Friday, October 14, 2016

Reverse Mortgages: When the Last Resort is the Best Resort

Recent research into reverse mortgages to fund retirement suggests that the conventional wisdom of spending home equity as a “last resort” after other savings are depleted should be rethought. On the contrary, I believe there are many retirement scenarios in which spending home equity as the last resort is the best resort.

The “don't wait” philosophy stems primarily from a paper written by Barry Sacks and Stephen Sacks in 2012 and the current unique circumstances for HECM reverse mortgages.

In a paper entitled, “Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income (2012), Barry Sacks and Stephen Sacks write:
A retiree whose primary source of retirement income is a securities portfolio and who also has substantial home equity must decide early in retirement whether to live within the safemax limit set by his or her portfolio . . . This decision is a fundamental component of overall retirement planning . . . The decision process also must take into account the degree of economic discipline required to live within the safemax limit.

If the retiree does conclude that he or she would, on balance, prefer to live beyond the safemax level and wants to remain in his or her home as long as possible, a reverse mortgage, including its substantial costs, is one tool to consider.”
The term “SAFEMAX” derives from the work of William Bengen and typically refers to a “safe withdrawal rate.” Historically argued to be around 4% to 4.5%, more recent work by Wade Pfau suggests that in the current low-interest rate environment the “safe” rate may be closer to 3%.

Sacks (2012) actually makes a fairly modest claim compared to the explanations subsequently provided in the media that spending as a last resort might be unwise. They state that the strategy isn't for everyone. The authors note that “particularly in the range of initial withdrawal rates between 5 percent and 6.5 percent, we have found substantially greater cash flow survival probabilities when the reverse mortgage credit line is used in either of two active strategies rather than in the conventional, passive, strategy as a last resort.”

In other words, for retirees willing to risk spending more (about 5% to 6.5% instead of 3% to 4%) from a volatile portfolio than planners have conventionally considered safe, using home equity to leverage an investment portfolio might provide better outcomes. That's a far cry from claiming that the conventional wisdom of spending home equity as a last resort is wrong, as subsequent reviews of the paper may have suggested.

Wade Pfau concluded in his 2016 book, Reverse Mortgages, that a simple strategy of opening a HECM reverse mortgage early in retirement and not using the line of credit until late in retirement outperformed both of the currently-proposed “coordinated strategies” and the use of tenure payments.

"Of the six strategies that use home equity," Pfau reports, "the strategy supporting the smallest increase in success is the conventional wisdom of using home equity as a last resort and only initiating the reverse mortgage when it is first needed . . . Meanwhile, the "use home equity last" strategy provides the highest increase in success rates."

(Note that Pfau compares two “Last Resort”strategies. The first spends as a last resort but waits to open the reverse mortgage until it is needed. That strategy performs worst, but opening the reverse mortgage early in retirement and letting the line of credit grow before spending as a last resort after savings are depleted performs best. Pfau refers to the latter as “using equity last.” Pfau further notes that if your goal were to create the greatest legacy and not to maximize the probability of successfully funding retirement, tenure payments provided the best strategy most often.)

The current unique circumstances for the HECM are the increased loan limit of $625,500 and present historically-low interest rates. When combined, these two factors could allow a borrower to create a very large line of credit, perhaps greater than the home's fair market value over a long retirement. As Jim Veale recently explained in a comment, the maximum HECM loan amount was increased from $417,000 to $625,500 as part of the American Recovery and Reinvestment Act of 2009. Many believed the increase would be temporary but it has thus far survived.

Regardless, there are many conceivable retirement scenarios in which spending home equity as a last resort, as the conventional wisdom holds, would be advantageous, given that opening the line of credit early is a clear benefit with any strategy.

Avoiding risk to home ownership when it may never become necessary

Some retirees want to pass their home debt-free to heirs. They probably should not borrow a reverse mortgage. Some don't plan to keep the home in their estate and won't mind risking ownership. Still others would like to leave their homes to heirs but realize they might not be able to pay for retirement without using home equity. By spending home equity as a last resort instead of committing it early in retirement, the latter group might find that they never need to risk their home or that they can at least minimize the amount of equity they do need to spend.

Think of it as matching home equity to contingent late-retirement liabilities.

Not encouraging overspending

Imagine a couple that divorces late in life after spending a lot of their home equity. Neither wants to continue living in the home. Perhaps neither can afford to continue living in the home, given their new financial situations. Their best financial alternative may be to sell the home, in which case their HECM will have to be repaid. Although they had planned to age in the home, they find themselves leaving the home and without much remaining home equity to pay for new housing.

I was recently asked to explain how this couple would have been better off by not borrowing the HECM. The answer is that the HECM may have encouraged them to spend more than was safe early in retirement, leaving them with little financial reserve in a crisis.

