considering.
I think planners, and especially researchers, are focusing on more than the refinancing opportunity offered by HECMs. I plan to discuss in a future post several strategies that have recently been studied.
Definitely interested in a post on optional payments benefits.
To my other readers, Jim also noted offline that Shelley Giordano's book, What's the Deal with Reverse Mortgages, has received a lot of good reviews. I have only completed about a third of the book, but given what I have read and Shelley's reputation, I'm comfortable recommending it.
Thanks for your continued input, Jim. Looking forward to more.
"Finance writers love to say that 'you can’t spend pieces of your home to pay bills.' But, a second way to generate retirement income from home equity, the oft-maligned reverse mortgage, enables you to spend little pieces of your home indirectly."
ReplyDeleteYet a reverse mortgage generates no income. The only participant in a reverse who does not make money on the creation of a reverse mortgage is the borrower, that is why in fact they are called borrowers. Whatever funds they receive either directly or indirectly become part of the balance due and must be paid off as required under the nonrecourse mortgage agreement.
When it comes to equity, as seen in other comments, most originators have little idea what equity really is. Some say that with a reverse mortgage equity will go down but will it? What if the value of the home rises faster than the balance due on the reverse mortgage does equity go down or up. There is little question that a reverse mortgage is a force pulling equity down but opposite that force is value either also pulling equity down or in most pulling it up. This is why I laugh when I hear reverse mortgage originators telling me that the amortization schedule shows how a reverse mortgage reduces home equity. But happens if the interest rate is much lower and the appreciation rate is higher?
Oh so many of my California, Pennsylvania, Texas, Oklahoma, Ohio, and New Jersey friends relatives would disagree with you. Many of them are receiving royalties for giving up their mineral rights years ago. Some have given up air, right of way, riparian, water, and other rights for cash. I am now dealing with a company that buys TIC interests in the home using trusts.
Years ago the industry used a right to increase the HECM loan amount based solely off of surrendering their rights to appreciation so it is now shared. We see that again with the REX Agreement and Equity Key.
I know people who use a portion of their home for business (implicit rent) rather than paying rent to a third party. If that is not creating cash flow (lower outflow), what is it? It is not income so what is it? Cash flow.
Your are correct that we are creating cash flow and not untaxed income, as planners frequently refer to the loan proceeds. It is ultimately a loan secured by the home, not a true source of income. (It costs the borrower to generate this cash flow.) Although I'm not sure that provides clarity for the typical retiree, who is simply searching for ways to increase consumption, I will correct that in the post.
DeleteIn fairness to HECM originators, the two with whom I have spoken directly both explained that equity can increase or decrease depending on the future market value of the home.
Thanks!
I really do not want to point out who said the following but it was NOT Mr. Cotton: "Secondly, there is another circumstance overlooked here. Many more people today are approaching retirement carrying household debt (mortgage and/or HELOC). There are only two ways to pay that debt: from current income (required on all mortgages/HELOCs except the reverse mortgage), or from equity when the borrower transfers title to the home. The HECM is unique in that its primary method of repayment is from equity upon departure from the home." The quotation is nonsense. First, a HECM can be paid fro from any asset, not just the cash current income provides. Second, a HECM is not paid from equity but from the total gross transfer value of the home which we will assume is its appraised value.
ReplyDeleteSo again what does Google tell us equity is (when searching "home equity definition example")? "Equity is typically the difference between the appraised value of your home and how much of your mortgage you have left to pay off."
Let us say a home has $400,000 in equity and the HECM balance due is $150,000 when title is transferred in an arm's length transactions where we will assume all transfer costs are just $20,000. Google tells us that the appraised value of the home should be $550,000 since this amount ($550,000) minus the mortgage pay off amount of $150,000 is the equity of $400,000.
So the third party title transferee in a arm's length title transfer transaction would give the escrow agent $550,000, the mortgagee would be paid $150,000, and the various transfer agents would be paid their share of $20,000, leaving the title transferor $380,000. So as the required payments are being made to all of the title transfer parties (including $380,000 to the title transferor), title would transfer to the third party title transferee.
Somehow getting $380,000 after paying off the HECM and all title transfer costs sounds much better to me than just $250,000 WITHOUT paying off the title transfer costs.
I would hope the person who made that quotation would agree that a HECM is paid off from the total value of the home, not just its equity!
Good afternoon,
ReplyDeleteI've been away for a couple of days and only now have I had a chance to catch up on the commentary on this posting.
First of all, Mr. Veale is correct in the history - I mis-remembered when stating that the lending limit rose in one step to $625,500. It was in the two steps he mentioned. My apologies for the error.
