How reverse mortgages work as a source of retirement income

A home equity conversion mortgage — more commonly known as a reverse mortgage —is becoming harder to dismiss as an income tool for retirement plans.

The following is an excerpt from “Reverse Mortgages: How to Use Reverse Mortgages to Secure Your Retirement” (Retirement Researcher Media, 2016). Mr. Pfau is a professor of retirement income at The American College, director of retirement research at McLean Asset Management and chief planning strategist at inStream Solutions.

If, after your clients have considered other housing options, they decide to remain in an eligible home or to move into a new eligible home, you may want to have them consider a Home Equity Conversion Mortgage (HECM) — more commonly known as a “reverse mortgage” — as a source of retirement spending.

The vast majority of reverse mortgages in the United States are HECM reverse mortgages, which are regulated and insured through the federal government by the Department of Housing and Urban Development and the Federal Housing Authority. Other options outside of the federal program pop up occasionally, like jumbo reverse mortgages for those seeking amounts that exceed federal limits.

The HECM program includes both fixed-and variable-rate loans, though fixed-rate loans only allow proceeds to be taken as an initial lump sum, with no subsequent access to a line of credit. We will not concern ourselves with fixed-rate or non-HECM loans here. Instead, we will focus only on variable-rate HECM options.

In the past, any discussion of reverse mortgages as a retirement income tool typically focused on real or perceived negatives related to traditionally high costs and potentially inappropriate uses of these funds. These conversations often include misguided ideas about the homeowner losing the title to their home and hyperbole about the “American Dream” becoming the “American Nightmare.” Reverse mortgages are portrayed as a desperate last resort.

However, developments of the past decade have made reverse mortgages harder to dismiss outright. Especially, since 2013, the federal government has been refining regulations for its HECM program in order to:
• Improve the sustainability of the underlying mortgage insurance fund.
• Better protect eligible non-borrowing spouses.
• Ensure borrowers have sufficient financial resources to continue paying their property taxes, homeowner’s insurance and home maintenance expenses.

The thrust of these changes has been to ensure reverse mortgages are used responsibly as part of an overall retirement income strategy, rather than to fritter away assets.

REALISTIC COSTS

On the academic side, several recent research articles have demonstrated how responsible use of a reverse mortgage can enhance an overall retirement income plan. Importantly, this research incorporates realistic costs for reverse mortgages, both in relation to their initial upfront costs and the ongoing growth of any outstanding loan balance. Quantified benefits are understood to exist only after netting out the costs associated with reverse mortgages.

In short, well-handled reverse mortgages have suffered from the bad press surrounding irresponsible reverse mortgages for too long. Reverse mortgages give responsible retirees the option to create liquidity for an otherwise illiquid asset, which can, in turn, potentially support a more efficient retirement income strategy (more spending and/or more legacy).

Liquidity is created by allowing homeowners to borrow against the value of the home with the flexibility to defer repayment until they have permanently left the home.

The media has been picking up on these developments as of late, and coverage is improving. But the trend of positive coverage is still a new phenomenon, and with so much pre-existing bias, it can be hard to view reverse mortgages objectively without a clear understanding of how the benefits exceed the costs. To understand their role, it is worth stepping back to clarify the retirement income problems we seek to solve.

Retirees must support a series of expenses — overall lifestyle spending goals, unexpected contingencies, legacy goals — to enjoy a successful retirement. Suppose retirees only have two assets — beyond Social Security and any pensions — to meet their spending obligations: an investment portfolio and home equity. The task is to link these assets to spending obligations efficiently while also mitigating retirement risks like longevity, market volatility and spending surprises that can impact the plan.

The fundamental question is this: How can these two assets work to meet spending goals while simultaneously preserving remaining assets to cover contingencies and support a legacy? Spending from either asset today means less for future spending and legacy. For the portfolio, spending reduces the remaining asset balance and sacrifices subsequent growth on those investments. Likewise, spending a portion of home equity surrenders future legacy through the increase and subsequent growth of the loan balance. Both effects work in the same way, so the question is how to best coordinate the use of these two assets to meet the spending goal and still preserve as much legacy as possible.

When a household has an investment portfolio and home equity, the default strategy tends to value spending down investment assets first and preserving home equity as long as possible, with the goal of supporting a legacy through a debt-free home. A reverse mortgage is viewed as an option, but it’s only a last resort once the investment portfolio has been depleted and vital spending needs are threatened.