Giving the household more time to see how retirement will unfold before committing resources

Committing to an early-spending reverse mortgage strategy (matching home equity to early-retirement liabilities) involves betting that the household will remain in the home and age in place. It is a bet against divorce and the early death of a spouse. It is a bet that you will feel the same about your home in 10 to 15 years that you do at the beginning of retirement. It is a bet that your home will accommodate future infirmities.

As Shelly Giordano's book on reverse mortgage suggests, waiting a decade or so before committing to spending your home equity provides more time to see how your retirement will unfold.

Holding a reserve for spending shocks

As I explained in Why Retirees Go Broke, the reason is usually a positive feedback loop of financial setbacks stemming from spending shocks, not from sequence of returns risk or poor investment results. Health care costs are an obvious risk, but there are many potential spending shocks that could leave a HECM borrower unable to afford their home going forward. In those instances, the HECM will need to be repaid leaving the borrower with little equity to help with housing costs.

Just in the past few weeks, I have heard the following stories of financial crises in which a HECM borrower would sorely miss home equity as a last resort after having used it to increase early-retirement consumption:
  • A wealthy corporate executive was driven into bankruptcy by his wife's Alzheimer's disease.
  • A woman's home is being taken by the state using eminent domain to build a highway through the property.
  • An elderly HECM borrower ran out of money and asked her loan originator to “send more.”
  • A couple needed to move his father into their home as his dementia progressed.
These crises might also occur after you spend your savings and begin spending home equity as a last resort, of course. In that event, you simply ran out of money and neither spending strategy was likely to save you. The danger is in finding the opportunity for additional consumption early in retirement too attractive and experiencing a more critical need for the reserves later in retirement.

Controlling balance sheet leverage

Leverage is risk and like any financial risk can be beneficial if appropriately exploited and dangerous if it is not. Any balance sheet that includes debt is leveraged and anyone who simultaneously holds a mortgage, conventional or reverse, and an investment portfolio has leveraged those investments. Understanding this leverage risk is important and maintaining a prudent amount of leverage is critical. (Michael Kitces explained it well here.)

Retirees who spend home equity as a last resort after depleting their portfolio will not simultaneously hold reverse mortgage debt and an investment portfolio – they will hold them sequentially. That doesn't mean they won't have leverage from other debts, or that the amount of leverage created by the reverse mortgage will be imprudent. That depends on the rest of the balance sheet. But, it does provide an opportunity to manage that leverage.

When spending home equity as a last resort is the best resort.
[Tweet this]

There are a number of advantages to spending home equity late in retirement. Retirees who don't live a long time may find that by waiting to use home equity they never need to risk their home to fund retirement. Delaying may enable the retiree to better observe how her retirement financial situation will unfold before committing to spending home equity. Some retirees will find a more critical need later in retirement than additional consumption early in retirement. Borrowing later may help control balance sheet leverage.

On the other hand, the argument that spending home equity early in retirement beats conventional wisdom isn't particularly compelling. Sacks (2012) argues only that it might provide better outcomes for retirees willing to commit home equity early and to spend more than most planners would consider safe. Pfau's analysis showed that the best outcomes were the result of simply opening a HECM line of credit early in retirement and waiting to spend it until after the savings portfolio is depleted.

If you expect to remain in your home throughout retirement, my advice is to consider opening a HECM line of credit today, while interest rates are low and the maximum HECM loan value is high, but to hold off on spending much of it until you see what life has in store. Often when spending home equity, the last resort will prove the best.

Your retirement planner says you have a 95% chance of funding retirement successfully? Find out what that means in my next post, Trump, Monte Carlo and Insectivores.


Reversing the Conventional Wisdom: Using Home Equity to Supplement Retirement Income, B. Sacks and S. Sacks, Journal of Financial Planning, 2012.

Reverse Mortgages: How to use Reverse Mortgages to Secure Your Retirement, Wade Pfau, 2016. Available on Amazon.


  1. Dirk,

    Another thoughtful posting. I applaud your efforts to help educate people. Much more is needed.

    That said, there is another population often overlooked. In focusing on those already retired, it is easy to overlook those still working, but approaching retirement eligibility, who are still carrying significant house-related debt. For that population, the strategy of refinancing their mortgage/HELOC debt and continuing to make optional payments, is seldom emphasized. While it seldom makes sense for a retired person to make optional payments on their reverse mortgage, since that would usually entail converting other assets (and perhaps incurring otherwise unnecessary tax liabilities) into income which could then be applied to making the payment, a person working who converts their current mortgage payment stream into reverse mortgage payments derives multiple benefits. Making payments manages the growth (or decline) of their mortgage debt, while often also providing the tax deduction benefit of paying mortgage interest. But more importantly, it builds up the increasing (and not subject to income tax) liquidity of their home, through the growth features of the reverse mortgage line of credit.