Secondly, my reference to "current income' was perhaps too cryptic. I was referring to the fact that other assets would normally have to be sold (converted to cash) before they could be used to pay down a mortgage. Since many times that conversion process would create a taxable income event (e.g., a 401K withdrawal), I referred to such a means of producing payoff-possible cash as "current income". I did not mean to restrict that category to wages or similar sources. I simply meant that the sale of other assets produced 'current income".
I used the term "equity' in a colloquial sense, referring to the net proceeds from the sale of the home, after all liens and expenses of sale were subtracted. Perhaps the more cumbersome terminology of "net sale proceeds" would have been a better choice of terms.
Regarding the point that the HECM is federally insured, one should keep in mind that lenders can fail, and that the FHA insurance protects both borrowers and lenders, though in different ways. In 2008, the FDIC took over IndyMac Bank, the parent of Financial Freedom Senior Funding Corp. But the failure of a lender does not jeopardize the borrower's benefits from the HECM, because the HECM program insures that the borrower's benefits continue. In fact, if I am not mistaken, in the IndyMac failure, even Financial Freedom's proprietary reverse mortgage borrowers were held harmless from the company's woes at that time. FDIC insurance protects bank depositors; FHA insurance protects HECM borrowers, as well as lenders.
Finally, the reference to past products which involved "equity-sharing" deserved some comment. In the 90's there were various non-HECM reverse mortgages that had an "equity-sharing" feature. In exchange for the borrower agreeing to remit a portion of the increased value of the house to the lender upon sale, the borrower usually received a more generous benefit. Fannie Mae, for example, offered its HomeKeeper and HomeKeeper with Equity Share reverse mortgages. With the latter, the borrower agreed to transmit 10% of the assumed value increase to the lender upon termination of the mortgage. But the equity sharing products were subject to abuse and controversy, and disappeared. Fannie Mae, for example, withdrew the HomeKeeper with Equity Share option in August of 2000, and I believe it was the last of its kind. To my knowledge, the HECM never had an equity sharing feature.
The reverse mortgage for purchase is discussed in another posting on this blog.
Jim, I don't believe there was an issue with viewing home equity as the net proceeds from the sale of the home. As I understand Jim Veale's concern it is with the use of the term equity to refer to the full market value of the home and it does get used that way sometimes. My working description is much the same as yours. Home equity is what you would have left if you sold your home and paid off the mortgage. I don't think there are any issues there.
DeleteThe planning industry is also prone to abbreviate any form of spendable cash flow as "income." I do that myself, sometimes. As Jim notes, cash flow from a loan isn't technically income, which is why it isn't taxed. It's money you borrowed.
I don't believe these were concerns specifically regarding your post as much as they were a well-deserved admonishment for all of us who sometimes use the terms "income" and "equity" too freely.
A lot of negative comments below. The reverse mortgage program has saved my parents retirement.
ReplyDeleteMyths:
Expensive
The bank owns the home
Heirs won’t inherit anything
We found comparison website, click quote save dot com, that found us a lender who charged $0 upfront fees (savings of $6k).
There was no haggling involved just tell them you don’t want to pay any upfront fees.
The title/ownership remains in my parents name and if home values increase I will inherit the remainder of the equity.
My parents are saving $24k/yr by not having a mortgage payment, and I don’t have to worry about their financial situation. They don’t need my assistance, everyone wins.
If home values decreases or they live for another 30 years I’m perfectly happy not inheriting any $ or the home. I just wanted them to have a comfortable retirement.
Don’t believe all the negative comments without doing your research first. Like any other service and industry there are good lenders out there.
Thank you all, and best of luck.
Jessica
Jessica, I reviewed the comments and couldn't find a single one I would consider negative. Not sure what you are referring to.
DeleteI, too, have found a couple of reputable originators who will credit all expenses except for the counseling fee of $125 or so. The amount of closing costs depend on the margin rate you select and the $125 option generally is provided with only the highest lender margin. I agree, however, that you can shop around and get a good deal.
You are correct, the homeowner retains title to the home.
As for the heirs not inheriting anything, that really depends on the future value of the home and the amount borrowed. If the home value is greater than the repayment, you will inherit the difference but it is entirely possible that you won't inherit anything.
I disagree with your no-haggling comment. There are two ways to pay no up-front fees. Some lenders will credit those fees if you accept a higher lender margin, which may or may not be the best thing to do. Others will add those fees to the loan balance and charge you interest on them for the life of the loan, reducing the amount you can borrow – you effectively borrow the money to pay the fees.
Lastly, you need to always keep in mind that if your parents have to move out of the home, the loan will become due and payable. I hope that's many years from now when they no longer need the home but it might not be.
Thanks for writing!