The research of the last few years has generally found this conventional wisdom constraining and counterproductive. Initiating the reverse mortgage earlier and coordinating spending from home equity throughout retirement can help meet spending goals while also providing a larger legacy. That is the nature of retirement income efficiency: using assets in a way that allows for more spending and/or more legacy.

Legacy wealth is the combined value of any remaining financial assets plus any remaining home equity after repaying the reverse mortgage. Money is fungible and the specific ratio of financial assets and remaining home equity is not important. In the final analysis, only the sum of these two components matters.

For heirs wishing to keep the home, a larger legacy offers an extra bonus of additional financial assets after the loan balance has been repaid. The home is not lost.

While taking money from the reverse mortgage reduces the home equity component, it does not necessarily reduce the overall net worth or legacy value of assets. Wanting to specifically preserve the home may be a psychological constraint, which leads to a less efficient retirement.

As Tom Davison of toolsforretirementplanning.com has described the matter to me in our discussions, a reverse mortgage allows a retiree to gift the value of the house rather than the house itself. Should the heir wish to keep the house, the value of the house they have received as an inheritance can be redeployed for this purpose.

UNDERLYING MECHANISMS

Two benefits give opening a reverse mortgage earlier in retirement the potential to improve retirement efficiencies in spite of loan costs.

First, coordinating withdrawals from a reverse mortgage reduces strain on portfolio withdrawals, which helps manage sequence of returns risk. Investment volatility is amplified by sequence of returns risk and can be more harmful to retirees who are withdrawing from, rather than contributing to their portfolio. Reverse mortgages sidestep this sequence risk by providing an alternative source of spending after market declines.

The second potential benefit of opening the reverse mortgage early — especially when interest rates are low — is that the principal limit that can be borrowed from will continue to grow throughout retirement.

Reverse mortgages are nonrecourse loans, meaning that even if the loan balance is greater than the subsequent home value, the borrower does not have to repay more than their home is worth.

Sufficiently long retirements carry a reasonable possibility that the available credit may eventually exceed the value of the home. In these cases, mortgage insurance premiums paid to the government are used to make sure the lender does not experience a loss. In addition, the borrower and/or estate will not be on the hook for repaying more than the value of the home when the loan becomes due. This line-of-credit growth is one of the most important and confusing aspects of reverse mortgages.

As the government continues to strengthen the rules and regulations for reverse mortgages and new research continues to pave the way with an agnostic view of their role, reverse mortgages may become much more common in the coming years. Many Americans rely on home equity and Social Security as the two primary available retirement assets.

BAD REPUTATION

Before discussing how reverse mortgages can fit into your retirement income plan, it is worthwhile to first consider in greater detail the bad reputation reverse mortgages have developed. Some aspects of that bad reputation are based on misunderstandings, some were once true but have since been mitigated, and some may still remain.

When considering a reverse mortgage, it is important to be responsible with the strategy and not give in to the temptation to treat the reverse mortgage as a windfall and spend it quickly. This point cannot be overemphasized enough, as the natural tendency may be to spend assets as soon as they become liquid. Responsible retirees have little to worry about, but if you lack sufficient self-control, reverse mortgages should be handled carefully.

Irresponsible borrowers who quickly deplete their assets and suffer later in retirement are part of the reason reverse mortgages developed their bad reputation. Recent government changes have been designed to encourage more responsible use, but in many cases, the compensation for loan officers originating these mortgages still may be linked to the initial borrowing amount. Loan officers may suggest taking more out sooner as a result. Consequently, borrowers should seek a loan originator who is not compensated based on the initial lump sum taken from the loan, unless they are also working with a trusted financial planner who can help manage this process.

Troubles regarding reverse mortgages are summarized below. Some of the troubles relate to misunderstandings, such as the idea that the lender receives the title to the home, or simple miscommunication among family members about future inheritances.

Other troubles relate to problems that have since been corrected by new HUD regulations. Some of these problems include concerns about withdrawing too much too soon, the potential problems confronting non-borrowing spouses, and foreclosures for desperate borrowers who could not keep up with their property taxes, homeowner’s insurance and home maintenance requirements.

Other problems have been addressed by the government, though these issues are not necessarily fully resolved. For many lenders, a notable cost is still involved in initiating a reverse mortgage, though these upfront costs have been reduced in recent years and some lenders can now offer minimal upfront costs. I also have concerns about whether the mortgage insurance premiums collected by the government will be sufficient to cover the nonrecourse aspects of the reverse mortgage.

KEY TROUBLES, REVISITED

Use reverse mortgages too quickly for questionable expenses.