    Recently, a reader of your blog whose situation exemplified this strategy contacted me. A person in his mid-60's, he anticipated being able to continue to work for a number of years. He reported mortgage debt of more than $150,000, a mortgage payment of more than $800 per month, and retirement savings of less than $500,000. Overall, he realized that funding retirement would be very challenging. By refinancing his mortgage with the reverse mortgage and continuing to make payments in the same range, however, he could set an achievable retirement goal of increasing his reverse mortgage line of credit to approximately $250,000. Converting that to tenure payments, along with Social Security and his existing retirement savings, created a much broader path to retirement income security that he is presently on.

    The reverse mortgage is a much more versatile retirement planning tool than most people realize, one that, as this person's situation illustrates, can enhance retirement security in ways that few other tools can.

  2. I think I read recently that about a quarter of households still have a mortgage at retirement and what you suggest is certainly a consideration.

    I do have a concern with this strategy, however. Tenure payments last the life of the mortgage, not the life of the borrower.

    I posted this at Advisor Perspectives yesterday:

    As we have also discussed, if a HECM borrower finds herself unable to continue to afford the home (e.g., after a spending shock, divorce or death of a spouse) or no longer desires to live in the home (e.g., after a divorce or development of an infirmity), the borrower might find selling the home to be the best financial alternative. Doing so, of course, would trigger repayment of the HECM. In fact, since HECM foreclosures are apparently non-existent, this appears to be a more likely scenario for losing the home than property tax, home insurance or maintenance issues.

    The scenario that concerns me is one like the following. (Substitute any financial crisis in which selling the home is the best alternative.) A couple opens a HECM line of credit early in retirement, falls victim to “gray divorce” after borrowing many tenure payments and neither can continue to afford to live in the home, even without mortgage payments. In fact, neither DESIRES to continue living in the home. When they sell the home they must repay the HECM. Much of their equity has been spent and the tenure payments, upon which they were reliant, permanently stop.

    The response so far at AP has been that this is a valid concern.

    While each individual household needs to be considered individually and this strategy might indeed be best for some, the borrower needs to consider the possibility that a financial crisis could leave them without a home and with little remaining equity to pay for housing. Yours is probably prudent advice if the borrower understands that risk and the rest of the retirement plan anticipates it. If losing the tenure payments late in life would cost the retiree his standard of living, then a life annuity would be a much better idea.

    This is an area in which the retiree needs retirement planning advice that covers all the bases and not simply retirement product advice. The two should not be confused.

    I think reverse mortgages are a great tool for the right job, but they're not a panacea.

    Thanks for the comment!

  3. You're doing a great job Dirk! This series on Reverse Mortgages (and the postings you have yet to make that I know are in your drafting stages) are excellent points and counter-points about how and when this tool may be properly used.

    The key point you make if someone opens a LINE OF CREDIT early, is NOT to access it until it is absolutely needed. For some, an absolute need might be a new boat - which is an example about them feeling encouraged to spend just because they have access to money. Once money is taken from a reverse mortgage, that balance GROWS ... and thus leads to the issues you discuss above. If no money is taken, then there is no balance to be repaid and home equity is retained for those unplanned potential issues in the future.

    Your last paragraph summarizes how someone might properly consider using these tools. But, it takes discipline to stick to the original intent of the plan - and not get glitter in the eyes when some desire comes along in the meantime. Real possible needs later in life need sticking to a solid plan with which a line of credit was taken out in the first place.

    I'm looking forward to your future posts on this topic!

  4. People in or facing retirement face many financial challenges, and need to carefully consider all the options available to them to meet their needs. Until very recent years, the willful "ignore-ance" (to coin a phrase) of the options that the reverse mortgage can offer, by the financial advice community, has done a disservice to many (as did the focus of the reverse mortgage industry on the fixed-rate HECM in the period from 2009 to April 1, 2013).

    No one solution fits all, but all can benefit from knowledge of their options. The reverse mortgage offers options that can solve some problems for some people, but not all problems for all people all the time.

    In retirement, the more one spends down one's assets, the fewer paths one has open to future financial security, whether those options are one's investment portfolio or one's home equity. But many people will have no choice except to spend down assets at some point. Generally, when one spends down an asset, one gives up ownership of that asset (thus forfeiting any benefit from future appreciation of that asset). The reverse mortgage certainly does allow one to spend down the asset of their home, but since it does not entail giving up ownership of the home, the borrower retains at least the possibility of benefiting from future appreciation of the asset.

