Reverse Mortgages, Part 2: Increasing financial flexibility by leveraging the equity in your home
Posted by Rick Fine on December 20, 2016
In last month’s newsletter, I discussed reverse mortgages and attempted to clear up some common misconceptions about this product. As I explained, reverse mortgages are loans offered by a commercial lender to an age 62+ homeowner using a portion of their home equity as collateral. As long as the homeowner-borrower adequately maintains the home in good working order and pays the property taxes and homeowner’s insurance on time, the loan does not have to be repaid until the homeowner moves or dies. After the loan is repaid, any excess home equity goes to the homeowner, or the homeowner’s estate if the homeowner has died. When applying, you have several options for taking the loan, including lump sum, line of credit, fixed term monthly payments, and tenure payments (similar to a life annuity) The line of credit option is appealing for many borrowers because the portion not used will accrue, thus increasing borrowing capacity over time.
In this article, I give examples of how a reverse mortgage might be put to good use by individuals and couples. I also discuss eligibility requirements and how a loan amount is calculated.
Potential uses for a reverse mortgage
Reverse mortgages can help preserve one’s living standard after a financial loss
Mary Sondheim’s husband passed away five years ago after a long illness that prevented him from working full-time during the apex of his career. Due to poor planning, as well as a distaste for insurance, her husband was inadequately covered for disability and life insurance that would have replaced a large portion of his lost wages. Now, at 65, Mary is facing a financial shortfall. Fortunately, her home, which she’s been told is worth approximately $800,000, is fully paid off. She owns a ranch-style (one floor) home, lives close to town, and has supportive neighbors. So, she would prefer to age in place if at all possible. At her age, a reverse mortgage on an $800,000 home might yield close to $300,000, which when added to her $750,000 in retirement assets, would enable her to age comfortably in her own home, provided she keeps her spending to a reasonable level. If she takes that $300,000 as a line of credit and doesn’t tap it for many years, that credit line could grow substantially by the time she needs to borrow from it. In the meantime, no interest charges would apply as long as she retains a zero balance.
Reverse mortgages can help you delay Social Security and IRA distributions after retirement
Bert and Linda Fenton are now 66 and 60 years old, respectively, and are in excellent health. Bert, the primary wage earner in the family, has decided to call it quits at his company. There is only one problem: most of his savings are in tax-deferred accounts, such as IRAs, and the market has been on a downward trend lately. With no more paychecks in his future, he will be forced to draw from his IRA at an “inconvenient” time in the market. These withdrawals would, of course, be subject to state and Federal taxes. He could file for Social Security benefits now, but his financial advisor strongly recommends delaying benefits until age 70, when he would be eligible for 32% more in lifetime benefits than if he started at age 66. This could come in handy in the event that he ends up living well past average life expectancy, which is likely given his family history. A reverse mortgage line of credit against the Fenton’s $650,000 home would provide more than enough spending money until the age of 70, when Bert has to start taking Required Minimum Distributions (RMDs) from his IRA, as well as start collecting Social Security. At that point, he will have more than enough income to cover monthly expenses AND pay down the credit line. Once the credit line is paid off, he can keep it in place as an emergency fund. Bert is reluctant to withdraw money from his retirement accounts while the market is down, so he is seriously considering the reverse mortgage, even though he realizes that there is no guarantee that the market will rebound in the desired four-year time-frame. He thinks it is worth taking the risk, especially when considering the additional Social Security benefits by waiting until age 70 to file.
Reverse mortgages can act as a long-term care funding resource
Tony and Beth Newington, both age 67, have just retired. Tony’s job was phased out due to technological innovations that made it possible to automate most of his daily tasks. Beth’s career was secure, but she has arthritis that makes it difficult to fulfill the demands of her job. The Newingtons have sufficient assets to maintain their living standard throughout retirement, provided there are no major contingencies that could derail their finances. Their biggest concern is the potential need for long-term care later in life. They could probably fund a year or two in a nursing home, but Beth has a family history of Alzheimers. Her mother and grandmother both suffered for approximately ten years. They both had to be moved into assisted living and eventually a nursing home once the illness had progressed past a certain point. The Newington’s retirement portfolio would not withstand this type of financial crisis, and it could leave Tony in dire straits if he survived Beth. Neither spouse is eligible for long-term care insurance due to pre-existing conditions that are disqualifying from an insurer’s perspective. They are eligible to take a reverse mortgage against their $700,000 home, which they own outright. At their age, they would potentially qualify for a $375,000 loan. Due to their concern that Beth might eventually need to leave the home for assisted living, they thought it would be best if Tony were listed on the contract as the sole borrower He could take the loan as a credit line and let it accrue at 3.5% per year until they need the money for long-term care. If the credit line grew to, say, $500,000 over 10 years, this amount would fund many years of in-home long-term care for both of them, or several years in an assisted living or nursing facility for Beth, while Tony remained in their home. The loan would not have to be paid back until the second spouse (probably Tony) leaves the home. If Tony predeceased Beth, she would be allowed to stay in the home as long as she was healthy enough to maintain it.
