If anyone had told me ten years ago that I would someday write favorably about reverse mortgages, I would have looked at them cross-eyed. Very few financial products have been the source of so much bad press and consumer misunderstanding. Variable annuities hold the top spot in this category. As with variable annuities, some of the bad press around reverse mortgages has been justified, if not over-played. Perhaps you’ve read about a relatively young widow being forced out of her home when her husband died because they had previously taken her name off the deed in order to receive a larger reverse mortgage. Or the couple who took out a reverse mortgage as a lump sum cash payment, only to blow through it in one year on questionable investments. They subsequently lost their home because they couldn’t afford the property taxes. Stories like these stick in people’s minds, despite being relatively uncommon. Moreover, first impressions are hard to overcome even when product improvements and additional consumer protections are introduced.
So, just what is a Reverse Mortgage, anyway?
A reverse mortgage (known in the financial services industry as a Home Equity Conversion Mortgage, or HECM) is a loan 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 (basic maintenance requirements are specified in the loan agreement) and pays the property taxes and homeowner’s insurance on time, the loan does not have to be repaid until the homeowner leaves the home (i.e., moves or dies). A surviving spouse (even if younger than age 62) who was not the borrower but has lived in the home may remain there until he or she moves or dies. When one of these scenarios does occur, the loan must be paid back in full with interest. The debt is often retired by selling the home, but not always if other resources are available. After the loan is repaid, any excess home equity goes to the homeowner, or the homeowner’s estate if the homeowner has died. (A non-borrowing surviving spouse or the spouse’s estate would not be responsible for repaying the loan.) It is also possible for heirs to hold onto the property simply by paying back the loan from other assets, including their own. They can also pay it back by taking out another loan. After all, the lender would prefer to receive liquid cash over illiquid property if at all possible.
A HECM insured by the Federal Housing Administration (FHA) is a non-recourse loan, meaning that the FHA will absorb any excess remaining on the loan balance if, at time of repayment, the home’s sales proceeds do not cover the full balance owed. Proceeds from the home’s sale (or signing over the deed to the lender) satisfies the loan in full. This is to the borrower’s advantage in the case where property values have declined significantly between the time the loan was first issued and the time of sale. In this case, the lender would acquire the value of the home or the home itself, but nothing more.
Setting the record straight
There are some common misconceptions about reverse mortgages that have persisted over the years. For example, many people think that the bank holds the title to your home when you take out a reverse mortgage. Not true. You, the homeowner, retain the title. Some believe that reverse mortgages are only for those who are unable to meet their monthly homeowner financial obligations, such as property taxes, insurance, and utilities – the “last resort” option, if you will, for staying in the home during retirement. That may be true for some borrowers, but certainly not all. A third common misconception is that the up-front costs on reverse mortgages are very expensive, upward of $20,000 or more. This used to be the case, and the cost depends on how (and with whom) you configure the loan agreement, as well as how much of the amount available to you is actually used in the first year. In many cases, however, the up-front costs are significantly less than they used to be.
Some myths have never been true. Others used to be true but have changed in the consumer’s favor due to recent industry regulations, changes in loan underwriting requirements, and competition among lenders. Finally, although not a misconception per se, some people just don’t like the idea of taking on debt in retirement, even if they don’t have to pay it back during their lifetime.
If configured wisely and used judiciously, a reverse mortgage can increase a homeowner’s financial flexibility by freeing up additional resources once considered illiquid and therefore out of reach. Certain improvements in how the loans are structured, newly available borrowing options, and cost reductions due to competition are causing people, including financial planners, to give reverse mortgages a second look.
How much can someone borrow, and what form might the loan take?
In 2016, the amount someone may borrow is a percentage of the home’s value or $625,500, whichever is less. This percentage is called the Principal Limit Factor, or PLF, with the Principal Limit being the actual dollar amount one can borrow. So, even if your home is worth $1.5 million, only the first $625,500 would be considered in the Principal Limit calculation. As an example, it is not uncommon in a low interest rate environment for a 62-year-old to be eligible to borrow approximately 50% of the home’s value, or 50% of $625,500, whichever is less. Generally speaking, the older the borrower is, and the lower interest rates are (in particular, the 10-year LIBOR rate), the higher the PLF and therefore the higher the Principal Limit.
A borrower may receive the reverse mortgage loan in one of several ways:
- A lump sum cash payment at the start of the loan
- A line of credit that can be tapped when needed (but there is no obligation to do so)
- A fixed-term regular monthly payment, to continue until a specified future date
- A “tenure” payment for as long as you live (similar to a life income annuity)
The line of credit option is especially noteworthy: just like a regular home equity line of credit (HELOC), borrowers are charged interest only on the portion of the credit line they actually use. Unlike a HELOC, however, they do not have to repay principal or interest until they leave their home. Also, whereas a HELOC has to be renewed after a certain period (typically 10 years), a reverse mortgage line of credit remains in place as long as the loan is active.
Perhaps the most intriguing aspect of the credit line is that the portion of the Principal Limit that is not used will continue to grow over time at some pre-specified growth rate. For example, if you take out a line of credit for $300,000 and don’t use it for the first 10 years (i.e. you maintain a zero debt balance), the entire amount available to you in the 11th year will be noticeably more than $300,000. Theoretically, it could even surpass the value of the home, although this would be more likely to occur if the home’s resale value declined significantly. This supports the notion that if you are going to take out a reverse mortgage (with the credit line option), it is better to start it when you are relatively young (i.e., close to age 62) rather than waiting to apply until you actually need the money.
The reverse mortgage line of credit is also used to fund the fixed-term or tenure payment options mentioned above. With these loan options, the total pool of available funds is not likely to grow as much over time because the debt balance is constantly growing and is therefore a greater proportion of the Principal Limit. However, these options are sometimes appropriate for more constrained borrowers.
Coming up in next month’s newsletter
There are numerous ways to use a reverse mortgage, only some of which relate directly to being able to stay in one’s home during retirement. A reverse mortgage can be integrated with a Social Security claiming strategy in order to ensure the highest Social Security benefit. It can be used as a substitute for drawing from retirement accounts in a down market (selling low), in the hope that the market will rebound. It can partially substitute for long-term care insurance if one is not eligible for coverage. It can even be used to pay off a regular mortgage or fund the purchase of another home. In next month’s newsletter, I will provide some examples of how a reverse mortgage might be used as a strategic component of an overall retirement income plan. I will also provide more detail about the loan eligibility process and for those eligible borrowers, how a loan amount is calculated.