    This can be illustrated by Dirk's caveat that "Tenure payments last the life of the mortgage, not the life of the borrower." That is certainly a true statement, and is a feature that differentiates the tenure option from an annuity. However, with an annuity, one transfers an asset to an entity that bears the longevity risk, receiving lifetime payments in return for generally foregoing any possible asset appreciation. In contrast, tenure payments diminish (but do not necessarily extinguish) one's equity in the home, which may or may not appreciate in value over time. Further, at any time while resident in the home, the borrower can cancel the tenure payments and withdraw their remaining Net Principal Limit (or leave it in their Line of Credit), to pursue whatever other financial options may better meet their needs at that time.

    The shift away from defined benefit pensions has placed much more responsibility on individuals to figure out how to fund their retirement needs, meaning that they have to take more initiative to understand the options available to them. The HECM reverse mortgage is a federally insured program that offers options too few people have explored.

    1. Jim, completely agree with your last paragraph and especially your last sentence. But all those options need to be carefully explored because each has its advantages and pitfalls. Reverse mortgages have been unfairly reviled in the past but are sometimes over-hyped now. The web page for a HUD-referred HECM counselor, for instance, clearly (and falsely) states that you never have to repay a HECM until you die.

      As a (mostly former) retirement planner and researcher who doesn't sell any product, I like to think I can provide a more rounded view and avoid the marketing hype at both ends of the spectrum. Reverse mortgages are a great tool for some households and a poor one for others. Retirees need to consider them very carefully to figure out which applies to their situation.

      Thanks for the comment!

  5. Here's the image that comes to my mind as I think of maintaining a standby LOC on a HECM.

    "In case of emergency, break glass."

    The vast majority of the devices with that label never get their glass broken, but it is comforting to know they are there to summon help if needed. (Well, in this day and age of ubiquitous cell phones, maybe they are pretty redundant, but back in the day, it must have been comforting to have these in place.)

    Of course, breaking the glass on one of these devices can be a lifesaver in time of real need, but it can also get you in BIG trouble if you break the glass for frivolous reasons.

    The same is true of the HECM LOC.

    1. Would it be less expensive to open a regular Home Equity line of credit while still working and then only tap into that if absolutely necessary?

      I realize the amount that you can access will be much less, but then you aren't paying all of the RM fees and the interest rate could be more favorable.

    2. Chris, that's an excellent question. The problem with HELOCs, and the one that started a lot of the academic interest in HECMs, is that the lender isn't legally required to loan you the money even after you have opened the loan. During the Great Recession, when money got tight a lot of HELOC lenders simply refused to loan money to people who had already set up the lines of credit for just such an emergency. A HECM lender is legally required to lend you the money from your line of credit. The HELOC can disappear when you need it, so even if it's cheaper it may not be a bargain.

  6. Dirk, not sure if you covered this in previous posts but can you add more details to your statement "my advice is to consider opening a HECM line of credit today, while interest rates are low". Is the HECM interest rate locked or is it like HELOC LIBOR+prime? Maybe a post on how HECM payments are calculated and also if there are age restrictions to open a HECM

    1. John, you qualify for a conventional mortgage with income, but you qualify for a reverse mortgage with age. The minimum age for a HECM is 62 and the older you are, the more you can borrow. Covering all of this in a blog post would be difficult. I suggest you read Shelley Giordano's book or check out the HUD website for more details.

      There are two types of HECM's: fixed rate and adjustable rate. The fixed rate loan has, as the name suggests, a fixed interest rate and you can only take the distribution as an initial lump sum. With an adjustable rate, you can choose to treat the loan as a line of credit.

      You can choose an annual or monthly adjustable rate mortgage. The rate will be based on the appropriate LIBOR rate plus a lender margin. I have recently seen quotes from 3% to 4.75% for the lender's margin, depending on how much up-front costs you are willing to pay (more upfront costs equals lower margin).

      In addition, you will pay a mortgage insurance premium (MIP). There is an up-front MIP and an ongoing MIP that adds 1.25% to the loan payment. So, your loan payment will equal the LIBOR rate (monthly or annual) plus the lender's margin plus the MIP (1/12th the MIP for monthly).

      The reason to open a HECM line of credit now isn't because you'll pay less interest (you will now, but that rate will adjust when interest rates inevitably rise). The reason is because, due to the unique way in which a HECM line of credit grows, adjustable-rate loans that start out with today's higher maximum loan amount ($625,500) and interest rates that are more likely to rise than fall should see the borrowing limit grow faster, leaving you with the ability to borrow a larger percentage of your home's fair market value in a decade or more.

      This is the basis for the strategy of opening a loan today and not using the money until later in retirement. If HUD lowers the maximum loan amount in the future, interest rates rise, or both, this strategy becomes less interesting.