In the past, retirees have opened a reverse mortgage to immediately spend the full amount of available credit — perhaps to overindulge irresponsibly in unnecessary discretionary expenses or to finance shady or even fraudulent investment or insurance products. This jeopardized the role of home equity as a reserve asset for the household.

Further discussion: HUD requires a counseling session and has enacted new rules to discourage taking too much too soon from the available line of credit. As of 2015, the mortgage insurance premium increased from 0.5% to 2.5% of the home value if more than 60% of the available proceeds are withdrawn in the first calendar year. Also, more than 60% of the available credit can be spent in the first year only for particular qualified expenses such as to pay off an existing mortgage or to use the HECM for Purchase program.

Family misunderstandings.

The media has reported on adult children who are surprised to find they will not inherit the house after their parents passed because their parents used a reverse mortgage.

Further discussion: Such media reports are typically based on misunderstandings on the part of angry children. Articles focus on only one aspect of inheritance (the home), and do not consider how to best meet the retirement spending needs of parents. Children can pay the loan balance and keep the home, and recent research clarifies that strategic use of a reverse mortgage to cover a fixed retirement spending need is actually more likely to increase the overall amount of legacy wealth available to children at the end.

Non-borrowing spouses.

In the past, younger spouses were taken off the home title to allow a reverse mortgage to proceed, only to be surprised when the borrower died and the non-borrowing spouse either had to repay the loan or leave the home.

Further discussion: As of 2015, new protections are in place for these non-borrowing spouses. They can remain on the home title and stay in the home even after the borrowing spouse has passed away. Though non-borrowing spouses cannot borrow more from the line of credit, they are now able to remain in the home, and lending limits will be based on their age to help protect the insurance fund. Eligible non-borrowing spouses no longer have to worry about loan repayment until they leave the home.

Home title.

Many people hold the common misconception that the lender receives the title to the home as part of a reverse mortgage.

Further discussion: This enduring myth about the HECM program is simply untrue.

Desperate borrowers.

Reverse mortgages were taken out by those who were unable to keep up with their property taxes, homeowner’s insurance premiums, and home upkeep. This could result in a default that triggers foreclosure.

Further discussion: As of 2015, a financial assessment is required to ensure that the borrower has the capacity to make these payments. If other resources are not available, set-asides will be carved out of the line of credit to support these payments. These do not become part of the loan balance until they are spent, but they do otherwise limit the amount you can borrow from the line of credit. Nonetheless, to the extent that the liquidity from the reverse mortgage leads to a behavioral issue of overspending, this is a concern for potential borrowers with limited self-control.

Foreclosures.

Foreclosures for the elderly generated by the inability to meet technical requirements of the loan generated negative media coverage and a misconstrued view of the HECM program.

Further discussion: New safeguards have been added, but it is important to keep in mind that such retirements were not sustainable in the first place. The reverse mortgage may have still created net positive impacts for the households, as their living situation otherwise could have worsened much sooner. For reverse mortgages, monthly repayments are not required, so nonpayment of the loan is not a way to trigger foreclosure. The reverse mortgage may have helped delay what was inevitable.

High costs.

Reverse mortgages are expensive to initiate.

Further discussion: In the past, the initial costs for opening reverse mortgages could be as high as 6% of the home value. These upfront costs have been reduced dramatically for competitive lenders. Nonetheless, HECM loans originated today include an unavoidable 0.5% upfront mortgage insurance premium. That adds up to $500 per $100,000 of ap-praised home value. Other closing costs for home appraisal, titling and other matters similar to traditional mortgages cannot be avoided. That being said, many lenders may charge the full allowed amount for origination charges. There are currently no easy ways to compare offers from different lenders.

Taxpayer risk.

People may worry about taxpayers being on the hook if the mortgage insurance fund is overburdened by the nonrecourse aspects of the loans.

Further discussion: Reduced housing prices in the 2000s created problems that would be addressed with the Reverse Mortgage Stabilization Act of 2013 to help make sure insurance premiums and lending limits were sufficient to keep the insurance self-sustaining. Nonetheless, this situation may not be fully resolved at the present, especially when interest rates are currently low and may rise in the future.

Stigma about using debt.

Psychologically, individuals may be challenged by the idea of using a debt instrument in retirement after having spent their careers working to reduce their debt.

Further discussion: This is a psychological constraint. If you think about the investment portfolio and home equity as assets, then meeting spending goals requires spending from assets somewhere on the household balance sheet. In this regard, spending from home equity does not necessarily need to be framed as accumulating debt any more than spending from investment assets. A reverse mortgage creates liquidity for an otherwise illiquid asset.