Forget the negative media reporting on reverse mortgages and forget the television commercials promoting reverse mortgages. A reverse mortgage can be a way to use home equity safely and strategically. Home equity is perhaps the least-used asset in most retirement plans.
With the right strategy, a reverse mortgage can use the home equity to reduce investment risk in retirement or increase lifetime income. Reduce portfolio risk. One of the biggest risks to retirees, especially those in the early years of retirement, is what economists call sequence of return risk. A retirement plan often assumes investments will deliver their long- term average return.
That’s reasonable for someone who is years away from retirement. But investments, especially stocks, don’t earn the long-term average year after year. Instead, they have years of returns well above average, such as the last few years, and years of below-average returns.
More importantly, stocks can have long periods of below-aver- age returns. Years of below-average returns can derail a retirement plan, especially when they occur early in retirement. Your portfolio is likely to have its high- est value ever at that point, since you’ve been saving and investing for years and haven’t taken many withdrawals.
A decline of 20% or more will sharply reduce the value of the nest egg. Plus, you’ll be withdrawing money from the portfolio, so it won’t all be bouncing back from the downturn as happened while you were working. This is where a reverse mortgage can be valuable.
There are several types of reverse mortgages. For this strategy, you want a home equity line of credit (HELOC).
You set up the reverse mortgage HELOC early in retirement. You can do it any time beginning at age 62. There will be some set-up costs, but there won’t be any interest charged until you borrow from the HELOC. You don’t draw from the loan while the portfolio is doing well. But the investments might lose value, and then you don’t want to be drawing down the portfolio.
You want as much money as possible to stay in the portfolio to take advantage of the future market recovery. At this point, you draw on the HELOC to help pay retirement ex- penses. Use any interest and dividend distributions from the portfolio, as well as Social Security and any other regular sources of income, to pay expenses.
But instead of selling assets to make up any shortfall, draw on the line of credit. You draw on the line of credit until the portfolio appreciates to a value at which you’re comfortable resuming withdrawals. Then, you can stop drawing from the HELOC. You even can repay some or all of the HELOC borrowing after the portfolio recovers so that you’ll have the maximum line of credit available when the next market downturn occurs.
Several studies in recent years demonstrated that using a reverse mortgage in this way increases long- term growth in the portfolio and reduces the risk of outliving your assets. The strategy is known as using a re- verse mortgage as a buffer asset and is especially valuable to someone whose primary source of retirement income is from 401(k)s or IRAs and whose net worth is $1.5 million or less.
But it’s valuable in other situations as well. Increasing guaranteed lifetime income. One way to avoid outliving your money is to have guaranteed life- time income. Almost all of us have one source of guaranteed lifetime income: Social Security. One alternative is to use a reverse mortgage to generate what’s called a tenure payment.
Instead of borrowing a lump sum or establishing a HELOC, you set up the reverse mortgage to send you fixed payments for life. You turn home equity into a guaranteed stream of income.
But there might be a better strategy. Set up the reverse mortgage as either a line of credit or a lump sum. Then, take the money from the reverse mortgage and use it to buy a commercial immediate annuity, also known as a single premium immediate annuity (SPIA).
The reason to do this is most of the time, a SPIA will pay you higher fixed payments for life than the tenure payment from a reverse mortgage. Run the numbers first and shop around for annuities to be sure this will work in your case, but often that’s the way to maximize guaranteed lifetime income.
There’s a caveat to this strategy. The Department of Housing and Urban Development (HUD), which oversees reverse mortgages, doesn’t allow a reverse mortgage to be taken to buy an annuity. That’s because of some abuses by insurance salespeople in the past. Instead of targeting its rules at the abuses, the Federal Housing Administration (FHA) won’t allow a reverse mortgage to be used to purchase any annuity. What this means is that you need to have additional funds other than home equity to purchase the annuity.
For example, take money out of your savings or investment portfolio to purchase the annuity. Then, replace it with the proceeds from the reverse mortgage. Unfortunately, if you don’t have those funds, you can’t use the strategy. Delay Social Security. You maximize lifetime guaranteed and inflation-protected income by delaying Social Security retirement benefits until age 70.
Many people say they can’t afford to do that, because they stopped working and worry about depleting their retirement portfolios if their income isn’t supplemented by Social Security. Studies demonstrate that it pays off in the long run to take more out of your nest egg to pay expenses early in retirement so you can delay Social Security benefits. Another option is the reverse mortgage.
Set up a HELOC at age 62 or when you retire. Draw on the reverse mortgage to help pay living expens- es and reduce portfolio withdrawals while delaying Social Security benefits, preferably to age 70. Reverse mortgage basics. In this article I discuss federally guaranteed reverse mortgages.
A few lenders offer private reverse mortgages, but there aren’t many and they don’t carry the guarantee. The money you receive from a reverse mortgage isn’t taxable. You’re borrowing against the home equity.
Interest will accrue on the out- standing reverse mortgage balance. No payments are due until the home no longer is your principal residence. After that, proceeds from selling the home first will be used to repay the reverse mortgage balance. If the home’s value isn’t enough to repay everything, the government insurance fund pays the difference to the lender. Y
ou, your estate and your heirs won’t be on the hook for the difference. If any home sale proceeds remain after the reverse mortgage obligations are paid, your heirs can inherit the excess. A reverse mortgage borrower must be age 62 or older. You can borrow only against home equity, so the home should have no existing mortgage or a small mortgage.
You need to meet with a HUD-approved counselor who must certify that you understand the loan and that you have enough resources to continue paying real estate taxes, homeowner’s insurance and maintenance on the property.
The determination of the maximum amount you can borrow and the interest rate charged can be complicated. Gener- ally, the lower current interest rates are, the more you can borrow. Also, the older you are, the higher the percentage of the home equity you can borrow.
If you take out a HELOC, the amount you can borrow can increase over time, especially if interest rates increase. At any time, you can repay amounts outstanding on a reverse mortgage. There are up-front costs to establishing a reverse mortgage.
Some are imposed by HUD, and the lender charges others. You can pay the upfront costs from your resources or have them added to the reverse mortgage balance. The lender will charge an origination fee, which can’t exceed $6,000. Traditional real estate loan closing costs also will be charged, such as an appraisal fee, title search, recording fees and probably others. HUD charges an initial mortgage insurance premium of 2% of the home’s appraised value.
There also will be an annual mortgage insurance premium equal to 0.5% of the outstanding balance. The lender is likely to charge regular servicing fees if the loan is outstanding. Shop around before taking out a reverse mortgage. Interest rates and fees vary considerably. Take a look at the “kosher mortgage” lenders listed on the website of the Mortgage Professor (www. mtgprofessor.com).