In discussing the challenges that many seniors face during their retirement years, Wharton emeritus finance professor Jack Guttentag, who runs a website called The Mortgage Professor, offers his perspective on how reverse mortgages can be a good strategy for a certain segment of the population.
Retirement has become a frightening prospect for millions of Americans who have not made adequate financial preparation for it, yet face the likelihood of living much longer than any prior generation of retirees. The Center for Retirement Research at Boston College reports that more than half of all households will not be able to maintain their standard of living in retirement.
The Home Equity Conversion Mortgage (HECM) — a reverse mortgage insured by the Federal Housing Administration (FHA) — is the only reverse mortgage program that survived the financial crisis, and it is a partial solution to the challenge facing many retirees. It is partial because it is feasible only for homeowners who have significant equity in their homes on retirement. But that is a very sizeable chunk of the retirees who need help. This article focuses on three seniors whose problems differ in severity, but each of the three is typical of millions of others.
- John retires at 65 with few financial assets, is largely dependent on social security for income and still has a (paid-down) balance on his mortgage.
- Mary is in the same position as John, except that her mortgage is paid off.
- Leslie has no mortgage debt and significant financial assets from which to draw spendable funds, but faces the risk that the funds will run dry while he is still alive.
John Pays Off a Forward Mortgage: The received financial wisdom of my generation was that your mortgage should be paid off by the time you retire. John, like so many others in his age cohort, did not follow this principle. He has a mortgage balance of $50,000 on a house worth $110,000, and is obliged to pay $540 a month until the balance is paid off, which won’t happen for seven years.
But John can use a reverse mortgage to pay off the balance now. This makes the best of a bad situation by replacing debt that John must repay in monthly installments with debt that doesn’t have to be repaid until he dies or moves out of the house permanently. Being relieved of the burden of paying $540 a month is the equivalent of having that much additional monthly income.
The unavoidable downside is that by using most of his reverse mortgage capacity now, he retains little capacity to draw spendable cash in later years. After repaying his mortgage balance, only about $13,000 remains, which he can draw in cash or leave as a credit line for future use.
There are a lot of Johns out there, but many are in the less populated parts of the country where reverse mortgage loan originators and counselors are hard to find. Getting the word out about the availability of the reverse mortgage option is a challenge I will be discussing in another article.
Mary Takes a Tenure Annuity: Mary has the same balance sheet as John except that at 65 when she retires, her mortgage will be paid off. This means that Mary has more options than John in how she uses a reverse mortgage. The principal options are a credit line for about $63,000, which grows over time if not used, a monthly “tenure” payment which will pay her about $331 a month for as long as she lives in her home, or some combination of the two. She could also select a monthly term payment, which would be larger than the tenure payment but cease when the term is over.
Since Mary wants to supplement her income permanently, by as much as possible as soon as possible, she will take the tenure payment. However, this doesn’t commit her forever, since a tenure plan can be modified at any time for $20 paid to the servicer. For example, if Mary finds after two years that the monthly tenure payment won’t be needed for a while, she can switch to a credit line of about $59,000. The line will grow in size from that point on, and if she swings back to a tenure payment after a few more years, it will be larger than the one she had originally.
In the opposite case, where she needs a larger monthly payment for a limited period, she can switch to a term annuity, with the option of switching back to a tenure payment or to a credit line any time before the expiration of the term. The HECM reverse mortgage is marvelously flexible.
Leslie Takes a Credit Line: Leslie just retired at 65 and is now largely dependent for current income on the wealth he managed to accumulate over his working life. It amounts to $600,000 in financial assets plus a house he owns mortgage-free worth $300,000. His financial status is thus a lot stronger than that of John and Mary. But Leslie has a richer lifestyle as well, and he is concerned about his ability to extend it indefinitely.
The financial advisor who manages Leslie’s money tells him that if he draws down his financial assets every year by the amount needed to maintain his lifestyle, the probability of running out of money before he dies is “only 5%.” That is supposed to make him feel secure, but it doesn’t – it makes him feel anxious. Nobody wants to spend their twilight years hoping they die before reaching the point of impoverishment.
Of course he could sell his house, which would increase his investable assets to about $900,000, but the cost of substitute shelter could eat up most or all of the additional investment income. Or he could wait until the worst happened and sell the house then, but the thought of having to move at that point in life is frightening.
The solution for Leslie is to take a line of credit under a HECM reverse mortgage and leave it unused indefinitely. This allows him to remain in his house while removing the threat of future impoverishment if he lives well past his life expectancy.
Based on interest rates prevailing on July 3, 2013, Leslie at 65 could obtain a credit line of about $159,000 on his $300,000 house. The line would cost him about $11,700 in fees, which are financed – there is no out-of-pocket drain.
The credit line and debt grow over time at a rate equal to the mortgage interest rate plus the mortgage insurance premium. On July 3, these were 2.82% and 1.25%. Assuming that these rates stay the same, Leslie’s line would grow to about $238,000 in 10 years.
But wouldn’t Leslie do better simply by waiting to see if the line is needed, and if so, taking out the credit line then? That would risk a drop in the maximum available line, and perhaps a very large drop. The main reason is that interest rates are very likely to rise over the next few years. Higher interest rates increase the growth rate of unused credit lines but reduce the maximum size of new lines.
And there is still another reason. The FHA, which insures lenders against loss on HECMs, assumes in calculating maximum credit lines that the borrower’s home will appreciate at an annual rate of 4%. The risk that Leslie’s home will appreciate by less than 4% is assumed by the FHA. It is a major reason why Leslie pays an insurance premium. On the other hand, if his house appreciates by more than 4%, he can refinance the HECM to take advantage of it.
In sum, taking the reverse mortgage now eliminates Leslie’s exposure to both interest rate risk and property value risk.