Reverse mortgages can be used to buy a new home without incurring monthly mortgage payments
Kathy and Tom Carson always wanted to retire to the Oregon coast. Now that they have both stopped working, they are reviewing their finances to see if they can fulfill their life-long dream. They think they can buy something in Oregon they would be happy with for approximately $300,000. Although they have paid off the mortgage on their $400,000 primary residence, they would prefer not to tie up most of their home equity in the purchase of another home. They recently learned that a reverse mortgage can be used along with a down payment to buy a new primary residence for cash. After seller’s costs, they would most likely net $375,000 from the sale of their current home. They can then buy a new home in Oregon for $300,000 using only $140,000 of the sales proceeds, supplemented by a reverse mortgage of $160,000, leaving $235,000 to go back into their investment portfolio ($375,000 net sales proceeds minus $140,000). The reverse mortgage would not have to be repaid until they leave their Oregon home. The $235,000 will be used to support their lifestyle during retirement.
How do I know if I can get a reverse mortgage loan?
The basic requirements to become eligible for a reverse mortgage are:1
- Age (borrowers have to be at least sixty-two)
- Equity in your home
- Financial resources to cover property taxes, insurance, and maintenance expenses
- No other Federal debt
- Receipt of a counseling certificate from an FHA-approved counselor for attending a personal counseling session on home equity options
For your property to be eligible, it must:1
- Serve as your primary residence
- Meet FHA property standards and flood requirements
- Pass an FHA appraisal
- Be maintained to meet FHA health and safety standards
If your home does not meet all standards, some home improvements may also be required to initiate a reverse mortgage.
How much can I borrow on a reverse mortgage?
For eligible borrowers, the Initial Principal Limit (the amount one can borrow at the loan’s outset) is determined by combining the home’s appraised value, the borrowers’ ages, the 10-year LIBOR Swap Rate, and the lender’s margin (set by the lender) into a series of formulas that culminate with the Initial Principal Limit. For all you math geeks out there, it looks like this:1
- The Expected Rate (%) equals the 10-year LIBOR Swap Rate plus the Lender’s Margin.
- The Principal Limit Factor (%) equals [(1 + ) divided by (1 + )] all to the power of the younger borrower’s remaining life expectancy.
- The Initial Principal Limit equals: Principal Limit Factor multiplied by the lesser of the home’s appraised value or $625,000.
As you can see, a borrower’s income, value of financial assets, and health history do not factor into the loan amount calculation (although income and financial assets are factored into determining eligibility). Based on the above formulas, it also appears that lower interest rates and higher ages at time of application result in a higher Initial Principal Limit. In fact, interest rates are more important than age in determining how much of a loan one initially receives.
If a borrower takes the Initial Principal Limit as a line of credit, any amount not actually used by the borrower will grow at the rate specified in the contract, resulting in greater borrowing capacity over time. For those who are well suited to using a reverse mortgage, and in particular, the credit line option, they should consider securing the loan sooner rather than later and allow the credit line to grow over time, for maximum borrowing capacity later in life.
Final thoughts on reverse mortgages
Reverse mortgages are not for everyone. People who are fully funded for retirement (can achieve all their life goals with current financial assets, Social Security and perhaps other forms of income, without having to rely on home equity) do not need a reverse mortgage, although they may wish to use one to leverage their home equity. At the other end of the spectrum, those who have minimal retirement savings or a poor history of managing debt and other financial obligations probably wouldn’t do well with a reverse mortgage (in fact, they might not even be eligible). Reverse mortgages are most suited to people who fall somewhere in between.
Also, you should be aware that there are certain features of reverse mortgages that may not be sustainable over time. For example, the tenure payment option does not rely on actuarially based life expectancy tables as regular income annuities do. Lenders could find themselves losing money if many borrowers who chose that option live longer than expected. Likewise, when lenders created the line of credit option, they didn’t take into account that borrowers might not use them for an extended period of time, thus growing the borrowing capacity of the loan potentially to a level that is more than the home is worth. As lenders gather more data from existing borrowers, it is entirely possible that they will tighten restrictions on the terms of these loans, perhaps not for current borrowers, but certainly for new ones.
Finally, for those who do apply for a loan, it is important to shop around with the help of your financial advisor and an attorney who has experience in scrutinizing these types of contracts.
1Wade Phau, PhD, CFA; Reverse Mortgages – How to Use Reverse Mortgages to Secure Your Retirement; Retirement Researcher Media, McLean, Virginia; pp. 59-61.